Most of all, beware those who love real-estate!

OK, so I invest in real-estate …

… but, I’m not in love with it.

Take a look at the above infographic [click to enlarge]; a picture (with numbers) tells a thousand words:

This person claims that they (or a client) bought a single-family home for only $35,000 and now clear (fees, insurance, and property taxes) $680 a month in rent.

Since they put in $7k in closing costs and rehab when they bought it, they are really returning $8k a year, which is 19% a year.

The key to real-estate is that you can add value.

To see what I mean, check out the highlighted items in the enlargement, below:

By spending just $5k in rehab, the purchaser immediately increased the value of the property by $18k, from $42k to $60k. Presumably, this similarly increased the rents.

The problem with this type of example is that it is unrealistic: this example assumes that you paid cash for the property.

Instead, I’ve made a ‘more normal’ example from this one, to show you how cash-on-cash returns really work, and why RE really is such a good investment:

[you can download the full spreadsheet here:  https://www.dropbox.com/s/ujuqaptgrr8hssv/Simple%20RE%20Analyzer.xls]

This analysis confirms that it is possible to get a 19% Cash-on-Cash Return, but:

1. You need to have a 15 year outlook; the first year produces a loss,

2. The assumed rent is VERY high.

The reality is that most residential real-estate tends to produce negative returns in the early years, and capital gains over the longer term. Whereas commercial real-estate tends to produce higher earlier returns but lower capital growth.

Still, by purchasing well, adding value (e.g. through a clever & economic rehab) it is possible to produce fairly reliable (when compared to the up’s and down’s of the stock market) cash-on-cash returns that blow away most other consumer-grade investments.

Read his story, make a selection, and leave a comment:

We are renting the commercial condo that our business is in for $1,800 per month, we can buy it for $160,000 should we?

We like the building, the location is a bit hard to find, and with a 20% down it will really cut down on the monthly expense but I will eat up $32,000 that we could use to expand the business. I don’t have $32k but I have a friend who offered to lend me half of it, I do have half.

We currently average $15k a month in sales, other than rent we have about $1000 in fixed expenses, I pay myself $2500, and we average about 25% for costs of goods sold. We currently have staff that costs about $2000 per month. This gives us about $4,000 of extra money at the end of each month….so far with this extra money we have bought lots of extra inventory to the point that we have enough, we have bought a commercial truck, the business is 100% debt free and has about $5,000 in liquid assets saved up (And we personally have over $10k), along with 30k in inventory and 10k in tools and equipment. Personally we are debt free other than the house, student loans and car….but with the house at 2% interest and the car at 2.9% and the student loans at 3.25% I don’t see any reason to send any of them more then the minimum because we make 4 times on most inventory that we buy.

So is now a good time to get the building? Or should we keep our cash free to keep buying things that are our core business? We are not in the business of real estate so should we own or rent?

Now, I’m not yet sure exactly what advice to give him, yet, so leave a comment and help us BOTH out

It (rightly) questions the typical “Wall Street” view that (a) asset allocation is important, and (b) that a 60/35/5 stocks/bonds/cash mix is the only way to secure your financial future.

Of course, a ride through 2008 fixed that view for a lot of folk …

So, I was quite impressed that a site that provides financial / portfolio allocation advice actually considers real-estate to be a viable investment option, and an equally important part of your portfolio.

The suggestion is to use real-estate to provide the real diversification that you need.

And, it may even be the right for successful investors (although, I prefer a portfolio that is more like 90/5/5 real-estate/stocks/cash) …

… but, it is not the right approach for investors who want to become successful.

Let me explain.

The balanced portfolio may help you retain your wealth if you already have it (i.e. if you are already a successful investor), but is unlikely to make you rich on your own.

You see, in order to:

- Become wealthy, and

- Maintain your wealth along the way

… you need two things:

1. An Income Driver: i.e. something to provide an ever-source of cashflow, and

2. A place to invest that cashflow that compounds.

The good news is that you can achieve this simply by modifying the second, larger section of the pie-chart, somewhat:

Your own business is the best way to provide a rich vein of income that you can then tap to fund an ever-growing investment empire in real-estate.

Now, you can certainly grow income in other ways besides having your own business: you could look for a sales job that pays very high commissions (hundreds of thousands per year; or, a management job (preferably, c-level: ceo/cfo/cmo/cto) that pays the same, or better; or, take on a second job or a part-time job; and, so on.

But, nothing has the earnings-growth potential of your own business (although, the ceo’s of certain Fortune 500 companies might – quite rightly – argue that point).

But, why real-estate?

