I am a Fundamental Investor – someone who acquires assets to hold and use for a long period of time. Not to be confused with trading, which involves buying assets, improving them quickly, and selling them for a quick profit, which is typically referred to in real estate investing as fix and flip. There are other ways to make money in real estate, but most of them add up to a job which requires full-time commitment – I don’t need another job…
I hold rentals because about a decade ago I determined that getting rich with real estate is more likely for an ordinary guy such as myself than by any other means.
GETTING RICH WITH REAL ESTATE
It is important to understand that there are a number of different profit centers in real estate. While some are helpful relative to my current finances, others build my future wealth. Let’s talk about this in hopes of isolating the moving parts in order to help you to most effectively structure investments.
Let’s begin with the basics:
WEALTH vs. FINANCIAL FREEDOM
Wealth is not the same thing as financial freedom. Today’s conversation is about wealth, but I feel compelled to draw this distinction in order to better focus the conversation.
A Basic financial statement has 2 parts – the Income Statement and the Balance Sheet. The income statement tracks all of the income and expenses and reconciles them into what we call Cash Flow:
The balance sheet, in turn, tracks values of assets (things that make money) and liabilities (things that cost money), and reconciles those values into Net Wroth:
In the most basic terms, cash flow represents financial freedom; specifically passive cash flow from real estate. As they say – equity doesn’t put bread on the table; cash puts bread on the table. Equity will not pay your monthly bills. Cash flow will pay for your mortgage and your daughter’s braces, put gas in the car, and pay for a vacation. Cash flow, that is to say cash in hand, is how we pay for life on a day to day, month to month, and year to year basis. Thus, it follows that should you be able to take possession of enough cash to be able to cover expenses of life without needing a job, then you can achieve financial freedom.
Passive Cash Flow is the essence of financial freedom – ability to pay for life regardless of whether we have a job, or not; whether we are healthy, or not… And rentals just happen to be one of very few ways to generate this passive cash flow – cash flow that you don’t need a job for.
Cash flow is a lot of the reason we buy income-producing real estate. But, cash flow doesn’t build wealth. Net worth represents wealth – having a number followed by a bunch of zeros on your balance sheet is what wealth looks like!
What makes rental property such a prodigious investment is that it offers both. The income from rental property, presuming that it is higher than the expenses of holding it, puts money in our pocket by way of passive cash flow. At the same time, property should, over time, benefit from appreciation, which shows up in our net worth and constitutes wealth.
Now – not all real estate benefits from appreciation. There are a million caveats to that, and a million reasons as to why property might not appreciate over time, and as an intelligent investor you should avoid rentals like these at all cost. In this article I can not possibly tackle what all of them are, but I discuss this in detail as part of the Cash Flow Freedom University.
2 WEALTH-GENERATING CENTERS
I will say, however, that the essence of the game is such that even if the property you own never appreciates in value, it will more likely than most other investments build your wealth. Why? There are 2 wealth-generating centers throughout throughout the life of an asset. One is the good-old appreciation, which may or may not happen.
But the other is recapture of equity by way of loan amortization. Presuming that some portion of the purchase price was financed with debt, every time you make a mortgage payment, a portion of which allocates toward pay-down of principle balance, your net worth goes up. And this happens automatically!
In my opinion, there are many good reasons to finance property with at least some amount of debt. Here’s the thing – as it relates to rental income-producing property, it is not you, the owner, making the mortgage payment – it is your tenants. It could be said, therefore, that your tenants are generating your wealth.
I am known as a No Money Down (100% financing) guy, which is to say that my goal has been to finance as close to 100% of every purchase as possible. Why should I build my own net worth if I can have other people do it for me – this has been the rationale. Regardless, I can understand that some people may not be comfortable with 100% financing; I do, however, insist that some significant portion of a purchase of income-producing property be financed!
Amortization is a balancing act. Level of leverage is another balancing act.