Ranking The Best Passive Income Investments

If you’re looking to achieve financial freedom, this post will highlight the best passive income investments to help you get there. Passive income is the holy grail of personal finance. Once your investments can generate enough passive income to cover your desired living expenses, you are truly financially free.

After about the 30th day in a row of working 12+ hour days and eating rubber chicken dinners at our company’s free cafeteria, I decided I had enough. I needed to generate more passive income to break free.

There was no way I could last for more than five years working in a pressure cooker environment like Wall Street. I started focusing on generating passive income in 1999.

However, it wasn’t until the 2008-2009 financial crisis where I became obsessed with building passive income. The previous financial crisis made working in finance no fun. I’m sure many people during the 2020 global pandemic are feeling the same way about their occupations as well.

We’ve discussed how to get started building passive income for financial freedom before. Now I’d like to rank the various passive income streams based on risk, return, feasibility, liquidity, activity, and taxes.

I’m updating my passive income rankings for 2021 given so much has changed since my original passive income rankings came out in 2015. A key difference to my best passive income investments ranking is the inclusion of taxes as new ranking variable. After all, tax treatment can significantly affect returns.

The best passive income rankings are somewhat subjective, but they are born from my own real life experiences attempting to generate multiple types of passive income sources over the past 20 years.

Best Passive Income Investments Starts With Saving

By far the most important reason to save is so you can have enough money to do what you want, when you want, without anybody telling you what to do. Financial freedom is the best!

Sounds nice right? If only there was a formula or a chart like the 401k by Age chart which gives people guidance on how much to save and for how long in order to reach financial freedom. Unfortunately, saving money is only the first step in building passive income. Figuring out how to properly invest your savings is even more important.https://5cde9d51df07e966d49efae412268b6f.safeframe.googlesyndication.com/safeframe/1-0-37/html/container.html

If you can max out your 401k or max out your IRA and then save an additional 20%+ of your after-tax, after-retirement contribution, good things really start to happen. The ultimate goal I recommend is for everyone to shoot to save 50% of their after-tax income or more.

It is your taxable retirement portfolio that is going to allow you to retire early and do whatever you want. Because it is your taxable retirement portfolio that spits out passive retirement income. You can touch your 401(k) and IRA before the age of 59.5 without a 10% penalty.

Let’s take a look at the best passive income investments for the new decade.

Ranking The Best Passive Income Investments

Below are eight best passive income investments to consider. Each passive income stream will be ranked based on Risk, Return, Feasibility, Liquidity, Activity, and Taxes. Each criteria will get a score of between 1-10. The higher the score, the better.

  • A Risk score of 10 means no risk. A Risk Score of 1 means there is extreme risk.
  • A Return score of 1 means the returns are horrible compared to the risk-free rate. A Return Score of 10 means you have the highest potential of getting the highest return relative to all other investments.
  • A Feasibility score of 10 means everybody can do it. A Feasibility score of 1 means that there are high requirements to be able to invest in such an asset.
  • A Liquidity score of 1 means the investment is very difficult to withdraw your money or sell without a penalty or a long period of time. A Liquidity score of 10 means you can access your funds instantly without penalty.
  • An Activity score of 10 means you can kick back and do nothing to earn income. An Activity score of 1 means your’ve got to manage your investment all day long like working a day job.
  • A Tax score of 1 means the investment is taxed at the highest possible rate and there’s nothing you can do about it. A Tax score of 10 means the investment is generating the lowest tax liability possible or you can do things to lower the tax liability.

To make the ranking as realistic as possible, every score is relative to each other. Further, the return criteria is based off trying to generate $10,000 a year in passive income.

Let’s look at my overall Best Passive Income Investments ranking chart.

Best Passive Income Investments Ranked

Rank #8: Peer-to-Peer Lending (P2P)

The least best passive income investment is P2P lending. P2P lending started in San Francisco with Lending Club and Prosper in mid-2000. The idea of peer-to-peer lending is to disintermediate banks and help denied borrowers get loans at potentially lower rates compared to the rates of larger financial institutions. What was once a very nascent industry has now grown into a multi-billion dollar business with full regulation.

With a diversified portfolio of 100 or more notes, the leading P2P lenders claim investors can make an annual return between 5% – 7%. The returns used to be higher, but the increased supply of money has brought returns down.

The biggest problem with P2P lending is people not paying investors back e.g. borrowers default on their loans. There’s something that just doesn’t sit right with people breaking their contract obligations.

