Cash Flow Investments for Building Passive Income
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Table of Contents
What is a Cash Flow Investment?
Cash Flow Investment Ideas
The Best Cash Flow Investments for High-Net-Worth Individuals
How to Live Off Passive Income
Building a Strong Portfolio
Long Angle’s 2024 High-Net-Worth Spending Report found that the number one financial goal among high-net-worth individuals was achieving financial independence; that is, a state where an individual is consistently collecting more passive income per year than they spend, decreasing or eliminating the need for active income sources.
The road to achieving financial independence, therefore, requires building consistent, stable sources of passive income, and cash flow investments tend to yield reliable returns. This article will consider types of cash flow generating assets well-suited to high-net-worth investors as well as strategies for maximizing passive income.
What is a Cash Flow Investment?
A cash flow investment generates regular income or returns in the form of cash inflows to the investor. These investments are typically designed to provide consistent and predictable income streams, which can be in the form of dividends, high-yield savings accounts, interest payments, rental income, or distributions from businesses.
Common examples include dividend-paying stocks, bonds, rental properties, and certain real estate investment trusts (REITs). Investors often seek cash flow investments to supplement their income, cover living expenses, or reinvest the proceeds to compound their returns over time.
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Cash Flow Investment Ideas
When selecting cash flow investments, high-net-worth investors should consider the following factors:
Return on Investment: Assess the annualized percentage return and compare it to other available options. Higher returns often come with increased risk, so it is wise to balance potential gains with risk management.
Payment Frequency: Determine whether the investment pays out monthly or quarterly, as this impacts cash flow stability. Regular income distributions can provide more predictable cash flow for budgeting and financial planning.
Tax Efficiency: Consider the tax implications of different investments, especially if they are taxed as ordinary income. Holding investments in tax-advantaged accounts or utilizing tax-efficient strategies can enhance after-tax returns.
Principal Growth: Evaluate whether the principal investment has the potential to grow over time or if it generates a fixed percentage return. Investments that combine cash flow with appreciation potential can provide a hedge against inflation and increase overall wealth.
Risk Management: Understand the risks associated with different investment types, including market volatility, credit risk, and operational challenges. Diversifying across different asset classes and strategies can help to mitigate risk.
The Best Cash Flow Investments for High-Net-Worth Individuals
Real Estate
Real estate remains a cornerstone of cash flow investments, favored for its potential to generate regular income while appreciating in value. Investors typically choose between different cash flow real estate categories, including multifamily rentals, single-tenant net lease (NNN) properties, and real estate investment trusts (REITs).
Multifamily Rentals: Multifamily rentals have traditionally been a popular choice for generating passive income because the principal investment grows over time if property values appreciate, while rental income provides a steady cash flow. However, rising property prices and inflated expenses, including debt servicing, have made it challenging to achieve solid returns. Investors should carefully evaluate current market conditions and consider leveraging property management companies to reduce the operational burden.
Single-Tenant NNN Properties: Investing in single-tenant NNN properties offers predictable returns, typically ranging from 4.5% to 8% annually, depending on lease length and tenant creditworthiness. This strategy is relatively low-risk, as tenants handle property-related expenses and investors enjoy consistent income with minimal management effort.
Single Family Homes (SFH): While multifamily properties have traditionally been popular, some investors are finding success with single-family homes, particularly in the Midwest. These properties can offer attractive returns, with some investors reporting up to 20% cash-on-cash returns post-COVID. SFHs often experience less turnover than multifamily units, as families prioritize stability for schooling, which can lead to more consistent cash flow.
REITs: REITs offer an alternative to direct real estate ownership, providing diversification and liquidity. Many REITs have historically outperformed direct real estate investments on a risk-adjusted basis. For example, Realty Income (O) has averaged an annual return of 13.8% since 1999. For those seeking broad exposure, the Vanguard REIT ETF (VNQ) offers a low-fee option for diversified REIT investment. Holding REITs in tax-advantaged accounts like IRAs can help mitigate the tax impact of ordinary income distributions.
