People often manage their own properties to save money... but what if I were to tell you that you might simply be wasting your time?
Oh the lure of a 'Passive Income' eh? The idea of earning a living without doing anything beyond an initial amount of time/effort/investment - sounds appealing doesn't it?
After re-reading my commentary today, I realise that the length might not be digestible for all and so here is the synopsis:
[A passive income is independent of our time input; managing a rental property ourselves converts a passive income into an active one; once we get active we effectively chose to earn a lower hourly rate than if we are passive and eventually we will run out of time to maximize the value of our rental portfolio. This decision actually becomes a lifestyle choice, where the opportunity cost could be time spent in leisure, travelling or with family for example. In order to get to the ‘ideal’ situation of being financially independent living off a passive income we need to make a commitment to saving for investment purposes now and develop a mind-set of a professional property investor rather than that of a professional property manager.]
Now back to my commentary if you are still in the mood…
First, a quick distinction is required; so here is my definition of passive income - Earnings that are not dependent on any significant amount of time input, with examples being:
And here is my definition of active income - Earnings that are to at least to a reasonable extent dependent on our time, with examples being:
Being self-employed (no employees)
Trading anything (i.e. buying and selling cars, antiques, eBay, shares, houses, etc.)
Any work that is paid by the hour/day or other time-based input
The sharp-eyed will have noticed that rental income appears in both lists with an asterisk. The reason being that as the featured article highlights, having a rental property could be defined as being either active or passive dependent on whether we manage the property ourselves or pass this over to an agent or property manager to undertake instead. As a side note, this concept can apply equally to other tasks involved in a rental business such as sourcing, refurbishment & maintenance.
So, the most important rule that defines whether our income is passive or active is that of time-dependency. Here, I am referring to the time required to maintain the income stream rather than setting it up in the first place. The time required to set up the income stream is actually an ‘investment’ (and we could easily quantify it and cost it out to measure our returns). However, time that is required in order to continue to receive the income is not an investment it is ‘labour’ and time-based labour is what makes this income active rather than passive.
With property management we have both a choice and cost associated with managing our property or properties. When we have a single property or even two, it would probably be difficult to live off the rental income unless we were fortunate enough to have such a sizeable property and / or have it without a mortgage. In this situation there would be a temptation to avoid paying for someone else to manage the property at c10%-15% plus VAT as a letting agent fee and instead keep this for ourselves. After all, once we get closer to 3 or 4 properties these letting fees added on top of our net rental income could in fact start to add up to a level where perhaps we could earn a living from the property, couldn't they?
I think this is where a number of property investors need to make a conscious decision as to their reasons for investing in the first place. But there are other factors that need to play a part in this decision and these include lifestyle and opportunity cost as two of the main ones.
Starting with opportunity cost - this is the idea that by doing something (or even by not doing something) there will be some sort of price to pay, be it an actual cost or a loss of something else. An opportunity cost in economic terms is by definition a financial measure but for me it could also be non-financial. To illustrate, in economic terms, if you had £10k in a savings account earning interest of say 3% and you are presented with an opportunity to lend this money to your brother to help him fund his marriage say, he may agree to pay you back along with 5% interest. Applying the concept of opportunity cost would mean that rather than making 5% you would in effect be making 2% as you would need to deduct the 3% you already receive by leaving the money on deposit. The opportunity cost here of lending to your brother is that of earning interest from the bank or building society. Other factors play a part such as risk and how long your money is 'locked in' also. A non-economic example of opportunity cost could be where you had a day job and started a business in your spare time but you also have a family that will see less of you. The opportunity cost of starting the business would be less time with your family, at least to begin with is what you hope.
The other significant factor to consider is lifestyle - this is a wide-ranging concept that covers leisure pursuits, travel interests and community projects for example, along with where and how you live, eat, hang out, etc. But the simplest definition for me is how do you wish to spend your time and Mars sum this up well with their 'work, rest & play' slogan (you can decide where community projects sits here if that is your passion...).
Now, after all of my ramblings we start to get to a common denominator don't we? Yes, it is time. Passive income is time independent (largely at least), pursuing our lifestyle interests requires sufficient available time and the non-economic opportunity cost has a time cost aspect to it also.
Some investors are not really looking to be 'investors' as such - they are looking for an alternative way to earn a living and in a similar way to buying a franchise chose to buy a rental property and spend their time on managing it in return for retaining most of the available rental income. This is in itself a lifestyle choice but also one that requires a conscious opportunity cost in where they can spend their time.
Other investors realise that by getting people, money and assets to work for them that they can leverage these drivers to generate even higher levels of income in the longer term. Nearly all of the Times Rich List are either entrepreneurs or have earning assets such as property working for them. An entrepreneur leverages the time and knowledge of others to generate profits over and above the cost of paying for them. We have already seen how a property investor can generate an income from their asset.
Perhaps what separates these two categories or passive or active investor is a commitment to carry on investing after a good start – many investors will be limited by time as a result of spending time managing their properties, whilst others will be hampered by the amount of capital they have and so plateau that way.
I think the point of the article and that of the big-thinking property investment gurus is that we have to view our time in a completely different way. What is the true value of an hour of a property millionaire in net equity with a 50% leveraged portfolio? Well, assuming a rather modest 6% yield it is around £75 per hour gross. If you were paid £75 an hour would this change how you approached how you would handle finding a tenant, or chasing a late rent payment or dealing with a faulty boiler? The mental trick is to realise that you are that £75 per hour property investor well before you actually are, so that you can take a decision to outsource some of the more systematic aspects of the business and instead focus on how you can get to owning enough property to attain that £1m net equity portfolio in the first place. The answer probably lies in investing more into saving for future deposits as possible, so that you can have more properties generating a passive income sooner. I realise that retaining the letting / management fees can play a part here but only if it is all reinvested and not relied upon to live on.
A passing note to those that might think this type of property portfolio as obscene. If you think of a pension fund requirement to replace an income in retirement, we would need a pension pot in the region of £1.67m to replace an average couple’s incomes into retirement at today’s annuity rates. In that sense, my £1m net equity property portfolio actually looks on the light side really doesn’t it? Oh and did we realize that the new pension fund limit of £1.25m means the tax benefits of investing in a pension beyond this limit are totally eliminated with the excess fund size being taxed at 55%!
In conclusion, in order to achieve that passive income we need to save hard, invest wisely and realise that our time has a significant value attached to it. Whilst it is tempting to bag the management fees ourselves it can actually be better in the long run if we spend as much time as possible on the business rather than in it. A difficult concept to grasp and even more difficult to practice at times all the same.