Over time, the P2P industry has seen its returns shrink due to higher competition and more regulation. As a result, I believe making money through P2P investing is one of the worst ways today.

Risk: 4, Return: 2, Feasibility: 8, Liquidity: 4, Activity: 7, Taxes: 5. Total Score: 30

Rank #7: Private Equity Investing

Private equity investing can be a tremendous source of capital appreciation with the right investments. If you find the next Google, the returns will blow every single other passive income investment out of the water. But of course, finding the next Google is a tough task since most private companies fail and the investment opportunities always go to the most connected investors.

The most liquid of the private investments are investing in equity or credit hedge funds, real estate funds, and private company funds. There will usually be 3-10-year lockup periods, so the Liquidity score is low. These funds should at least provide for some semi-regular passive income distributions.

The least liquid of the private investments is when you invest directly into a private company. You could be locked up forever and receive zero dividends or distributions.

Access to private investments are usually restricted to accredited investors ($250K income per individual or $1 million net worth excluding primary residence), which is why the Feasibility Score is only a 2. But the Activity Score is a 10, because you can’t do anything even if you wanted to. You’re investing for the long term. The Risk and Return score greatly depends on your investing acumen and access.

Gaining $10,000 a year in private equity investing is difficult to quantify unless you are investing in a real estate or fixed income fund. Such funds generally target 8-15% annual returns, which equates to a need for $83,000 – $125,000 in capital.

Risk: 5, Return: 7, Feasibility: 2, Liquidity: 2, Activity: 10, Taxes: 6. Total Score: 32

Rank #6: Certificate of Deposit (CD) / Money Market

There was a time when CDs or money market accounts would produce a respectable 4%+ yield. Nowadays, you’ll be lucky to find a 5-7 year CD that provides anything above 2%. The great thing about CDs is that there are no income or net worth minimums to invest.

Anybody can go to their local bank and open up a CD of their desired duration. Furthermore, a CD and money market account are FDIC insured for up to $250,000 per individual, and $500,000 per joint account.

Now you can only get an online money market account paying 0.5% as of 4Q2020 because the Fed slashed rates to 0% – 0.25%. In comparison, the 10-year Treasury bond yield is hovering between 0.7% – 0.8%.

The problem with CDs and money market accounts really is the low return. It takes a tremendous amount of capital to generate any meaningful amount of passive income. To generate $10,000 a year in passive income at 0.5% requires $2,000,000 in capital! At least you know your money is safe, which is great during bear markets.

The huge drop in interest rates is why it’s prudent to lower your safe withdrawal rate in retirement and/or build a bigger net worth before you retire. It takes a tremendous amount more capital to generate the same amount of risk-adjusted income today.

Best passive income investments - you need more capital to generate more income now

The main thing savvy investors can do to take advantage of a huge drop in interest rates is to refinance debt or take on debt and invest in higher return investments. At the very least, homeowners should be refinancing their mortgage. Check out Credible, my favorite mortgage lending marketplace where lenders compete for your business. It’s free to get a real mortgage rate quote.

Risk: 10 (no risk), Return: 1 (the worst return), Feasibility: 10 (anybody can open up a savings account). Liquidity: 7 (savings are easily accessible, but not CDs without a penalty). Activity: 10 (you don’t have to do anything to earn passive income. Taxes: 5 (interest income is taxed as normal income). Total Score: 43

Rank #5: Physical Real Estate

Real estate is my favorite asset class to build wealth because it’s easy to understand, provides shelter, is a tangible asset, doesn’t lose instant value like stocks overnight, and generates income. When I was in my 20s and 30s, I thought owning rental properties was the best passive income investment.

The only bad thing about owning physical real estate is that it ranks poorly on the Activity variable due to tenants and maintenance issues. You can get lucky with great tenants who are self-sufficient and never bother you, or you can be stuck with tenants who never pay on time and throwing house-damaging house parties all the time.

Owning your primary residence means you are neutral the real estate market. Renting means you are short the real estate market, and only after buying two or more properties are you actually long real estate. This is why everybody should own their primary residence as soon as they know they want to stay put for 5-10 years. Inflation is too powerful a force to combat.

In order to generate $10,000 in Net Operating Profit After Tax (NOPAT) through a rental property, you must own a $50,000 property with an unheard of 20% net rental yield, a $100,000 property with a rare 10% net rental yield, or a more realistic $200,000 property with a 5% net rental yield.

