Acquiring real wealth requires understanding what it is and how it is measured. The most common measure people use, net worth, is inadequate, and it suggests strategies more akin to speculation than true investment.
The sellers of today's featured property followed a strategy of wealth building that is serving them well.
Irvine Home Address … 50 GREENFIELD Irvine, CA 92614
Resale Home Price …… $324,900
{book1}
Now everybody's got advice they just keep on givin'
Doesn't mean too much to me
Lot's of people out to make-believe they're livin'
Can't decide who they should be.
I understand about indecision
But I don't care if I get behind
People livin' in competition
All I want is to have my peace of mind.
Boston — Peace of Mind
Peace of mind is an underrated and undervalued emotional state. Most people choose lives of speculation, competition, and make believe. They erroneously believe if they arrive at some destination known as "being rich," they will have everything they ever wanted, and that will make them happy. It won't.
There is a peace of mind that comes with wealth, but this emanates not from the pile of money, but the cashflow that pile of money gives off. The size of the pile may get bigger or smaller depending on the market winds, but if the cashflow is stable, the size of the money pile is irrelevant. The real wealth is in the income stream.
I last wrote about this subject in Real Estate, Cashflow Investment and Retirement, but it is an important topic worthy of revisiting.
Many people dream of being rich. At its core, the desire to be rich is the desire for power, and with most people, it is the desire for unlimited spending power. Of course, rich people didn't get rich by spending all their money, but most people want money for what it buys rather than the peace of mind true wealth brings.
Formulas for measuring wealth
People who study accounting and finance are taught how to measure wealth. They believe wealth can be captured in a formula:
Wealth = Assets – Liabilities
That wealth measure, also known as net worth, is convenient because it is easily measured, and it provides a conceptual framework for money managers to measure performance.
It is also hopelessly inadequate. Let me explain.
Perhaps for the uber-rich, an asset and liability model is useful, but for anyone who feels compelled to work for a living — which is most people — the model is not very helpful. Focusing on the balance sheet does not solve the problems of daily life. For that, people need to examine their income statement:
Savings = Income – Expenses
That wealth measure, also known as net income, is better because it captures the real world lives of the vast majority of the population. Maximizing net income is more important than maximizing net worth.
Short of working until death, people need alternate sources of income to substitute for wage income. Some retirees may have savings or annuities from pension or investments, but many end up living only on social security. A steady stream of income from cashflow-positive real estate can make a major difference in a retiree's standard of living.
What would life be like?
Take a moment to imagine your own retirement. If you follow a plan of maximizing wealth as measured in the net worth equation, if you are fortunate, you may acquire significant wealth, but you may not be able to do much with it. If you can't easily convert this wealth to cash, you will feel limited and impoverished regarless of what your balance sheet says.
If you follow a plan of maximizing savings and net income, you may not acquire significant wealth, but you may obtain an abundant income stream to meet your daily living needs for the rest of your life. You will have spending money that no one can take away from you. It is the ultimate peace-of-mind. In addition, you will be able to pass this form of wealth to your heirs with a minimum of taxes.
That is the life I want.
One rich man's cashflow woes
Over the last several months, I have been sharing Wednesday lunches with a man who is very wealthy by the first measure — his net worth is nearly eight figures — but he is totally broke; his assets provide him no income. This causes him stress because he has to sell assets and increase liabilities to live his life.
What's worse, his financial advisors are telling him to sell some properties he owns with no debt — properties he could rent for significant cashflow — and increase the debt on other properties he owns that he wants to keep for his personal use. It is the worst possible advice, shameful, in my opinion.
What this man needs — what every investor needs — is unencumbered cashflow.
What is unencumbered cashflow?
The one characteristic of all true investments is positive cashflow. Any asset valued for potential cashflow or growth is speculation. Many assets blur the line between speculation and investment, but all true investments have one thing in common: they need never be sold to obtain their value.
The man I described above has a speculation problem. None of the assets he controls give off cash; therefore, in order for him to have spending money, he must sell or borrow. This is not a sound way to manage finances.
