Most people invest in stocks to sell it off at a higher price and earn a profit. However, there are some other people who invest in stocks for income. This is a slow way to grow wealth but has worked well for many people. Another way to invest for passive income is to buy a property and rent it out. In this way, you receive a monthly income from the rental collected. However, the problem is buying a property is expensive especially in Singapore. If we were to buy a private condominium, the down payment is already 20% which means it could be $200,000 for a $1 Million dollars condominium. How many of us actually have that kind of cash to begin with?
Investing in stocks seems to be a more practical way for a start. So how do we go about investing for passive income?
Beware the temptation of high yields/dividends
When investing for income, we like to see good dividends which translates into high yields on our investment. Imagine if the yield is 10%, every $10,000 invested will give you $1000. It is really tempting to go for high yields. However, as investors who invest for income, even though high yields seems attractive, we should not jump straight into in.
Jumping straight into a high yield stock is like jumping into an ocean without knowing if its water is shark infested. It all seem good from the outside but if we look deeper, there may be dangers lurking ahead. A company which pay out high dividends have to get the money from somewhere. It can be paid from its income or it can be paid from its existing cash.
There are a few questions we need to ask ourselves when investing into stocks for passive income.
- Where does the company pay its dividends from?
- Are the dividends sustainable? Will the company continue to grow?
- What's the trend of its past dividend payouts? Is it increasing or decreasing year by year?
Since we're investing for income, we want that income to be sustainable and even better if its increasing yearly. Look at the company's business structure for clues on where they derive its income. If income is not stable, most likely the high dividends are not sustainable as well. This is especially so for REITS where their income is derived from rental collected.
Be a lazy landlord by investing into REITS
A REIT, also known as a real estate investment trust, has a portfolio of properties which they rent out to collect income. Buying a share of the REIT makes you a shareholder of the many properties that it has. For example, if you buy the shares of Capitamall or Suntec, then you actually become a shareholder and own part of the shopping malls you see at City Hall, Tampines, Jurong, Woodlands and many other parts of Singapore. Some of these Reits have properties in other parts of the world too.
The rental collected is distributed to all the many other shareholders and each will receive a portion of the income according to the number of shares they own. Reits listed in Singapore typically pay a range of 5-8% in dividends. If dividend remains constant, the lower the price you buy a share of the Reit for, the higher the expected dividend yield will be. The best thing is you don't have to manage the property to get the rental. The Reit manages it for you.
Reits own assets which are mostly properties. If we can buy a Reit at its fair value to its asset or better still at a lower value than its asset, then it may be a good investment. Think of it this way. When you're buying a house in this particular estate and you realise the house is selling at 20% cheaper than the neighbour who stays beside you, is it a good deal? Of course its a good deal which should be kept secret from your neighbour when you move in. This is buying at a lower value to its asset.
Therefore, buying a Reit below its asset value is much better than buying above its asset value. If we buy below its asset value, we're buying it at a discount. The net asset shows the total assets a Reit has. Divide this amount by the number of common shares, we get the net asset value (NAV) per share. If a Reit's NAV per share is $1 and we buy it at 50cents, we're buying it at a 50% discount. This NAV figure is mostly provided by the company in its annual report.
Watch debt like a hawk
Debt is a powerful force. We can use debt to buy a penthouse at Sentosa cove and everyone will think you're rich. But in actual fact, you do not have the actual money to own it. Reits also use debt to buy some of their properties. It may not be a bad thing as long as they don't stay it it or leave it vacant. It has to be rented out to other people so they can collect rental every month.
Renting out your Sentosa cove apartment may make you a lot of money but the problem comes when you can't find any tenants to rent it out to. Without tenants, you lose your income and still have to pay the debt (monthly housing loan) every month. If you still can't find tenants and you don't have money any more, you'll be in deep trouble. This is similar for Reits. If they can't find tenants and their debt is very high and they don't have much cash, it'll be like a bomb just waiting to explode.
Passive income for financial independence
In our early days of investing, the dividends received should be reinvested to let your money compound over the years. Once your dividend income (passive income) surpasses your monthly expenses, you've reach financial independence. If you're still working, you can now save 100% of your take home pay and just spend using the passive income. Now, you can choose to work or not to work. Now, you can choose to do the stuffs you're passionate about.
Investing for passive income can make you money for as long as you live. If you buy a property and rent out over the years, you would have got back all your capital after some time and still be able to collect rent as long as there are tenants. If you invest in shares of companies, you also get back all your capital after some time and this company still continues to pay you as long as its still around and listed on the stock exchange. A slow way to grow money but this patience will definitely pay off after a period of time.
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