Because both the capital value of the asset (i.e. the amount that you paid for it) and the income stream grow at least in line with inflation, given a long-enough investment horizon … so, you get a double-whammy of increase in your net-worth (i.e. the building grows in value) and the ever-growing rental income stream – if you save it rather than spend it – will eventually help you buy another, and another, and so on.

Keep this up for long enough, say 7 years, and my experience says you can become rich

I recommend that you read his original post, but the chart itself is pretty self-explanatory; it shows the problem in personal finance … and that’s:

As your income grows so do your expenses.

It’s called ‘lifestyle creep’ and is one of the key reasons why the actual wealth of high-income earners (as indicated by the grey shading between the green income line and the red expense line) is not necessarily that much higher than that of some medium- (or even low-) income earners.

The obvious solution, according to Joe and many other pf bloggers, is to reduce your spending:

This way, you decrease the red expense line relative to the green income line …

… in the process, enlarging the grey-shaded area between the two lines i.e. allowing, at least in theory, even low-income earners to increase their wealth!

The problem with this strategy is that saving – especially, saving more (probably a lot more) than you do now – is really, really, really hard.

Austerity hurts. Austerity is against nature (well, my nature).

It gets worse: saving now so that you can spend later simply doesn’t work!

To make this type of cookie cutter personal finance plan actually work, you need to be debt-free and be able to live on just half your current annual income for your whole life.

In other words, you need to drop the red savings line to no more than half the green income line … not later, but now … and keep it there for the rest of your life.

Never fear, I have a better plan …

… it’s one that is far more natural, because it allows you to maintain your current standard of living, even increase it over time:

Let’s say that you start off as an average-income earner; here are your steps to success:

1. You can start to save a little, perhaps more than you have done in the past. Don’t worry, this austerity is temporary … after all, you already know how I feel about too much belt-tightening.

2. Once you have a little money beginning to pile up, you should find a way to put it to use to help you grow your income. Perhaps you could: start a part-time business; buy an ‘absentee-owner’ franchise; or open a car wash. You could work a little smarter and score that big (or little) promotion. Maybe you could collect a windfall: a tax refund; find a rich aunt who dies and decides not to leave all her money to her cat after all; or, you get really lucky and hit a small jackpot at Binions.

3. As your income grows, you should increase your spending by no more than 50% of your after-tax ‘pay rise’. The rest must go back into your little pile of money. Then you should concentrate on finding even more ways to put it to use to help you grow your income. Are you beginning to see a pattern here?

4. As your income grows at a (much) faster rate than your spending, you will slowly begin to see that you are actually already tending towards saving 50% of your income without even trying!

Keep it up for 15 to 20 years, and you’ll be able to sustain that savings rate all the way through – and beyond – retirement, as you build a big enough bucket of wealth (your net worth) as shown by the green-shaded area between your income and expense lines.

What’s more, this fully sustainable standard of living is always more than your current standard of living, so you never, ever need to tighten your best. The secret with this plan is that you simply don’t loosen your belt as fast as other high-income earners tend to do.

Obvious, really …

Now, that’s what I call eco-friendly finance

[You can also read this post in the Carnival of Personal Finance:  http://wealthpilgrim.com/carnival-of-personal-finance-happy-days-are-here-again-edition ]

Now, do you need to be smart to become wealthy? Is “but, I’m not very smart” a valid excuse for not even trying?

It turns out that the answer to both questions is NO.

You see, your IQ (more correct: your cognitive ability – i.e. your ‘smarts’) has very little to do with how wealthy you will become …

… studies have shown that 97.5% of the factors that can explain wealth have nothing to do with how smart you are:

Zagorsky found a correlation of 0.30 between IQ and (recent annual) income, which is relatively low — roughly 9% of the variance in income can be accounted for by IQ, and the other 91% is due to ‘other factors’. On average, he found that each IQ point added about $200 to $600 in annual income. As for net worth, the correlation with IQ was even lower, at 0.16, meaning an explanatory power of about 2.5% (leaving 97.5% of the variance to be explained by non-IQ factors). In his words, “Since the statistical results are not distinguishable from zero, this suggests IQ test scores and net worth are not connected.” You can view a scatter plot of net worth vs. IQ here: http://www.flickr.com/photos/pke…

the non-relationship between financial worth and iq

from the journal intelligence

He also dives into about 30 other variables with interesting outcomes. For example, your net worth at age 28 has only a slight correlation of 0.13 with your net worth at 33-41. Self esteem has a correlation of 0.11 with net worth. Being US-born (as opposed to being an immigrant) has a correlation of negative 0.01 with net worth, while having siblings has a net worth correlation of -0.06; but don’t worry, those aren’t significantly different from zero either.