Many people bought houses during the bubble and thought that made them rich. The land barons in particular were guilty of this mistake. Acquiring assets with negative cashflow with copious amounts of debt may make people wealthy on paper for a while if the assets increase in value (Wealth = Assets – Liabilities); however, this is a huge drain on their income statements (Savings = Income – Expenses). Since asset prices are often volatile, acquiring negative-cashflow assets only works as long as lenders are willing to continually increase debt — the essence of a Ponzi Scheme.
Instead, if investors buy property and work to pay it off, they may not look as wealthy on paper, but their stable income stream provides them the benefits of real wealth; spending power and peace-of-mind. However, to really have peace-of-mind, the cashflow should be as free from claims as possible. It should be unencumbered.
Eliminating encumbrances
There are two main encumbrances to any source of cashflow: taxes and debt service. Real estate has property taxes, income taxes, and a host of expenses that lay claim to the rental income, but by far the largest claim to this income stream is the debt investors typically put on the property.
Depending on the location, rental income can be very stable and predictable which makes it an ideal source of cashflow. The goal of asset management is to minimize the claims against the property because these claims represent risk. Investors who own property without debt never face foreclosure. Speculating land barons lose all their properties to foreclosure in a market bust. The prudent use of debt is the distinguishing characteristic separating investors from speculators.
If an investor can arrange it, owning un-debted real estate — or real estate investment trust shares — in a Roth IRA is the best of both worlds. After age 59 1/2, there is no longer income tax claims on the rental income. If an investor owns the property in California, the property taxes are limited too. Personally, I want to own as much cashflow-positive real estate or other income streams in a Roth IRA. It is the focus of my investment and financial planning.
How do you obtain unencumbered cashflow?
Since this method of investment is how I run my own financial life, I have put significant energy into figuring out how to do it. With respect to real estate, I have created a series of analysis spreadsheets that allow me to look at the income and expenses of any property. These spreadsheets from the basis for the IHB Fundamental Value reports shown in a series of upcoming posts on investing in trustee sales and in the posts IHB Investor Reports and IHB Property Valuation Reports.
Upcoming posts include:
Foreclosure 201: Buying a Rental at Trustee Sale
Foreclosure 201: Flipping Trustee Sale Houses on Speculation
Foreclosure 201: Flipping Trustee Sale Houses to a Buyer in Escrow
Foreclosure 201: Buying Trustee Sale Properties Using Conventional Financing
Today's featured property
This property will likely sell quickly. It is at or below rental parity, and it is one of the lowest priced on the market. The prices are still bloated, but with the low interest rates, this property could be a decent buy-and-hold.
These properties are the traditional move-up. A buyer gets in under rental parity, saves money for the next property, and then when it is time to move, this one is rented for positive cashflow.
The owner's of today's featured property did not HELOC it. I commend them on their financial prudence, and I hope this post helps them find a buyer. They display the habits of true wealth.
Irvine Home Address … 50 GREENFIELD Irvine, CA 92614 
Resale Home Price … $324,900
Home Purchase Price … $190,000
Home Purchase Date …. 6/29/2001
Net Gain (Loss) ………. $115,406
Percent Change ………. 71.0%
Annual Appreciation … 6.1%
Cost of Ownership
————————————————-
$324,900 ………. Asking Price
$11,372 ………. 3.5% Down FHA Financing
5.24% …………… Mortgage Interest Rate
$313,529 ………. 30-Year Mortgage
$69,124 ………. Income Requirement
$1,729 ………. Monthly Mortgage Payment
$282 ………. Property Tax
$0 ………. Special Taxes and Levies (Mello Roos)
$27 ………. Homeowners Insurance
$361 ………. Homeowners Association Fees
============================================
$2,399 ………. Monthly Cash Outlays
-$289 ………. Tax Savings (% of Interest and Property Tax)
-$360 ………. Equity Hidden in Payment
$24 ………. Lost Income to Down Payment (net of taxes)
$41 ………. Maintenance and Replacement Reserves
============================================
$1,814 ………. Monthly Cost of Ownership
Cash Acquisition Demands
——————————————————————————
$3,249 ………. Furnishing and Move In @1%
$3,249 ………. Closing Costs @1%
$3,135 ………… Interest Points @1% of Loan
$11,372 ………. Down Payment
============================================
$21,005 ………. Total Cash Costs
$27,800 ………… Emergency Cash Reserves
============================================
$48,805 ………. Total Savings Needed
Property Details for 50 GREENFIELD Irvine, CA 92614
——————————————————————————
Beds: 2
Baths: 2 baths
Home size: 1,267 sq ft
($256 / sq ft)
Lot Size: n/a
Year Built: 1984
Days on Market: 3
MLS Number: S613513
Property Type: Condominium, Residential
Community: Woodbridge
Tract: Ad
——————————————————————————
EQUITY SALE**NOT A SHORT SALE**NO NEED TO WAIT THAT LONG AS A SHORT SALE**DOWNSTAIRS END UNIT**QUIET INSIDE LOCATION**VERY POPULAR OPEN FLOORPLAN**VERY CLEAN AND WELL MAINTAINED PROPERTY**VERY SPACIOUS LIVING ROOM**NICE SIZED KITCHEN WITH BREAKFAST BAR**KITCHEN OPEN TO SPACIOUS DINING ROOM**LARGE MASTER SUITE SEPERATE FROM 2ND BEDROOM**INSIDE LAUNDRY ROOM**NEUTRAL CERAMIC TILE ENTRY, KITCHEN, AND DINING AREA**MUST SEE**PRICED TO SELL FOR FAST**
ALL CAPS and asterisks instead of periods.
