The Most Important Real Estate Story You’ll Ever Hear

There is an unspoken truth in the real estate investing business about what it actually takes to create real, sustainable, life-long wealth in real estate.

No one talks about it because it’s not a simple, concise piece of advice that fits well into a sound bite or a homestudy course.

In fact, this is going to be one of the longest blog posts you’ve ever read, because I’m actually going to try to make sense of this open secret for you—in the form of a story.

Let’s take 2 imaginary real estate entrepreneurs, Investor A and Investor B (well, OK, they’re not all that imaginary—they’re both based on people I know, and if you look around a little, you’ll see examples of both, too).

Both investors start from the same place. It doesn’t matter where—maybe they’re are frustrated corporate employee who hate their jobs and despair of being able to retire while they’re still young enough to enjoy it. Maybe both have decent credit and $20,000 in savings. Maybe both earn $70,000 a year at their jobs.

In any case, 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 traditional 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 wholesale contracts 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

Contract 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 big ol’ tax bill—nearly 50%, because his flips are all classified as “ordinary income” and subject to self-employment taxes—plus his $50,000 in marketing and overhead, he clears $180,000 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 fully renovated and therefore have no major maintenance problems, he’s discovered that when one of his tenants moves out—which happens an average of once per year per property—he does have to clean, patch, and paint the walls, clean and occasionally replace the carpet, and advertise the property for rent. Any cleaning or repairs beyond ordinary wear and tear are charged against the security deposit, but it still ends up costing him about $500 out of pocket to turn over a unit. What’s more, he loses an average of 45 days’ rent (all while paying the interest, taxes, and insurance, plus utilities, lawncare, etc etc) while he gets the property ready to rent and waits for the perfect tenant. In years where a tenant moves out of a property, which is most years, his annual net income of $2,100 on that property turns into 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, at an incredible conservative appreciation rate of 3%, each of his properties gains $4,500 per property in value each year, so despite having to take $200 per property out of his pocket to own each house, he STILL gets $4,300 richer for every property he owns. Plus, the mortgage balances are dropping each year, slowly at first but accelerating every year, which more than offsets the $200 loss in cash flow.

Oh, and he pays no taxes at all—in fact, since he has no ordinary income against which to offset the depreciation from his rentals, he has losses that he can’t even take!

 

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 house-shopping. In fact, they go everything-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 actually has a real positive cash flow on the properties he bought in the first 5 years.

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. Tenants are also hard on kitchen floors, medicine cabinets, and countertops—not big items, but enough to cost him a few thousand extra dollars per property every decade or so. 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 rentals. 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 mid-6 figure 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 25 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.

Take, for example, wholesaling. I can make an argument that a successful, systemized wholesaling business is, in itself,  an asset that has a value outside of the deals it does. In theory, my proprietary marketing materials, my buyer’s list, and the systems that my employees follow to wholesale a deal every week could be “sold” or “licensed” to a competitor for some amount of money. In fact, that’s pretty much what companies like HomeVestors have done—created a business model that works, then sold that business model to others. Now, other people pay them a significant amount of money upfront, plus a monthly fee to continue to use the model. Since the franchise creators can depend on a certain amount of this income every month, whether or not they generate new franchisee, it is passive income.

So in this sense, wholesaling can both create immediate cash AND future value—except that when you create and sell the business, you’re not really wholesaling anymore, are you? By creating a wholesaling BUSINESS, you’ve left the business of wholesaling and entered the business of business. It’s not wholesaling itself that has the potential for future sale or licensing—it’s the systems. Wholesaling itself is a job the creates instant income, and not much else.

On the other side of the investment spectrum, I know a number of investors who have focused their efforts on low-income, high cash-flow properties  and who would argue that they are creating both immediate income and long-term wealth by purchasing cheap houses in rough areas and letting the tenants pay them off.

But, in my experience, what these landlords are mostly living off of is 1) borrowed money, as in the example of Investor A, 2) borrowed equity (every dime that’s taken out of these much-abused properties is a dime that doesn’t go into crucial maintenance, and without constant infusions of cash, these properties actually decrease in value over time), or 3) unrecognized cash generators—more on that in a moment.

In general, landlords who try to treat their properties as cash cows end up sacrificing any significant long-term wealth building—these properties do not tend to appreciate much over time, due to the undesirable nature of the area, and letting them run down decreases the value even more. So in taking out their income in cash now, they lower their future income and equity.

Unquestionably, landlords who buy properties in more desirable areas and take proper care of them over time achieve very high cash flow…when the properties are paid off, that is.  But ask any landlord who is buying AND MAINTAINING this kind of property whether they make any significant cash flow at all during the first 5-10 years of ownership, and they’ll set you straight: all of the “benefits” from these properties come from tax breaks, appreciation, and mortgage pay down.

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.

Oddly—and again, I think this is largely the result of the cash-strategies focus of the investment education industry in recent years—a lot of full-time investors haven’t figured this out yet. I have one local colleague who “sandwiches” properties via land contract, and is very successful at it, completing 30-40 deals each year. He drives a $60,000 car, lives in a $700,000 house (note to readers on the coast—that’s a nice house in Cincinnati), takes a couple of great vacations a year, and pays out 50% of his income in taxes. If he quit today, he’d be totally destitute in about 48 months, when the last of his current land contracts cashed out. Why? Because the whole basis of his business is buy-sell, buy-sell, buy-sell. He has no long-term investments that are just sitting there, growing in value, generating unspendable equity and tax breaks instead of imminently spendable cash. He’s been in the real estate business for 15 years, and hasn’t even begun to think about how he’ll live when he doesn’t want to work anymore.

Now, this particular gentleman has an almost pathological fear of tenants and, it seems, with leaving any money in any deal. But he could also create long-term passive income by shuffling some of the cash he earns into mortgage notes, or a partnership in a commercial property, or timberland, or stocks, or better yet, all of the above in a tax-free retirement plan.

The more common problem that I see with students is that they have a wealth-building strategy, but no cash-producing strategy. They’re working like dogs to create retirement income, but giving up lots in their current lifestyle in order to build a future lifestyle. And while I admire that kind of self-discipline, it’s not wholly necessary. 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. Some get involved in MLMs like Pre-Paid Legal. Some build websites. 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!