How to Become a Passive Income Millionaire

Key Points

Investing in real estate is a great way to generate passive income. High-quality dividend stocks can produce attractive total returns. Bonds are lower-risk ways to generate passive income. 10 stocks we like better than Realty Income ›

There are many ways to become a millionaire. One of the highest-probability and least-risky paths to becoming a millionaire is through passive income. This strategy involves investing in income-generating assets such as real estate and dividend-paying stocks. You reinvest the income produced by these investments into additional income-generating assets, which helps you grow your income and wealth.

While this strategy won't make you a millionaire overnight, it will help you steadily march toward that goal. We'll explore how this investment strategy works and some potential investments to consider to help you build a future $1 million portfolio via passive income.Image source: Getty Images.

Passive income investments

Passive income investments are those made into an asset for the purpose of generating income for the investor. There are lots of ways to produce passive income. Among the more popular investment options are:

Real estate investments: There are countless ways to invest in real estate to make passive income, including rental properties, real estate investment trusts (REITs), real estate funds (e.g., REIT ETF or REIT mutual fund), and real estate partnerships. Dividend stocks: Many companies pay dividends, with several offering high dividend yields. Debt investments: Investing in debt (e.g., Treasury bonds, corporate bonds, MBS, or other loans) generates interest income.

Here's a breakdown of these passive income investment options.

Passive income from real estate

Investing in real estate has long been a popular strategy for generating passive income. Owning a rental home or commercial property entitles the investor to a share of the rental income it produces after expenses. In addition to the income, the investor can benefit from the property's future appreciation in value.

One of the easiest and lowest-cost ways to invest in real estate is through REITs. Congress created REITs in 1960 to enable anyone to invest in commercial real estate. These investment vehicles own portfolios of commercial properties that generate rental income. REITs must distribute 90% of their net income to investors via dividends, providing them with passive income.

REITs can be very lucrative investments. According to data from the National Association of REITs, they have delivered a 12.6% average annual total return since tracking started in 1972. At that rate of return, you could become a millionaire in as little as 38 years by investing $100 a month into high-quality REITs.

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Realty Income(NYSE: O) is a great option to consider. The diversified REIT (retail, industrial, gaming, and other properties) has produced a strong 13.7% average annual total return since its public market listing in 1994. The REIT has consistently paid an attractive monthly dividend (6% average yield) that it has grown at a 4.2% compound annual rate.

Realty Income has also steadily grown its portfolio by investing in additional income-generating properties. Those investments have grown its income (5% average annual funds from operations per share growth rate), allowing it to steadily increase its dividend, which has contributed to the steady rise in its share price.

Passive income from dividend-paying stocks

Dividend-paying stocks have been powerful wealth creators over the years. The average dividend stock in the S&P 500(SNPINDEX: ^GSPC) has delivered a 9.2% average annual total return during the past half-century, according to data from Ned Davis Research and Hartford Funds. That's more than double the return of non-dividend-paying stocks (4.3%). Meanwhile, the highest returns came from companies that regularly increased their dividends 10.2% annually. At that rate, a $100 monthly investment would grow into $1 million in about 44 years.

There are many ways to invest in dividend-paying stocks. One of the easiest is through a dividend-focused exchange-traded fund, such as the Schwab U.S. Dividend Equity ETF(NYSEMKT: SCHD). The fund invests in 100 dividend stocks selected based on several quality characteristics, including dividend yield and five-year dividend growth rate.

The Schwab U.S. Dividend Equity ETF's investment strategy has been highly successful. Since its inception in 2011, the fund has produced an 11.6% average annual total return for its investors.

A fixed-income strategy

Bonds are lower-risk, lower-returning income-generating investments. According to data from Vanguard, bonds have delivered about a 5% average annual return over the past 100 years. Given their lower returns, it would take a lot longer to become a millionaire by investing $100 into bonds every month (about 76 years at a 5% rate of return).

However, bonds are still an important part of any passive income portfolio. They help reduce a portfolio's risk profile by producing steady fixed income.

There are many ways to invest in bonds, including buying shares of a top bond ETF, such as the iShares Core U.S. Aggregate Bond ETF(NYSEMKT: AGG). The fund provides broad exposure to U.S. investment-grade bonds (the highest-quality bonds). The iShares Core U.S. Aggregate Bond ETF holds nearly 13,000 bonds by a variety of issuers, making it a great way to invest broadly in low-risk bonds to generate passive income.

Mix your way to becoming a millionaire

The best strategy for building a $1 million passive income portfolio is to allocate money across several passive income investment classes. That will help reduce risk, putting you in a better position to steadily grow your portfolio toward your target. While the strategy takes time, it can be one of the paths with the least resistance for those seeking to become a future millionaire.

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Matt DiLallo has positions in Realty Income, Schwab U.S. Dividend Equity ETF, and iShares Trust - iShares Core U.s. Aggregate Bond ETF. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.

How to Become a Passive Income Millionaire was originally published by The Motley Fool

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