Three Challenges For Passive Income Portfolios

With much of the Baby Boomer generation at or nearing retirement, more people than ever are chasing the passive income dream. Financial freedom, exotic vacations, time with family….it’s easy to see why passive income is so appealing. 

But it’s never been easy, and even less so in the modern era. In the current environment, traditional passive income strategies just aren’t going to perform like they used to. 

We’ve identified three major shifts in the passive income landscape that will make things more challenging for those looking to build a passive income portfolio

Prices VS Rent In US Real Estate

Undoubtedly, the go-to strategy for passive income among American families is investing in rental properties. The model worked well - as long as property prices maintained a proportional relationship with their rental yield.

But in recent years, as property prices surged compared to rents, the return rates in the real estate market have dwindled to below 4.5% gross and approximately 1.5% net - relatively low numbers based on historical returns.

Inflation is another relevant problem. Its main symptom is the increase in the nominal prices of all goods and services in the economy. However, some prices, such as wages, are in "rigid" markets, subject to contracts and preset adjustments.

Can you guess what happened to people's real incomes during the last few years of high inflation?

Paradoxically, the most significant increases occurred in property prices rather than in rental incomes, leading to a decrease in market profitability. Simultaneously, as wages remained even more rigid, the most impacted aspect was the affordability of rents - the perfect storm.

The outcome is clear: real estate has transitioned from a passive income strategy to a capital gains approach. Essentially, the primary focus isn't on rental income but rather on the potential for price appreciation.

This closely resembles the “greater fool theory”, suggesting that profit can be made by purchasing overvalued assets because there's usually someone (the greater fool) willing to pay an even higher price. And sometimes, it works. But it just isn’t a stable foundation for a passive income strategy anymore. 

Dividends and Market Prices of Equities

Dividends on equities have long been a go-to choice for more sophisticated investors. In the past, dividend strategies played a significant role as a market driver. However, in recent years, the market's focus has also been on capital gains.

In previous articles, we highlighted several reasons to believe that the American market, as measured by the S&P 500, seems dramatically overvalued.

For example, classic metrics like the price-to-earnings ratio and the Buffett Indicator are considerably above their historical averages.

Would you really get into a market that’s hovering around two deviations away from its historical mean based on what Buffett once claimed was his favorite indicator?

Also, take into account that only 20 companies make up 36.04% of the entire index and the technology, finance, and healthcare sectors alone contribute to 53.5% of the index. In other words, the market is highly concentrated and might not be suitable for income portfolios.

Finally, we must see how low dividends are now, as the average dividend yield of the S&P 500 is nearing historic lows at 1.5%. As a passive income strategy, the equity market seems unappealing.

Given all this, it appears evident that there's an asset class offering high interest rates at the moment—bonds. Bonds have never failed, have they? The conventional wisdom was that bonds are a superb choice for an income strategy due to their history of providing security and lower volatility. 

But there’s just one small problem - bonds are currently in the biggest treasury bear market, ever.

An Unstable Market Due to FED Intervention

Because interest rates are high - close to 5% - the bond market might seem like a great opportunity. But that’s where concerns about the structure of the bond market should come to mind.

Buying bonds means being subject to a controlled market where the Fed's ongoing intervention prevails. Appealing reinvestment rates are not guaranteed, and neither is the capital.

Consider how one of the largest ETFs that track the U.S. bond market has fallen more than 50% in the last few years as interest rates went up.

Simultaneously, if inflation data continues to remain favorable, it's unlikely that the FED will keep its rates unchanged. You'd reinvest your money at lower rates, making a passive income strategy far less appealing.

Of course, here we're making important assumptions:

• There won't be significant issues with the economy.
• The United States' credit rating won't further decline.
• There won't be any major credit events.

However, any of these assumptions could change.

In summary, the bond market offers limited guarantees and is vulnerable to the risks associated with persistent inflation or recessions.

For example, according to the Federal Reserve's traditional dot plot, long-term real interest rates shouldn't exceed 0.5% as the goal is to achieve a 2% annual inflation.

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Put differently, this market might appear to be a good opportunity right now, but the true risks lie in being subject to the inherent risks of a debtor (the Federal government) that continues to accumulate perpetual debt, can alter its payment conditions at any time, and won't offer appealing rates for a solid passive income strategy.

Conclusion

With new challenges to traditional passive income strategies, savvy investors will have to think outside the box to find the “mailbox money” that’s become so sought-after. 

This leads us to farmland. Farmland is one of the most resilient asset classes on Earth, as proven by its outsized performance across multiple economic cycles.

Farmland in Colombia is just now gaining attention on the world stage, and there’s still time to get in early and take full advantage of this window of opportunity. But it won’t last forever. Don’t wait to get in touch with Farmfolio’s team to learn how you can enter the Colombian farmland space easily and profitably.