Cash Flow Investing vs. Wealth Building
Introduction
Over the years, there have been multiple arguments amongst real estate gurus about which is better, cash flow investing vs. wealth building. In today's post, I go into more detail on what to look for in your portfolio.
First, let’s take a look at one of the biggest mistakes young would-be investors make. I don't mean young in age, but in experience (it is never too late to start). Unless we were raised by successful investors at home, chances are the only thing we heard was to get a good education, a good paying job, and invest in the stock market where your money will compound over time. At some point, a young investor comes across internet noise regarding real estate investing. Suddenly, they join all the groups and start reading books or watching youtube for clues on how to start.
I love trolling the Facebook and LinkedIn real estate groups to see the questions people ask. It is great to have a network and a community of investors to bounce ideas off, however, there are more starting wanna-be investors in these groups just like you who feel like they need to answer questions. The answers are so far from good advice in many cases. So after getting a lot of advice in these groups, they venture off to the excitement of that first deal. Here's where the mistake is made…
They've been talking to or influenced by a lot of inexperienced podcasters or group trolls like me (lol). They go into their first deal with 3-4 different strategies thinking they are doing this right. They lack clarity around what they are actually working towards. One of those areas is this idea of cashflow investing vs. wealth building that we'll discuss here today.
Cash Flow Investing
Over and over, ads are sold by gurus to sell a course or a book on how to build cash flow in real estate and leave your job. It is suggested that with only a couple of deals all of this passive income is going to replace your income in a relatively short period of time. Passive income is amazing and is the crown jewel of investing. Make no mistake, real estate investing is rarely a passive activity the way most people do it.
“Never take your eyes off the cash flow because it’s the lifeblood of business.”
There is an idea sold out there that the income produced should equal 1% of the sales price of the asset. That may be true in some markets, but not all markets are as achievable as the norm. In my home market, it can be difficult to find the right properties at the right price to achieve the 1% rule. Another rule I hear is that you should not invest if you're not getting $200 positive cash flow per door on day one of taking over. Again, that is a market-specific strategy and does not work in every market. It can be deceiving.
So, here's the reality of cash flow. When analyzing a deal, you review all of the historic income and expenses and make sure to include your debt service. When purchasing small single-family or small multifamily properties, debt service is a huge key to managing your cash flow. In my market, there are a lot of properties that are solid investments with rent that has not been raised in 10 years, so identifying a day-one cash flow may not be easy to achieve. It may actually cause you to turn away a lot of great deals that can make you a lot of money in a short period of time.
It is easy to be blinded by day one cash flow. The inflow of revenue is affected by current rents, market rents, and vacancies. Expenses include management, maintenance, utilities, insurance, taxes, contractors, etc. Finally, the debt service you choose has a huge impact on your cash flow.
My recommendation to young investors is to know your numbers and the business plan to achieve success on your plan. What expenses and what income can be manipulated to reach your cash flow goal? Raise rents? Add "free" wifi service? Add covered parking? Negotiate lower expenses? Shop for the best loan? Increase your down payment to reduce your loan? All of these will impact your cash flow.
The first four-plex I purchased turned out to be a bust on day one that had my partner pretty upset with me. We were not going to be able to afford a manager without going into the red monthly. So, I looked for a solution and offered to manage the property until we got the unit’s rent up. Over an 18-month period, we did see positive cash flow monthly (not a lot, but some). What was most exciting though was the financing structure that we negotiated to buy the property. The seller wanted a certain amount monthly to offer owner finance. We overpaid on price but we got below market interest rate and a 20-year amortized note. Most people don't understand that and I won't go into why that was a great thing here.
In eighteen months, we created a six-figure payout and sold the property above market value at the time. We did NOT get a lot of cash flow in those early years, but it was enough to cover expenses and maintenance. My partner was thrilled. He wanted to walk away from the deal, and I convinced him why we should hold on. Had we held on longer, the monthly cash flow was increasing with every lease and the value continues to climb today. We would have nearly $1500 per month cash flow today on that property if we held.
A general rule I look at on any of these projects small or large is not day one cash flow (it's a bonus if we can achieve it). I look for month 18 -24 cash flow to see where the numbers are shaking out based on successfully working my business plan on the property. Remember, owning real estate is running a business. The best deals are the deals you can see clearly how to grow the cash flow.
