Mail Bag: How Would You Convert a Pile of Money Into Passive Income?

Here’s a good question for beginners about how one might think about converting an asset base, or pile of cash, into a stream of passive income.

Hi Mr. Kennon,

I’ve been a reader of your blog for quite a few years now, and i’ve learnt a lot from you. Thank you for continually sharing your knowledge.

My question is, if a person who sets up an internet company, and later sells it for millions, how could he invest so that he would still live be able to live on enough passive income a year?

Thanks.

jclifesuc

Whether it was selling a business, receiving an inheritance, or winning the lottery, a person who suddenly found themselves sitting on a large pile of cash, and who did it without slowly amassing that cash through investing, would need to begin putting the money to work in assets that produced passive income.  To understand what this means, I wrote a very basic explanation of passive income over at my Investing for Beginners site at About.com.

In layman’s terms, it comes down to needing to convert a pile of money into assets that produce a stream of money.  If you manage your risk well, and operate conservatively, a pile of money can run out whereas a stream of money can last much longer.  Do it right and your children and grandchildren could still living off it when you’ve left this world for the sweet by and by.  Just look at Quincy, Florida – a big chunk of the town is still living off the secret Coca-Cola fortunes their grandparents and great-grandparents amassed.

There are only so many places you can execute this conversion process of turning a pile of capital into a stream of earnings.  We call these asset classes.  A few of the major asset classes are:

• Business equity (you own private companies or stocks),
• Fixed income (you lend money to institutions or people in the form of bonds, certificates of deposit, direct loans, etc.),
• Cash and cash equivalents (meant to be stable and safe, such as FDIC-insured checking deposits on Treasury bills),
• Real estate (apartment buildings, storage units, office buildings, townhomes, rental houses, industrial warehouses), and
• Commodities (gold, silver, wheat, soybeans).

There are lots more, but most people keep almost all of their net worth in those major categories.  Each asset class has its own risks, rewards, dangers, traditions, laws, and economics.   Some securities, such as mutual funds, are not really an asset class themselves (some people mistakenly refer to them as such), but more of a mechanism through which you own one of the big asset classes.

If it were me, I would want a mix of my assets coming from all of the asset classes, with a heavy emphasis on business ownership and real estate.

Let me walk you through what I mean.  Please understand that none of this is intended to be, nor should be taken as, investment advice.  I’m solely interested in sharing a high-level view of what the primary mechanics might look like to help better illustrate the task at hand; to clarify and focus what it is I want to accomplish as I set about structuring my holdings.  In that sense, the question I am going to answer is not, “How would you convert a pile of money into passive income?” but, rather, “How would you think about converting a pile of money into passive income?”.

With that said, imagine that you had $10,000,000 (throughout my response, I’m going to use “you” to refer to the royal “you”, as in everyone or our hypothetical investor, not you, specifically).  You started some business, sold it, and have no idea what to do with this money.  You decide to take $2,750,000 and build apartment units such as this, paying all cash and using no debt:

 

(On a side note: If you were an experienced real estate operator with a good history of understanding risk and protecting your downside, it might be perfectly reasonable to choose a conservative capitalization structure and, instead, build $5,500,000 worth of property using $2,750,000 in equity and $2,750,000 in debt.  If you were particularly sophisticated, you might even do something like create a real estate partnership, contribute your $2,750,000 in equity, raise more equity from passive investors, take on debt financing that was non-recourse, earning management fees of some sort for your role in structuring the entire operation, effectively providing leverage and economics of scale on your equity capital in a way that, properly done, can involve less risk than trying to handle the project entirely with your own wealth.  That is far beyond the scope of the simplified, theoretical academic exercise in which we are engaging but, frankly, the latter would probably be my approach given my comfort with starting companies and handling day-to-day operations.)

You hire a real estate management company to take care of everything for you.  On a pre-tax cash basis, you should demand at least $22,500 per month in rents after paying expenses.  As long as you maintain the property, and it is located in a healthy market, you now have a money machine.  While you sleep, vacation, read, or play video games, this money machine is pumping out fresh cash for you to save, spend, reinvest, or give.

Now, you are left with $7,250,000 of your $10,000,000.  You may decide you want to buy 30 blue chip stocks, and invest $100,000 in each of them, just like the case studies we did of McDonald’s, Procter & Gamble, Clorox, Hershey’s, Nestle, Tiffany & Company, Coca-Cola, Colgate-Palmolive, General Mills, Chevron, etc.

This will cost you $3,000,000 in total.  At current earnings yields, you might expect your share of the net profits to be around $200,000 per year, but only $81,000 of this is going to be distributed as cash dividends, with the rest of it reinvested for future growth (the reason, historically, stocks have crushed every other asset class over the long-term though there is no guarantee the future will look like the past).  As your money is reinvested for you by the various management team, you still get to add $6,750 per month in cash income from dividends generated by your companies selling everything from chocolate bars, cheeseburgers, ice cream sundaes, laundry detergent, dish washing soap, bleach, toothpaste, infant formula, carbonated beverages, breakfast cereal, oil, natural gas, diamonds, emeralds, and more.  Twenty, thirty plus years from now, these shares should be worth far more than your real estate investment.