What is wrong with a period? Isn't a simple dot more efficient than two of those strange looking star-like things? And why no spaces? That description is nearly impossible to read.
Good post today. A $325K 2 bedroom below rental parity. Irvine must be in a Depression to get such a good deal.
What if home prices and rents go down. What then?
It will be the end of the world for the people who buy this below current rental parity.
A friend of mine purchased at a shade higher than rental parity in Mountain View, CA in 2007. Comparable rents for 1 bedroom condos were roughly 1700- 1800. He purchased his place for $365K. I’m assuming the loan was for right around 300K, making his monthly payments about 1800. Since then, identical units in the same condo building have sold for $250K, and comparable rents are $1200.
Unfortunately, all you have to go off of is *current* comp rents. As prices come down, so do the rents.
When the world ends in Mountain View, CA the people buying today for $250K will sink into depression and gain 30 pounds after rents fall to $1000 per month.
You’re good at being snide, but no so good at countering wherethebeef’s and es’s points. If rents go down, today’s “rental parity” is meaningless.
There is nothing to counter when presented with a scenario. What if…. What if anything, anything can happen and should be considered. There is no such thing as risk free.
I don’t want to put words in their mouths, but I think they were implying it wasn’t a “what if” but a “when”. In other words, you take the data and you make predictions based on the data. If you’re not doing that, then I suppose it is just a “what if”, in which case you’re definitely in trouble if you have anything at stake.
> Savings = Income – Expenses
Thanks IR.
Focusing on Net Income and using Roth IRA are great ideas!
The realtor needs to look up how to spell “separate”.
IR, not sure what you mean when you say un-debted real estate is akin to REIT shares. Can you explain?
I think he is referring to good REITs acting as cash cows. I sold most of my REITs, but I kept one. It has appreciated 25% since I bought it 6 or 7 years ago, but it throws off 15% a year in dividends. That is where the action is at.
My goal is to get where my dividends and rental income pay my bills. That is what one calls a stress reducer. I am working the same program IR is talking about here.
I think you could also call it `get rich slow`.
Exactly, you have to be careful when buying REITs because some use debt which defeats the purpose. Direct pass through REITs with no debt and with diversification of locations and property types is very stable cashflow.
Which public REITs do not use debt?
Healthcare REITs use very little, and they have superior dividend yields as well.
How do you know they use very little debt, because they say so? That’s not a good enough answer unfortunately. Debt reporting is filled with fraud and still is after the melt down.
If you are getting a 15% dividend there is debt, and lots of it. Always be wary of high dividends. Sometimes risk is OK, but clearly there is significant risk.
You are correct, this REIT has significant leverage. I expect the div to come down once short term rates go up. I am betting on the manager being able to navigate the situation. They made it through the heart of the crisis well so I have some basis for my optimism. But I do look at 15% and think of selling first and asking questions later–often.
Which public REITs do not use debt?
Almost all use debt. The issue is how much debt and how it is managed. This gets complicated (short term, long term, ARM, fixed, credit quality, covenants, etc., etc.)