Generating High Rental Income Is Tough On The Coasts

In expensive cities like San Francisco and New York City, net rental yields (cap rates) can fall as low as 2.5%. This is a sign that there is a lot of liquidity buying property mainly for appreciation and not so much for income generation. This is a riskier proposition than buying property based on rental income.

In inexpensive cities, such as those in the Midwest and South, net rental yields can easily be in the range of 7% – 10%, although appreciation may be slower.

I’m bullish on the heartland of America real estate and have been actively buying commercial real estate there through real estate crowdfunding and speciality REITs, which we will discuss more below.

Real Estate Has Great Tax Benefits

The tax benefits of owning physical real estate are very attractive. The first $250,000 in gains is tax-free per individual. If you’re married and own the the property together, then you receive $500,000 in tax-free gains upon sale.

Then there’s the ability to exchange a property you own for another property via a 1031 Exchange so you don’t have to pay any capital gains tax.

If you own rental property, you can take non-cash amortization expenses to reduce any rental income tax. Owning property over the long term is one of the most proven ways to build wealth and generate passive income for the average American.

I believe there is an attractive opportunity to buy real estate in 2020 and beyond due to low mortgage rates, a rotation out of stocks, and the desire for more income and less volatility. I’m personally looking to buy another single family home to rent out.

Further the value of rental income has gone way up since interest rates have gone way down. Therefore, I think buying rental properties in this low interest rate environment is good because rental property valuations have not appreciated as much as the cash flow they generate.

Risk: 7, Return: 8, Feasibility: 7, Liquidity: 6, Activity: 6, Taxes: 10. Total Score: 44

Rank #4: Creating Your Own Products

If you’re a creative person, you might be able to produce a product that’s able to generate a steady flow of passive income for years to come. At the extreme, Michael Jackson, makes more dead than alive due to the royalties his estate makes from all the songs he produced in his career. Since Michael’s death, his estate has made over $2.5 billion according to Forbes.

Of course it’s unlikely any one of us will replicate the genius of Michael Jackson, but you could produce your own eBook, e-course, award-winning photo, or song to create your own slice of passive income.

Example Of A Product

In 2012, I wrote a 180-page eBook about severance package negotiations that regularly sells about ~50 copies a month at $87 – $97 each without much ongoing maintenance. The book is updated for 2020 to teach people how to negotiate a severance. Once you have a severance, you have a financial runway for your next chapter in life.

In order to generate ~$50,000 a year in passive income from the book as I do now, I would need to invest $1,250,000 in an asset that generates a 4% yield. To earn $10,000 a year in passive income would therefore need roughly $250,000 in capital.

Who would have thought a book about engineering your layoff could regularly generate so much revenue? We’re so busy with our jobs that our childhood creativity sadly vanishes over time. Now that millions of jobs are at risk, the book has become a better seller.

Leveraging the internet to create, connect, and sell is something every person should attempt to do given the startup cost is so low. The only risk is lost time and a wounded ego. Here’s my step-by-step guide on how to start your own profitable site in under 30 minutes.

Below is a real income statement of a personal finance blogger who started his website on the side while working.

Blogging For A Living Income Example: $300,000+

If you are a creative person who takes pride in making money on your own, creating your own product is one of the best ways to go. The margins are extremely high once your product is produced. The only thing you need to do is update the product over time.

Risk: 10, Return: 8, Feasibility: 7, Liquidity: 6, Activity: 7, Taxes: 7. Total Score: 45

Rank #3: Fixed Income / Bonds

As interest rates have been going down over the past 30 years, bond prices have continued to go up. With the 10-year yield (risk free rate) at roughly 0.7%, it’s hard to see interest rates declining much further. That said, long term interest rates can stay low for a long time and can head to 0%. Just look at Japanese interest rates, which are negative (inflation is higher than nominal interest rate).

Bonds provide a terrific defensive allocation to an investment portfolio, especially during times of uncertainty like during the coronavirus pandemic. If you hold a government bond until maturity, you will get all your coupon payments and principal back. But just like stocks, there are plenty of different types of bond investments to choose from.

Anybody can buy a bond ETF such as IEF (7-10 Year Treasury), MUB (muni bond fund),  or a fixed income fund like PTTRX (Pimco Total Return Fund). You can also buy individual corporate or municipal bonds. Municipal bonds are especially enticing for higher income earners who face a high marginal tax rate. You can also directly buy Treasury bonds through your online brokerage platform.

The main issue people have with bonds is its lower historical performance compared to stocks. However, with the combination of lower volatility, higher coupon payments, and defensiveness during times of uncertainty, bonds are an attractive investment. See below the various bond fund returns in recent times.