Ironically, you will need a reasonably high IQ just to understand what this is all telling you, so let me simply remind you of a story that I shared some time back:

I bumped into a friend of mine, who was voted “least likely to succeed” at high school. I was surprised to see him stepping out of a shiny, new, red Ferrari.

After we exchanged pleasantries, I congratulated him on his success, told him that I wrote about personal finance, and asked him how he made his money.

He said that he simply bought and sold stuff on a 3% margin, and that’s been enough to fund an amazing lifestyle and a huge real-estate portfolio to underpin his retirement.

Well, I was incredulous … only a 3% margin?! And, I told him so.

But, no, he said: “I really do work on a 3% margin: I buy stuff for $1 and sell it for $3. That’s 3%!”

As I said, whether or not this post makes any sense to you whatsoever, it will have absolutely no bearing on how wealthy you will become … thank goodness

I am in my early 20s, earning between $110-180k/yr depending on my bonus. Would it be inappropriate for me to drive a $50k Mercedes Benz?

Most people would deal with this by saying things like:

- Can you pay cash for the car?

- If you buy a Merc now, what will you buy next year?

- Save for your own home

- And, so on …

Which are all valid concerns …

… but there is one important question that nobody thinks to ask:

What is your current net financial position (i.e. net worth)?

Yet, this is the most important question to ask!

Why?

Because it’s your Net Worth that sustains you in retirement:

- Before your retire, you earn income

- You save and invest as much of your income as possible to build up your ‘nest egg’ (this is your net Worth on the day that you retire)

- After you retire, you live off the income (e.g. interest, dividends, investment income, etc.) generated by your Net Worth and/or deplete it over time

And, this takes you directly to The Golden Rule of personal finance …

… because, it’s the one financial rule to live by; the one above all others; the one that – if you follow it – will answer all of your financial questions and guarantee your financial future:

Always have 75% of your net worth in investments.

This means: at least until you retire at a time and place of YOUR choosing, that you should always have no more than the remaining 25% of your current net worth (tested yearly) as equity in your own home, car, possessions, etc..

These rules of thumb then follow:

- Have no more than 20% of your current net worth as equity in your own home

- Have no more than the remaining 5% of your current net worth in your other possessions. It is typical to split this 50/50 between your car and your other ‘stuff’.

- This means that you should have no more than 2.5% of your current net worth in your car. I suspect that the reader’s proposed Mercedes would break this rule.

There are a few important things to note, if you’re going to obey The Golden Rule:

1. You can – in fact, should -break the 20% Equity rule for your first house (otherwise, you will never be able to afford to buy one), but don’t upgrade for as long as you will be breaking this rule.

2. You will probably need to borrow money to buy your house (first and/or future home), but don’t spend more than 30% of your take home pay on the mortgage repayments, except – again – for your first house (but, only if you absolutely have to).

3. Never borrow money to buy a depreciating asset (e.g. car) UNLESS it’s required to earn income AND you have no other way of buying one. Even then, obviously buy the cheapest that will do the job, borrow the least, and pay it off early.

4. For a pleasant surprise, test these numbers annually: because your Net Worth will go up each year, yet your car and other ‘stuff’ will depreciate (check eBay). This means, you can actually afford to buy more ‘stuff’ every year or so, if you like, or just save up your ‘spare net worth’ for a couple of years to upgrade your car, etc. when ready.

So, are you following The Golden Rule?

If not, what do you have to change in your life so that you do?

As much as I know that I should read some of your posts to better understand some of the questions I’m about to ask, I thought it may be faster to drop you a line.

Yep, this really is part of an e-mail that I received today …

Now, I don’t mind – in fact, I love – receiving e-mails from my readers.

And, as many of you will attest, I really do try and answer them all (often backing up my answers with a post, such as this one)!

But, there are so many online sources that provide great, basic information …

… so, why waste your time asking a multimillionaire how to tie up your shoelaces, when he’s willing to almost-literally (well, as good as) give you the keys to the golden treasure chest?

Instead, I heartily suggest you first try doing your own basic research then, by all means, ask me to help you fill in the blanks …

[AJC: Google is an amazing tool for finding the answers to standard personal finance questions. Another great tool is the comment section to my posts, where one of the other readers may be able to help; and, I often respond to comments, as well]

… believe me, I’ll be more than happy to do so.

And, if you’ve put in the work ahead of time, what you’ll end up with is some information that you will not be able to find anywhere else.