IrvineRenter,
“After age 59 1/2, there is no longer income tax claims on the rental income. If an investor owns the property in California, the property taxes are limited too. ”
Are there no income taxes for rental income (Sch E)? How does one fill out the form to remove the Sch E income after on the 1040 or is it removed on Sch E itself?
Owning rental property without a mgr can be a lot of work, especially in a harsh climate or poorer area. As for Planet Reality comment, rents do go down and they can be vacant for some time. It’s a lot easier to ride out the loss of rental income when the property is free and clear. Had a unit vacant for 6 months. Had to do an eviction too and fix extensive damages. All these expenses add up and most of the time collecting on an evicted tentant is very hard if not impossible. One bad one > 4 years of profit on a unit.
“Are there no income taxes for rental income (Sch E)? How does one fill out the form to remove the Sch E income after on the 1040 or is it removed on Sch E itself?”
If the property is owned by the IRA, there are no deductions for losses or depreciation and no tax on income. None if it feeds to a 1040.
“Owning rental property without a mgr can be a lot of work, especially in a harsh climate or poorer area.”
I am going through that now. My rental is in Perris and I have been fixing it since Nov. The place was trashed and needed new kitchen and mostly new bathroom after repairing all the water damage that the tenant did not call about. I figure I have spent over 10k so far not counting missed opportunity for the rent. Having no debt makes it ok because when I am too busy to work on it, I just lock the door.
We talk about getting a manager for it after it is fixed up but then I would have to watch the manager.
Out of curiosity, where was the photo taken that shows the luxury high rise next to the slums?
Brazil. He used the photo in a recent post, but I forget which.
A period (.) denotes the end of a sentence.
It’s too much to ask for sentences from RE ads. That would cost an extra $25,000 for the personalized RE service.
There is a reason why this place is priced low. I actually went and took a look at this place and it was like touring a dungeon. You don’t get any sun light!!! It certainly does look good on paper but I know for certain that I can’t last a day in this place.
Until you actually have rented a few homes you have no expericence at how bad it can get and I have rented two in my life that I owned and now I am a renter as well.
Both homes one was a wash and the other a total mess with lawsuits with a large loss.
The folks thought they could blackmail me for money as well. A long story they went BK it cost me three years of my life and twenty K in attorney fees and even more on loss of property because of prior fire. They were found guilty in the end.
Here in CA those that have owned property years prior have the lower tax rate and can rent a lot less you have to compete with those folks as well.
For example I rent from a man who has owned this home for twenty years his tax on it is 4k. But the neighbor next to us has owned hers for thirty years and her tax base is not even 2k. Imagine if she rented that house it would push rents down even further.
I also think it was great to be a landlord when prices are going up but not when they are going down. No one buys a depreciating asset with an unlimited amount of downside risk that is unknown.
So external factors are to be considered along with location and rent. Time waiting for profits is money wasted.
Because the other alternative is cash flow and that is dividends in the form of safe haven stocks. That income is much more liquid you can sell a stock in one day. You can buy in a roth or a MLP and have the money invested without tax payments until you sell –or you can do an IRA as well.
So you have a lot of options best bet is to do all of them. So you are using every resource available to you to increase your income.
The biggest mistake is always putting everything in one basket your friend had terrible advice.
One has cash, stocks with dividends, and owns property with cash flow so when one of these has problems the other asset can keep them afloat.
And I will say not every area is desirable for renting as we can see many empty homes just sitting.
Not only are you losing owing the mortgage costs but taxes as well and maintenance.
One of our friends bought a house in Riverside 5 years ago for his son to go to college and rent it out. The loss on this home is 50% it’s price. The breakeven was the boys paying the mortgage. So what does he do now? Walk away I assume. All equity and down payment will be lost.
People involved in larger pooled groups who are buying up homes and renting them out with available tax advantages are the ones who will survive because they have much more leverge.
A single person who is doing this must have a very large amount of free cash here in CA to withstand the loss of rent and the devaluation of property.
Just my experience for what it’s worth.
I don’t see how real estate is supposed to deliver annual appreciation of 6% (if the seller gets his asking price) while stock markets deliver a zero percent or negative return over the same period with more volatility. From that perspective this property is still overpriced. And I agree with wheresthebeef that rents are falling in Irvine so the rental parity comparison may be true today but things will look quite different in a year or two after rents are down 20-30%.
re: Wealth = Assets – Liabilities
Greenspan used a formula like that in his book to say it was ok that people had huge debts relative to their incomes, because the value of their assets (ex. housing, stocks) had risen as well.
