There’s a dark secret that many investors know but that no one seems to talk about much. It’s a secret that every full-time investor eventually discovers for himself or pays the consequences.
To illustrate, let’s take 2 imaginary real estate entrepreneurs, Investor A and Investor B. For the sake of simplicity, let’s imagine that both investors start from the same place. Same income, same credit, same skill level. Then, both attend a real estate conference one weekend in hopes of finding a way to quit their jobs in short order and become full-time real estate entrepreneurs.
The story of Investor A
Investor A latches on to a landlording course. He’s attracted to the idea of building wealth and loves the tax-advantaged nature of rental properties. On Monday, he sets out to build a rental empire that will allow him to become financially independent in short order.
“A” is very successful in finding under-priced rentals in his hometown. His typical deal looks like this:
ARV: $150,000
Repairs: $20,000
Purchase Price: $85,000
Rent/mo $1,200
His standard procedure is to buy the property no money down using private investors, fix it up using credit cards, rent it, then refinance it with a friendly local lender at 80% of the new value. Once the refi is completed, his deal looks like this:
Value: $150,000
Loan: $120,000
PITI Payment: $1,025 (assumes 8% fixed interest rate, $150/month in taxes and insurance)
Rent minus PITI: $175/mo
Cash out from loan: $15,000
Equity: $30,000
By any measure, this is a good deal. Investor A has achieved an infinite return with a $175/month cash flow (not including vacancy and maintenance) on a property in which he has no money. He has $15,000 cash in his pocket—borrowed, true, but also tax-free—and is still $30,000 richer than he was before.
It’s so good, in fact, that he does it 20 more times in his first year. At the end of 12 short months, he owns properties with a net value of $3 million, equity of $600,000, cash flow of $42,000 per year, and has pocketed an additional $300,000 in borrowed money from the back. That’s when he gives notice at his job and settles into life as a full-time real estate entrepreneur.
The Story of Investor B
Investor B, being a more “gotta have it now” kind of guy, takes another track. He finds his way to a wholesaling seminar, where he learns to quick-turn properties for a quick, cash profit. He also sets out on the fast track to real estate success, and begins to do this deal over and over:
ARV: $150,000
Repairs: $20,000
Contract price: $75,000
Sale Price: $85,000
Profit per deal: $10,000
Now, since Investor B doesn’t have to hassle with all that fixing-up-and-refinancing stuff, he’s able to do twice as many deals in his first year as Investor A. At the end of 12 months, he’s flipped 40 properties for a gross profit of $400,000. After paying his 50% in taxes and $50,000 in marketing and overhead, he clears $150,000 in real profit—more than twice what he’s making at his job. So he, too, gives notice and quits his job at the end of the year.
Trouble in Paradise
Meanwhile, back at Investor A’s office, there’s a problem. Although his rentals are newly renovated, he’s discovered that when one of his tenants moves out, he has about $500 in expenses to turn over the unit, and loses an average of 45 days’ rent (about $1800. His annual net income of $2,100 per property is, in fact, a net loss of $200 per year.
But in the big scheme of things, a small net loss in cash flow is OK—it still leaves him $14,800 in cash from his borrowed money to live on. Plus, his well-chosen properties are appreciating, and his income tax bill is close to $0.
There’s also an issue over at Investor B’s office. After his incredible first-year success in the wholesaling business, he and his wife go shopping. Flush with all that cash, they get 2 new cars, a great new pad (with great new furniture to match), take a couple of spectacular vacations, and finally get to put the kids into that private school they’ve always wanted. Unfortunately, there’s not a dime left over, and the B family’s fixed expenses (car payments, house payments, tuition) have more than doubled. But that’s OK, Investor B knows how to make money now. He hires an acquisition coordinator, redoubles his efforts, and does 100 deals the next year, netting $300,000 after expenses.
10 Years Later...
Flash forward 10 years. Investor A is now the proud owner of 200 properties, worth over $30 million! His net equity is now over $6 million (remember, some of his houses are 10 years into the payoff cycle). Thanks to rent increases over the years, his cash flow on the properties he bought in the first 5 years is actually positive.
Unfortunately, much of this new-found cash flow is being used to pay the full-time property manager/handyman he needs to help him with the sheer volume of properties he’s dealing with. And the rest is being eaten up by the increasingly major work that those early properties now need—every single one of the houses he bought in the first year have now needed all new carpet TWICE, and this year he’s probably going to have to replace all the appliances in those 20 properties. Luckily, he’s still pulling down $300,000 a year in cash-out refinances, so he’s able to live pretty well, except…
Investor A can’t stop buying houses. Not because he’s got a compulsion, but because his entire lifestyle is built on borrowed money. His properties don’t cash flow, and they won’t until the mortgages start to pay off in another 20 years.
