How to Calculate your Passive Income target?

In the previous article I suggested that your first goal in life is to achieve financial freedom. I define financial freedom as generating sufficient passive income to pay your living expenses. Financial freedom is not some lofty dream reserved for the few. Every one of us will need to take a break from the 9 to 5 and retire. It is inevitable. And when that time comes you must have achieved financial freedom. Not having enough passive income means that you will need to use your savings to pay for your expenses until your savings run out. 

For years  financial experts have told us how much cash savings we need at retirement in order to retire. Targets of $1M to $3M are frequently mentioned. These cash saving goals appear distant and unreachable. This could explain why the median retirement savings of workers aged 50 to 55 is $8,000 according to the Economic Policy Institute. The same financial experts fail to tell us how these cash savings will be converted to monthly income and how it will affect your legacy. In order to address these 2 issues I propose a more practical approach: monthly passive income goal.

In this article you will calculate your own monthly passive income goal and I will show you how to achieve this goal through real estate investments. (By passive income I mean regular monthly income generated from investments, such as house or apartment rentals. It is passive because the day-to-day management of the rental units can be handled by a third party property management company.) Unlike the lofty one or two million dollars savings goal, a monthly passive-income target is more tangible. You can easily take concrete steps to reach this goal. There are no hidden assumptions with this strategy because your investment is immediately converted to cash flow and you can see income being deposited in your bank account every month.

A monthly target has several advantages: it is easy to track, it encourages you to take action, you know exactly the source of your passive income, and you don’t have to wait until retirement to take advantage of your passive income and its tax benefits. Let’s look at your current monthly expenses as a starting point.

Most financial experts and online retirement calculators assume that your expenses will be less at retirement. If you want more income at retirement they will tell you that you need to save more today. This is what I call the “live less now or live less later” compromise. While some expenses will go down, others will most likely go up. I am currently living in San Francisco Bay Area, arguably one of the most expensive areas in the United States,. I am planning to move in a couple years, so I expect my living expenses to go down. I also expect to travel more so I expect that I will be spending pretty close to what I am spending now. This is the lifestyle that I am used to and want to continue at retirement. Most likely, your expenses will also shift from one category to another. Living expenses might go down while recreation, hobbies, and medical expenses might go up. Nobody wants to “live less” at retirement, right? The first step is to add up your current monthly expenses. If you are planning to relocate, adjust your living expenses based on that new location. Then eliminate all the expenses that you would consider truly wasteful. Using the table below write the amount on the first line of the table beside current monthly expenses.

We all have unexpected expenses so let’s add a 5-10% safety to that number and write it on line 2. Add lines 1 and 2 together, and write the sum on line 3. For example, if your expenses are $9,000, add an extra $1,000 safety, which will bring your total expense to $10,000. If you are one of the lucky few who is expecting an employer-sponsored pension plan (do not include 401k), write down your expected monthly pension on line 4. For your social security benefits, go to the Social Security Administration website, and write down your expected monthly pension on line 5. Now, calculate your monthly passive-income target by subtracting lines 4 and 5 from line 3; write the result on line 6. For example, I don’t have an employer sponsored pension plan, so I write $0 on line 4. I then check my Social Security benefits online, and let’s say it adds up to $2,000, so I write $2,000 on line 5. My monthly passive-income target is $8,000 ($10,000 from line 3-$0-$2,000).

How does this number feel? Does this feel more achievable than trying to reach a huge cash saving  goal? As I mentioned earlier, this target is not a nice to have goal, it is inevitable. You will need this monthly passive income in order to retire. The earlier you reach this goal the earlier you will be able to retire. How can you generate this kind of passive income? The easiest way to reach your goal is by investing in rental properties. If you live in an inflated market like I do this may sound impossible however there are multiple markets in the United States where rental properties can provide a positive cash flow. If you Google “turnkey rental properties for sale”, you will get a list of companies specializing in the sale of turnkey rental properties. These properties are called turnkey because all the work has been done already and it has property management already in place.

For example, you can buy a single family rental property in Cleveland, OH for $80,000 by putting $16,000 down and getting a mortgage for the rest. This property will rent for $800 and generate $250/month in positive cash flow after paying for the insurance, taxes, property management, and mortgage. How many rental units do you need to reach that goal from line 6 above? Using my previous example where my monthly passive income target was $8,000 I would need 32 houses to reach my goal. Having to put down roughly $16,000 per house you only need $512,000 to achieve this goal. Does this sound achievable?

My goal for this article was to emphasize the inevitable need for financial independence and to define goals in terms of a monthly passive income target. I also chose to illustrate how someone could reach their goal by building a portfolio of single family rentals. Single family rentals are a good way to get started if you are new to real estate investing because it allows you to add properties to your portfolio over the years and it has significant tax advantages that are beneficial while you are still not free from your daily job. However this is just one of many strategies that could be used to reach your passive income target.

Feel free to contact me if you have any questions or comments.