Bond fund performance 2019-2020 coronavirus

Main Concern With Bonds

The main concern for bonds is the future of interest rates. If interest rates do go higher, bonds will decline in value, all else being equal. That said, so long as you hold the bond to maturity, you should get your initial principal back along with all the coupon payments if you are buying a highly rated bond e.g. AA.

Bonds are a great investment to help decrease volatility in your portfolio. I hope everybody at least takes advantage of lower interest rates and refinances their mortgage.

If you think about it, refinancing your mortgage or any debt is one of the easiest ways to generate new passive income. I refinanced my mortgage to a 7/1 ARM at 2.25% for minimal fees with Credible. As a result, I boosted my cash flow by $400 a month, which is like boosting passive income!

Best passive income sources - refinance your mortgagee and take advantage of all-time low mortgage rates

Risk: 8, Return: 3, Feasibility: 10, Liquidity: 7. Activity: 10. Taxes: 8. Total Score: 46

Rank #2: Real Estate Crowdsourcing

Currently, my favorite passive income source is real estate crowdfunding. Real estate crowdfunding enables individuals to buy a percentage of a commercial real estate project that was once only available to ultra high net worth individuals or institutional investors.

Owning individual physical real estate is great, but it’s like going all-in on one asset in a particular location with leverage. If the market goes down, your concentrated investment could lose big time if you are forced to sell Many did during the last financial crisis.

Real estate crowdsourcing allows you to surgically invest in multi-family or commercial real estate project for potentially 7 – 13% annual returns based off historical data.

My favorite real estate crowdfunding platform for accredited investors is CrowdStreet. They are focused on investing in individual real estate projects in 18-hour cities where valuations are lower and net rental yields are higher.

If you are not an accredited investor and like to invest in diversified funds, you can invest in a private eREIT through Fundrise. Fundrise is the leader in this more diversified style of real estate and has been around since 2012.

Unlike with other passive investments on the list, with real estate crowdfunding, you at least have a physical asset as collateral. Both platforms are free to sign up and explore.

Fundrise Due Diligence Funnel

100% Passive Income Is Nice

For those of you who don’t want to come up with a $300,000 downpayment and carry a $1,200,000 mortgage to buy the median home in an expensive coastal city like SF or NYC, who don’t want to deal with tenants or remodeling, and who wants to sit back after an investment is made, real estate crowdfunding is a great alternative to owning physical real estate.

In mid-2017, I sold my San Francisco rental property for 30X annual gross rent. I reinvested $500,000 of the proceeds in a real estate crowdfunding portfolio to take advantage of lower valuations across the country with much higher net rental yields. Not having to deal with maintenance issues and tenant problems has been wonderful.

Coastal city real estate has become too expensive. I expect people and capital to naturally flow towards lower cost areas of the country, especially with tens of millions experiencing shelter-in-place. The future of work is remote. Take advantage of a multi-decade demographic shift inland.

Further, the performance of Fundrise’s eREITs have been relatively steady during stock market downturns or flat markets, as we saw in 2015 and 2018. I expect the same type of outperformance to continue in 2020 as the S&P 500 remains volatile. Real estate is defensive because it becomes more affordable as mortgage rates decline. Investors want real assets that provide shelter and income.

Fundrise Compound Annual Returns

To be able to invest in real estate, but 100% passively is a great combination. You can invest in publicly-traded REITs as well for real estate exposure, however, as we saw in the violent March 2020 stock market downturn, REITs performed even worse.

Risk: 7, Return: 7, Feasibility: 10, Liquidity: 6, Activity: 10, Taxes: 7. Total Score: 47

Rank #1: Dividend Investing

The best passive income investment is dividend-paying stocks. The “Dividend Aristocrats” are a list of blue chip companies in the S&P 500 that have demonstrated a consistent increase in dividend payouts over the years.

Let’s say a company earns $1 a share and pays out 75 cents in the form of a dividend. That’s a 75% dividend payout ratio. Let’s say the next year the company earns $2 a share and pays out $1 in the form of dividends. Although the dividend payout ratio declines to 50%, due the company wanting to spend more CAPEX on expansion, at least the absolute dividend amount increases.

Dividend stocks tend to be more mature companies that are past their high growth stage. As a result, they are relatively less volatile. Utilities, telecoms, and financial sectors tend to make up the majority of dividend paying companies.