And A has another problem looming: in 10 more years, all those properties that he bought in year 1 are going to start needing new roofs, new furnace and central air units, new decks, new kitchens etc in order to maintain their value and rentability. A repair bill of $10,000-$15,000 per property is coming, and he knows it. So in a few years, all the cash he’s taking out of the refinances of new properties is going to go straight into the old properties, leaving him nothing but his miniscule cash flow to live on. Unless, of course, he doubles the amount of properties he buys each year. But that means more tenants, more overhead, more help, more everything. If course, he could start selling off some of his houses, using the cash he gets to fix up the others, but converting his equity to cash makes him poorer, not richer.
And Investor B? Well, 10 years later, he’s doing just great. He’s got the killer house, the vacation home, the latest and greatest gadget—and why not? He’s making a hefty income! But he, too, has a problem...he can’t quit flipping houses. His income and lifestyle are completely based on his continuing to generate deal after deal after deal. No matter how tired or sick or fed up or bored he gets, he has to keep working to maintain his current lifestyle.
Alright, so my examples are oversimplified (and maybe a little heavy-handed), but the basic lesson is real: you can get rich in real estate, or you can live like a king, but you can’t do both—at least not right now, and not if you are trying to do both with the same strategy.
And that’s the dirty secret of successful real estate investors—those that have both high income and lots of future wealth, are using at least 2 completely different strategies: one that generates cash—and lots of it—today, and one that builds long-term wealth.
The Cash Generator vs. The Wealth Generator
In the short term—and by short term, I mean 10-15 years—there is not one single real estate strategy that, in and of itself, constantly and predictably creates both high levels of income and builds wealth and passive cash flow for the future.
Now, I know that this is going to create a lot of controversy among people who think they’ve found the golden ticket—and a fair amount of criticism from gurus who are in the business of selling a single strategy as the be-all and end-all of real estate investing.
And, in fact, I could even take the devil’s advocate position and argue with myself that various techniques CAN fit the bill. The problem is, after 17 years in the real estate business and a whole lot more years than that observing real estate investors in their natural environments, I can’t convince myself that it’s true.
The fact is, that while each real estate strategy can be massaged to provide both active, current income and long-term, passive income/wealth, each, when taken by itself, is incredibly lopsided in this regard.
So What’s the Answer?
The point here is not to evaluate whether long-term wealth is more or less desirable than current income—it’s to say that BOTH are crucial. The truth is, we all have to have a way of generating cash AND some non-cash-producing, long-term investments in order to be rich now and rich later. While living the way we want to now, we also need to be putting real effort into investments that have no current cash input—and while building wealth for the future, we need to have a way to eat today.
Look around, and you’ll see that most of the happy, well-fed investors you know have a cash strategy whether or not it happens to be directly related to real estate. Some wholesale or retail, some continue to keep day jobs, some start “lateral” real estate businesses like mortgage brokering, property management, a contracting company, and so on. Some sell real estate education. But whatever it is that they do, they KNOW that they can generate cash predictably, scalably, and regularly.
Think about this: in order to have a worry-free (or at least low worry!), well-rounded financial life, you need to be taking care of today AND tomorrow. And in order to do this, you have to have a way of earning cash and a way of earning wealth. And financial structure won’t just “happen”—it has to be planned for, committed to, and placed into action on purpose.
Meet Investor C
In fact, the perfect investment plan for a real estate investor might be summed up by smushing together Investor A and Investor B from the beginning of this article into a guy we’ll call—very creatively—Investor C.
Investor C sees the pitfalls of putting all of his energy and focus into either long-term landlording or wholesaling. So instead, he makes a plan engage in BOTH of the strategies. Since he’s only 1 guy, he can only do half as many of each as A&B together, so at the end of the first year, he’s acquired 6 rentals worth $150,000 each and has borrowed $120,000 against each. He has $180,000 in new equity and $90,000 in cash reserves from the excess money he borrowed when he refinanced the properties. This means that he can pay CASH for the 7th property, and borrow just $20,000 for repairs, which gives the 7th property an after-all-expenses cashflow of $700 a month, which he can use to pay off the small first mortgage in less than 3 years.
He also wholesales 20 properties with a gross profit of $200,000. He avoids taxes on about $20,000 of this thanks to the depreciation from his rentals. He applies the resulting tax savings of $5,000 to payoff on one of the rentals, which pays it off in just under 12 years instead of 30 if he continues to do it each year.
In 10 years, Investor C has at least 7 fully paid off properties that have a true positive net cash flow of at least $900 each, or over $75,000 per year. He has another 93 in various stages of payoff and a wholesaling business that continues to net him over $100,000 per year in real, adjusted dollars. Now C has a choice: keep investing? Or sell of 75 or so of his houses to pay off another 15, hire a property manager to run them, and live off a passive income of $200,000 a year or so? This is a choice Investors A and B will never face—retirement isn’t an option for either of them after just 10 years.
So let’s all agree to give up this fiction that our favorite strategy is the be-all and end-all of financial independence, and make a new map for ourselves that actually gets us where we want to go. Let’s make a plan that includes cash now and massive, passive future income!