Now, you’re left with $4,250,000.  If we were in an ordinary interest rate environment – we are not, this is a once-in-a-few generation low-rate anomaly – you might take $2,500,000 and park it in tax-free municipal bonds which, under ordinary conditions, would be paying you 4% or more per year.  That would have added $100,000 per year to your income, and there are no Federal or state taxes owed under most conditions (there are always exceptions, which is why it is so important each investor speak with a qualified CPA or other tax professional).  That would have been another $8,333 in cash per month.  Unfortunately, this isn’t an option right now, but throughout most of history it was, and I believe it will be again, someday.  It might take years, maybe even decades, but we will revert to the mean.

Now you are left with $1,750,000.  You might take $500,000 and keep it in the bank as emergency cash reserves.  Again, in an ordinary interest rate environment, you would have been earning 3% on this money, which would have added $15,000 per year to your income, which works out to $1,250 in extra cash each month.  That isn’t an option at this moment, but as before, I think it will be, again, at some point in the future.

This would leave you with $1,250,000.  You might decide that you want to actually have a career and not sit around all day and do nothing.  You decide to join the McDonald’s corporation.  You setup a limited liability company – for the purpose of our hypothetical illustration, we’ll call it Consolidated Hamburger Holdings, LLC – and use it to buy a franchise in your hometown.  As per McDonald’s requirements, you make it your full time job.  You have a place to show up every day, help create jobs, generate tax revenue.  Unlike other McDonald’s franchisees just starting out, you get to jump in with a much larger-than-average chunk of equity and would only need to borrow a small amount of the purchase price, which would be paid off within a few years (or, if you wanted to take your other investment income and redeploy it to debt reduction, barely more than 12 months).  All else equal, in a decent sized town with a fairly normal location, you might expect to make around $21,000 per month in profit between your combined salary and operating profits.  This isn’t “passive” income, obviously, since you are involved and have set hours, but who wants all of their income to be passive?  There is a reason a lot of people die or give up on life when they retire and no longer have a purpose.  Most people want to work; to feel productive.

Now, in an ordinary interest rate environment, you would have been earning as much as $59,833 per month in cash; real, liquid greenbacks that flood into your checking account. Remember, though, that you’d be making much more in actuality because your stocks are retaining a big portion of their net profits for future expansion.  Your weighted average tax rate it is going to be fairly low because you will be able to use depreciation to shield your real estate income, your tax-free municipal bond income doesn’t require any payments to the Federal, state, or local government if you did it correctly, and your dividend income is taxed at a low rate of 15%.  If you were to put things like SEP-IRAs in place and you were married, you could shave even more off your tax bill by sheltering the money through these special pension plans.

This means that your $10,000,000 has been converted into a collection of assets that pumps out as much as $59,833 per month in cash – a figure that, assuming normal economic conditions and wise management – should grow at a rate slightly faster than inflation in the future.

(Right now, given that we are in such a massive bond bubble where investors are not adequately demanding interest rates that are likely to result in real, long-term purchasing power maintenance on an after-tax, after-expense basis, I would have adapted, and been earning more, because the cash that would have been allocated to municipal bonds in this scenario would have been, instead, put to work in a secondary real estate project.  If and when rates return to normal, I’d have a period of couple of years where I lived well below my means and built the bond component.  At present prices, real estate is much cheaper than bonds.)

That’s it.  The situation would change based upon your own skill set, abilities, risk tolerances, and preferences.  I know some people that would never want to own a fast food restaurant or who would be terrible operators so they would invest more in real estate with no private businesses, for example.  Still, it gives you a general idea of how the thought process behind the task might work.  It’s about putting together cogs for your compounding machine.  The big thing is to never invest in something you don’t understand because a poor decision can destroy a lot of wealth very quickly.  Personally, I have people in my own life that if they were to ever try and run so much as a lemonade stand, they’d go bankrupt, yet I could find a way to franchise it and be collecting lemonade fees without having to work myself.  Everyone has different abilities.  You have to know your limits and be aware of that when putting together your portfolio.  Do not try to structure your affairs based on what other people are doing.  It has to work for you.  Your individual situation, circumstances, risk tolerances, preferences, skills, abilities, time considerations, and much, much more all matter.

A major consideration in designing a portfolio is that it should be able to survive a recession.  Consider the hypothetical example I structured in this illustration.  Under present conditions, and assuming a talented operator, the portfolio owner would have very little debt, all of which could be paid off in under a year.  The portfolio should be able to survive a 90% drop in the stock market – the owner isn’t relying on the stock price to fund cash flow, the equity component consists of a diversified collection of blue chip companies, and there are no outstanding margin balances that can be called by the broker-dealer.  It should be able to survive a spike in interest rates – at worst, the fixed-income component holds intermediate term bonds.  A reasonable person should not lose sleep if he or she did it right.  For example, the real estate should be insured against risks such as earthquakes, floods, fires, tornadoes, etc.  Stated plainly, an event bad enough to take down a portfolio like this likely indicates a situation so horrific that there probably isn’t much of a national economy left, anyway, so there’s no use being upset about it.

Update: Due to requests from the blog community, I restored this post on 05/18/2019 as part of a project that involved bringing back some of the past articles and essays from the private archives.  It required making a few minor edits along with adapting it to the new blog template by adding higher resolution images.  In addition, several of the conversation threads in the comments were deleted as they involved discussing different scenarios.  Although neither the post nor conversations were intended as investment advice, and clearly all of it was general and academic in nature, I was not comfortable with it being published on my personal blog now that, all these years later, Aaron and I are the founders of a fiduciary asset management firm, Kennon-Green & Co., and we manage wealth for other individuals and families alongside our own.  This compromise was the only solution in which I found myself willing to restore the piece so those of you who found the core lessons valuable could have access to it.