That, I can promise!

Happy googling

… and, I made $7m in 7 years.

So, if you’re an early reader, that means that you should have added around $1m to your net worth since you started reading this blog.

Have you?

If you haven’t, I’m guessing that it’s for this reason:

[Source: http://www.quora.com/Life-Lessons/What-is-the-most-important-life-lesson-that-you-have-learned-up-to-this-point]

The things that I discuss in this blog aren’t for reading or intellectualizing [AJC: is that even a word?] …

… they are for doing.

If you don’t get out of your comfort zone and actually change the way that you go about things – and, I’m speaking financially, here, but this is equally valid for any aspect of your life that you wish to improve – then how can you expect your results to change?

As Albert Einstein said:

If what you’ve been doing hasn’t brought about the life-changing financial situation that you’ve been hoping for, then think about what you should be doing …

… and, just starting doing it.

In order to budget they – actually, you – have to ‘get’ … well … you.

Confused?

Let me give you an example:

I tried going to my accountant when I got back to Aus after a few years in the US, and here’s how the conversation went:

Him: Well, you could start off with a budget of $150k per year and see how you go

Me: Start by writing 4 things on your whiteboard:

1. Private Schooling for 2 children

2. One to two overseas trips per year

3. Invest in at least one startup per year

Him: OK, now what?

Me: Write $50k next to each of those

Him: OK, that’s $150k total

Me: That’s $150k per year, then you can add your $150k ‘starting budget’

Him: Oh shi …

The steps to perform the only kind of budget that really makes sense are as follows:

1. Do a One-Time ‘As Is’ Budget

I described this kind of budget in this post, and it truly is the one and only time that I have ever made a personal budget.

It consisted of everybody in my family (at the time, only my wife and me) carrying around a pencil and piece of paper for a whole month …

… and, writing down every single thing that we spent a penny or more on during that month, whether by cash, check, credit card, or electronic transfer.

At the end of the month, it was fairly easy to categorize the expenses and tally them up. Of course, we also needed to prorate in some expenses, such as insurance, that are paid one-time, and prorate out similar multi-month expenses that may have been paid during that month.

At the end of it, you should have a fairly accurate picture of what you are currently spending.

2. Create your ‘To Be’ Budget

After my earlier post, you should have a reasonable idea as to how to do a Top Down Approach To Investing analysis.

It consists of working out how much money you need in order to stop work (retire … early!) i.e. Your Number, and when you need it i.e. Your Date.

Then you can work backwards to find out how much compounding you need and what investment vehicles can get you there.

But, the missing step is working out how much starting capital you need …

… now, I can’t tell you that, as it depends upon what you have in mind.

But, the chances are – and, to me, this is the sole point of doing your budget anyway – you will need to find a way to increase your savings to build up that little investing war chest of yours.

And, the best way to do that, is to start by paying yourself twice!

[AJC: most of the 'how to' detail in this post has been covered in the earlier posts that I have listed, above ... don't be afraid ... go click some links!]

Now, that’s how to do a personal budget

.

.

Since you’re unlikely to win a car …

[AJC: if you haven't seen yesterday's April Fools Day post, you can check it out here ...]

… you may be thinking about buying one.

For example, Michael asks:

My business is going well and I’d like to update my old Ford Ranger pickup (160k miles) with something new.  I saw that there is a bonus depreciation on vehicles over 6000 lbs GVW so I was looking to use that to save on taxes.  I settled on a new Range Rover Sport.  But here lies the issue…

It makes me uncomfortable to think about how others will perceive me in the Rover.  [But, if I buy another type of car] the lack of tax advantages would probably end up costing me more than the “pretentious” Rover.

Before we worry about what brand of car to buy, I would question why Michael’s buying a new car, rather than a new investment property.

Other than that, he should simply buy the cheapest car that meets his requirements.

You see, unless the vehicle specifically supports your business (think delivery truck), it’s just a depreciating liability (it doesn’t earn you any money, so it sure ain’t an asset!) …

… which means that any money that you don’t spend on it (or can claw back in tax deductions, etc.) is the next best thing to not spending the money in the first place!

Why spend money just to feel uncomfortable?!

Don’t spend more money just to get rid of the discomfort: spend less (e.g. buy a lower-profile American or Japanese car; one that costs less than 60% of the list price of a Rover) or none at all.

Why not put off buying the car, altogether?

On the other hand, if your business is producing enough cash to support its own growth and is producing enough to fund outside investments, there’s no reason why you shouldn’t spend what’s left …

… after all, that’s what money’s for, right?