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Are you confused by the title of this article?
Here’s the thing—seasoned investors on BiggerPockets like Jeff Brown, Brandon Turner, J Scott, or Brian Burke are not at all confused by this title; they know exactly what I’m saying and why.
BiggerPockets is a great place to learn the terminology and the formulas. But that's the easy part because now you have to put what you've learned into perspective, which is not quite so easy. I'll go even further and at the risk of offending your sensibilities say that if having learned the formulas for cash flow, NOI, CAP rate, DSCR, IRR, and other basics, you are not still confused, then the best thing you can do for yourself is to stay as far away from real estate as possible—for now.
You should be confused. Real estate is not rugby; it is chess at its highest level, and the truly difficult aspects are hidden from sight. If you are confused, as I hope you are, it is because either consciously or subconsciously you are aware of the following:
Not everything that shines is gold!
Truth is found within finer distinctions, and you are confused because you are not able to make the finer distinctions past the formulas and numbers. It is time for some perspective.
Defining Gold
Relative to acquisition of income-producing assets, something that you hear me and others say often is that cash flow is everything; cash flow is gold. When I say this, I allude to several realities:
- Cash flow constitutes safety as it allows us time to weather storms,
- Cash flow constitutes financial freedom via passive income,
- Cash flow is far less taxed than other forms of income and thus we don’t need as much of it.
All of the above are indeed true on the surface. But there are a lot of things beneath the surface, and just because something cash flows doesn’t make it a good investment opportunity.
Why not, you are thinking to yourself. Financed with 30-year notes, these $30,000 houses cash flow like crazy. And they are cheap, and you can wrap your newbie brain around them. Besides, you seem to be getting all kind of reassurance from BP that this is a good way to go (be careful who you talk to). In reality and for a variety of reasons, this is the worst thing you can do!
Related: BP Podcast 014: Cash Flow, Creative Finance, and Life with Ben Leybovich
Not All Cash Flow is Created Equal
Yes, cash flow is gold; we want cash flow. But having established the basic truth, now we must dig deeper.
First things first—we buy income-producing assets for two global reasons:
- To achieve financial independence
- To achieve financial wealth
Financial Independence
Financial independence is thought of as your ability to generate income without having to show up. Financial independence is not needing a job, not dealing with the boss. It is knowing that your family will be OK should something happen to you. It is being able to live and retire on your own terms.
Yes, passive cash flow from income-producing property is indeed a good means of achieving all of the above. But here’s what you need to understand, and this is absolutely crucial:
What it takes is not just passive cash flow; what it takes is STABLE passive cash flow! Cash flow is nice, but unless it is stable, you won’t be able to rely on it the way you want and need to rely on it. Are you thinking yet?
Therefore, the question becomes:
What type of an asset, in what location is capable of generating STABLE passive income today, tomorrow, and forever—without needing you to babysit it constantly?
Let’s talk this through.
A Discussion of Desirability
Value in real estate is driven by the concept of desirability, and this is true at every stage of the life-span of an investment. Follow me:
If people don’t feel that your unit (where it is and what it is) is desirable, then you are certainly going to have to work very hard at keeping it full. Folks with options are going to choose a more desirable unit, and your pool of potential tenants will be left consisting of folks without options. Do you think this would be a good thing? Do you think that these folks hold the key to economic value? Have you ever tried to market a unit that people do not want—talk about work; completely opposite of passive!
Well, if people don’t want to be there, then the income generated by your unit will not be stable by definition, which is a problem not only because stable income is key to the financial independence that you are trying to achieve, but also because you’ll find it difficult to grow rents over time or to grow value—not good!
And furthermore, when you are ready to sell, you’ll find it difficult to do since your potential buyers have all read this article and know that in order to achieve our goals we must buy assets that are more desirable than your $30,000 junker.
Related: Don’t Buy That Cheap Property! (UNLESS…)
So…
You bought this house for $18,000 and spent $12,000 to put lipstick on the pig. You’ve had to work hard to keep it full. The house was trashed more often than not. You’ve evicted most tenants because people that are willing to live in this location and in a unit of this character are economically unstable. This doesn’t mean that they are bad people, just that they don’t have control of their financial lives, which often leads to evictions and frustration!
Now, let me ask you a question:
Do you think that this junker will grow your wealth over time, which is the other objective? Do you think that it will appreciate? Isn’t it kind of necessary for it to be desirable in order for people to want to pay more money for it? Do I need to say any more?
Conclusion
When buying income-producing real estate, we have but two objectives: strong and stable cash flow that will allow us to leave W2 and 1099 income in the past, as well as reasonable probability of appreciation—at least enough to keep up with inflation. It matters not if on paper something looks like it'll cash flow. Use your brain! Buy quality assets!
[Editor’s Note: We are republishing this article to help out newbies who have found BiggerPockets more recently.]
Do you agree or disagree? Why?
Share with me in the comments below!