Cash flow is about sustaining the business from business activity and not your personal bank account. Over time, cash flow can create additional streams of income for you to enjoy a lifestyle like no other, but don't be deceived thinking day 1 is where it's at. On day 1 you're buying a lot of problems to solve. It's your job as a real estate investor to solve those problems and reach your goals as in any other business.
Wealth Building
This is where things can get really exciting. Remember my example of selling our four-plex in 18 months for a six-figure payday? That was a great day! Ultimately, averaged out with monthly cash flow and the final equity gain, we averaged over $6000 per month in gain! Keep in mind that most of the gain came from forced appreciation which is not widely understood among newer investors. Single-family homes don't get forced appreciation, only market appreciation. Multifamily properties are valued based on the income generated.
The other part of our gain came in from the owner financing we negotiated on that 20-year amortization. The renters paid down the note at a faster rate than a traditional 30-year loan. Keep in mind though that the shorter amortization created less monthly cash flow from higher debt service. You really have to understand how this works to utilize strategies like this. And when they work, they work well. We invested $28k for a six-figure payout only 18 months later. That was a 4x multiple on our original investment! That's something you cannot do in the stock market easily.
Wealth building in real estate is about long-term asset value and debt service paid off by others. It's about investing a small amount for a much larger payout down the road. Initially, if you're buying assets you won't have a great deal of cash flow, but you have an asset that has been neglected in some way and you can force appreciation through management efficiencies.
“The trouble for most people is they don’t decide to get wealthy, they just dream about it.”
Another example was a client of mine who purchased a 16-unit property and really overpaid for it at the time according to most gurus. He purchased it for $925k and 24 months later he refinanced his loan with a value of $1.4 MM. His monthly cash flow was somewhat anemic during that time as we worked through the business plan. In some months he had no cash flow and in others, he has $3-4000 of positive cash flow. Move-outs and renovations of units were in play which affected his cash flow. I managed the asset for him during that time and took it from $9,000 per month in revenue to $13,000 per month over 18 months. When he refinanced his interest rate saved $1500 a month on debt service. He is thrilled today, although it was a little stressful for the first 18 months.
Can you imagine turning a $300,000 down payment into $900,000 in equity over that time? That is the power of wealth-building! His cash flow was positive roughly $35,000 per year while his equity grew at $300,000 per year during those first 2 years.
Forced appreciation and tenants paying down the debt are where real wealth is built. Cash flow comes with time. I hope you're seeing the value in this.
What Should You Do?
So most young investors I talk with want to build a multi-million dollar portfolio for passive income. That's what they've been sold. That's a great goal and know that it is not an overnight equation that is passive inactivity. However, during the pandemic, I experimented and set up a property management company. I grew it to a meager 64 units managing that with one part-time assistant. It nearly killed me with the amount of time it took. I tell you that because, during that time, I discovered the path to acquiring 100 and 200+ unit apartment complexes that actually create passive income for our investment partners.
As a group, we actually do all the heavy lifting for our partners. We find the deals, sign on the debt (taking all that risk), we manage the asset after closing, and work on the business plan. Our limited partners are just that, limited. For example, we recently purchased a $42 million dollar 208 unit complex that required $15 million in equity. Our team put up a portion of personal money and our limited partners brought the rest. Minimum investments were $100,000 to own a portion of a $42,000,000 asset completely passively!
As we do all the work, our limited partners continue working in their jobs with their money working hard in the background. This particular deal has cash flow distributions starting 30 days out after we closed on it. One of the other deals we closed this year needed more work so cash flow distributions start in month 13. Either way, both of these assets will grow in value by roughly $15 million dollars over the next 3-5 years. Every limited partner gets to share in that upside based on their percentage of ownership!
That is truly wealth-building. You may be saying, yeah but I invest in this for the cash flow. Did you start out investing in the stock market with the goal of growing wealth over time? This is no different. What is different is the component of cash flow that kicks in relatively shortly into the game. You are investing for the long term in assets with partners who have a lot to lose.
Remember the 2008 -2009 market crash that eroded over 50% of household savings in the stock market? Many people never recovered from that crash. In the market, your equity investment is 100% at risk and there is nothing you can do to recover it. In these types of real estate investments, a bad year can recover much more quickly with efficient management of the hard asset you own. So you may have a year in which the monthly cash flow distribution is held back to deal with market corrections. Your stock market portfolio that promises 6-8% growth annually over a 30-40 year span can't compete with commercial real estate that is actually backed by an asset. It's like the gold standard but with real estate as the wealth protector.
For more information on building your long-term wealth strategy, drop us a line to schedule a strategy session.
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