Dividend Yield of S&P 500 versus 10-year yield

Tech, Internet, and biotech, on the other hand, tend not to pay any dividends because they are reinvesting most of their retained earnings back into their company for further growth. But growth stocks can easily lose investors tremendous value over a short period of time.

Pay Attention To Dividend Yields

To achieve $10,000 in annual passive income with a ~1.8% S&P 500 dividend yield would require $555,000. Instead, you could invest only $154,000 into AT&T stock given its 6.5% estimated dividend yield. It all depends on your risk tolerance. I give dividend investing a 5 on Return because dividend interest rates are relatively low. Further, the volatility is now relatively high.

One of the easiest ways to get exposure to dividend stocks is to buy ETFs like DVY, VYM, and NOBL or index funds. You can also use a digital wealth advisor like Betterment to automatically invest your money for you at a low fee. The key is to invest consistently over time.

In the long run, it is very hard to outperform any index. Therefore, the key is to pay the lowest fees possible while being mostly invested in index funds. Dividend index investing is great because it is passive and liquid. However, given dividend rates are low and volatility is high after a 10+-year bull market, the Return score is lower than in the past.

Risk: 6, Return: 5, Feasibility: 10, Liquidity: 9, Activity: 10, Taxes: 8. Total Score: 48

Best Passive Income Investments Review

Based on my new six-factor model for ranking the best passive income investments, the top five passive income investments are:

  • Dividend Stocks
  • Real Estate Crowdfunding
  • Fixed Income (Bonds)
  • Creating Your Own Products
  • Owning Rental Properties

If you can stomach the occassional volatility, investing in dividend stocks is truly one of the best passive income investments over the long run. If you want less volatility with likely higher yields, invest in real estate crowdfunding and fixed income instead.

There was a time when I loved owning physical real estate the best in order to generate a steady stream of rental income. However, once I became a dad in 2017, I no longer had as much time or energy to manage properties. Real estate crowdfunding through platforms like Fundrise and CrowdStreet are good solutions for my real estate investment capital. 100% passive income is wonderful.

For those who are the creative types, starting your own website like this one and creating products online feels extremely rewarding. Some say making $1,000 on your own is like making $5,000 or $10,000 at a job. However, blogging would score a 1 in the Activity Score since these posts don’t write themselves. Instead, you really want to create products like a book or a course to sell passively.

Finally, owning rental properties is becoming more attractive given how low interest rates have fallen. The value of rental income has increased so much that I’m looking to buy another physical rental property in 2021.

Best Passive Income Investments Table

Once again, here are the best passive income investments. All eight passive income investments are appropriate ways for generating income to fund your lifestyle. The right ones depend on your personal preference, understanding of the investments, creativity, and interests.

Best Passive Income Investments Ranked

Build More Passive Income Today

Enthusiasm for work is strongest when you are young and have very little money. After four years of high school, followed by another four years of college, work sounds like an exciting adventure! But after a while, your job can begin to beat you down.

Perhaps a coworker purposefully tries to make your life miserable because they resent your success. Maybe you get passed over for a promotion and a raise because you weren’t vocal enough about your abilities. Maybe you mistakenly thought you worked in a meritocracy. Whatever the case may be, you will eventually tire.

This is why it is important to take action while you still have the energy. With interest rates at rock bottom levels, building passive income will take a lot of effort and patience. Start now!

My Current Passive Income Investments

Below is my latest passive income streams that I’ve been building since 1999. Our passive income allows both my wife and I to be stay at home parents to two children. Our next goal is to generate $300,000 in passive income by 2023 and relocate to Hawaii for kindergarten.

Financial Samurai 2020 Passive Income Streams

Saving early and often is no sacrifice at all. Instead, the biggest sacrifice is living a life on someone else’s terms due to a lack of funds.

On your journey towards financial freedom, please diligently track your net worth, analyze your investment portfolios for excessive fees, and regularly calculate your retirement cash flow needs through a free financial tool like Personal Capital.

I’ve been tracking my net worth and my investments with Personal Capital since 2012 and have seen my net worth sky rocket as a result. My favorite tool of theirs is the Retirement Planner that enables me to properly forecast my cash flow.

Remember, if the amount of money you’re saving and investing doesn’t hurt, you’re not saving and investing enough. At the end of the day, nobody cares more about your money than you.


Books to Read

Think and Grow Rich | Buy on Amazon

The little book of common sense investing | Buy on Amazon

I Will Teach You To Be Rich | Buy on Amazon

The Intelligent Investor | Buy on Amazon

A Wealth of Common Sense | Buy on Amazon

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