Credit Investments
Credit investments are good options for investors seeking cash flow without the challenges associated with direct real estate management. These investments range from bonds and fixed income to niche opportunities like collateralized loan obligations (CLOs) and hard money lending.
Bonds and Fixed Income: Bonds and fixed-income securities currently offer strong yields. They provide a higher position in the capital stack, offering greater security, but the returns are often taxed as ordinary income, which can be less appealing to investors in higher tax brackets.
Collateralized Loan Obligations (CLOs): CLOs are a type of structured credit investment that derives principal and interest from a diversified pool of non-investment-grade, senior-secured corporate loans. They have potential as a high-yield, scalable investment alternative to corporate bonds, with favorable historical credit performance. CLOs are subject to credit, liquidity, and mark-to-market risk, so investors must understand their complex structures and the credit profiles of the underlying collateral.
Hard Money Lending: With hard money lending, investors provide short-term loans to real estate investors. This strategy can generate 8-12% annual returns, typically with monthly payments, with the lender holding a first-position mortgage to secure the investment. Some lenders focus on renovation/flip projects or new construction. While generally safe with the right due diligence, hard money lending requires sourcing quality deals and managing the risks associated with borrower default. Successful hard money lenders often rely on their personal networks and local market knowledge to source quality deals.
Business Development Companies (BDCs)
BDCs offer another avenue for generating cash flow through investments in small and medium-sized enterprises (SMEs). BDCs provide exposure to private debt and typically offer higher yields than traditional fixed-income securities. However, like CLOs, they are subject to credit and market risks, so thorough research and portfolio diversification are crucial.
Dividend Stocks and Funds
Dividend-paying stocks, mutual funds, and exchange-traded funds (ETFs) are reliable sources of passive income, especially for investors seeking to balance growth and cash flow. Popular options such as the Vanguard High Dividend Yield ETF (VYM) and the Vanguard Dividend Growth Fund (VDIGX) offer stable yields of 3-5% while benefiting from capital appreciation potential. While not specifically tax-advantaged, holding these investments in tax-sheltered accounts can help reduce the tax burden.
GP Stakes
With GP stakes, investors acquire ownership stakes in general partnerships of private equity or real estate firms. These investments can start with low single-digit yields and build over time, with the potential for appreciation. While not as tax-efficient as direct real estate, they offer diversified exposure and the possibility of significant returns.
Short-Term Debt
Short-term debt investments, including private banking and collateralized short-term lending, can offer high returns with controlled risk, making them suitable for investors looking to generate cash flow without a long-term commitment.
Alternative Cash Flow Investments
Some investors explore unconventional options such as ATM machines and car washes for cash flow, though it is worth noting that the increasing prevalence of cashless transactions may impact the long-term viability of ATM investments.
Options Strategies
More sophisticated investors might consider options strategies for income generation. One approach involves buying low-beta stocks and selling in-the-money calls, typically with a three-month expiration. This strategy can generate quarterly premiums while allowing for customizable risk/reward profiles.
How to Live Off Passive Income
Cash flow investing and generating sufficient passive income allows many high-net-worth individuals to consider early retirement. This is the goal behind the popular FIRE (Financial Independence, Retire Early) movement.
The amount of consistent income needed to retire varies according to factors such as location, spending habits, and lifestyle, but many investors find around $200K-$300K in annual passive income sufficient. That being said, there is always risk to consider, so it is smart to be conservative when determining the amount of passive income needed to sustain one's lifestyle.
Building a Strong Portfolio
Building passive income through cash flow investments requires a thoughtful approach and a diversified portfolio. From traditional real estate and credit investments to GP stakes and short-term debt, investors have a range of opportunities to generate reliable income. It is important to note that personal expertise and strong networks can significantly impact the success of direct investments, especially in areas like real estate and hard money lending.
By carefully evaluating the potential returns, tax efficiency, and risk profiles of each investment, high-net-worth individuals can create a balanced strategy that aligns with their financial goals and lifestyle aspirations.
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