Of course, when the market value of the assets crashed, but the debts remained, we all know that didn’t work out so well…
http://www.cnbc.com//id/36667656
“The average number of days from when a borrower stops paying on his/her mortgage to when the bank sends out the first foreclosure notice is 417, Zelman notes, and the final foreclosure can take up to a year more.”
Can this be true? Or just media smoke?
If RE is in a IRA, and you’re tax deferred until you take out the money, are you lossing the deduction on the depreciation before 59 1/2, but paying the tax on the sale even when the depreciation benifit was not taken? Depreciation must be declared yearly, even if no benifit to you. For example, high tax bracket and AMTed out so no deduction or taking depreciation in low tax bracket and must pay tax on the accumulated depreciation when in high tax bracket upon sale of the property.
I am terrified of being a landlord, because I have no home-improvement skills, and have had bad experiences finding good help. Plenty of people say they’ll show up, but don’t, including some whites ones bitch incessantly about immigrants taking all the construction work.
I figure I’d need to find a solid carpenter/electrician/handyman, and then pay him 25% above his usual rates, so he’s eager to show up.
Thanks for today’s post: A light bulb went on above my head. The distinction between speculative and cash-flow investment should not be taken lightly. Sometimes speculation can be a better play, but not usually.
I think a lot of today’s landlords fail to understand this, because they failed to examine the possibility of surviving on rental income alone, sans appreciation. My current and previous landlords had no idea what they had signed up for, and the current one still doesn’t. I doubt he even scribbled the pros and cons on the back of a napkin before buying this place.
The issue of encumbrance has ugly implications for those with limited capital. Mine capital grows slowly, month after month, from living within my means, but is not yet large enough to purchase an income-producing asset with little debt load. I see partnerships and REITs as encumbrances of a sort, albeit light ones: every additional party you share ownership with makes the asset less liquid and/or limits your freedom of action: yech.
It is good to be Warren Buffett.
I won’t be signing up to be a landlord, ever, but today’s post set the gears grinding in my little. head. All my gains so far in life have been in speculative investments: commodities, index funds. I can’t limit myself like this.
Landlording will come back to bite you in the ass.
If it were really such a great idea, the banks would be renting the units out instead of selling them.
Reading the copy in the listing tells me everything I need to know.
EQUITY SALE!!! blah blah blah.
Code for.
I CAN’T FIND A RENTER!
Just because some fool overpays for a similar rental doesn’t mean they’ll overpay for yours. No different than a buyer overpaying for the house next door.
Things I’ve learned being a landlord:
* Get a good property manager. Difference between good, experienced manager vs. inexperienced one is that the first is pro-active and the second is re-active. Experienced managers will take steps to minimize future problems, versus inexperienced managers hasn’t seen enough problems with tenants to raise red flags.
Why get a property manager? You want to get a call at 10am from your tenant about a backed up toilet? No? Pay the $$ for a manager.
* Real estate, like any other investment, carries risk. But an analysis should not be based solely on numbers. When you’re looking at a property, take a more holistic view and ask yourself “how do I feel here?”
Aristotle wrote “The whole is more than the sum of its parts”. The parts (wood, carpet, etc) used to build the house alone does not consititute all the external factors in the environment that affects your mood and emotion. If you go inside a house and the place makes you feel in a negative way, chances are that your tenants may feel the same, so don’t buy it. In some cases it can be remedied with rennovation, but you’d be taking a chance.
Only invest in properties that 1) generate positive cash flow, and 2) makes you “feel good”, or at least neutral.
* Your home (personal residence) is not an investment property. As a matter of fact, like your car it’s a financial liability because it doesn’t generate profit. Do not treat your “home” as an investment.
* If anyone is interested in using their 401K or IRA account for self-directed IRA investment in RE, you must consult a professional. Do not attempt yourself.
I enjoyed the article.
Some of my clients are still in the housing market after the bubble collapse and are doing quite well. They are those that didn’t overextend themselves and created an income flow.
Positive cash flow is really the only way to become rich.