The Secret the Rich Understand About Building Wealth (And No, It’s Not All About Cash Flow)
If you’ve been on BiggerPockets for any significant period of time, you’ve no doubt heard the virtues of cash flow being espoused from every angle possible. We have calculators to help us determine it. We have rules of thumb to help us find it. We have arguments in the forums that can seem like real estate aficionado death matches over the preferred method to figure it out. The cash flow struggle is real.
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People want it.
They want it for several reasons. The most common reason is likely the purpose of replacing their J-O-B income with real estate income. I’ll admit, cash flow can be nice in that way. It can provide freedom, flexibility, and financial help. Isn’t that what we all want? In my circle, we have so many names for it. Mailbox money. Horizontal income. Passive income. Cash flow. Everyone is chasing this cash flow. From what I’ve seen, it’s valued far and away greater than any other benefit of real estate.
I’m here to say we might be a little too focused on cash flow.
Wait! Before you rush for your pitchforks and start rounding up a posse to hunt me down, give me a minute to explain myself. I’m not against cash flow, I promise. I just think we may benefit from viewing it in its property perspective. Allow me a moment to present a theory on how we got here based on real estate’s recent history.
The Recent History of Real Estate
I’m 33 years old. I can’t tell you what was going on with real estate 20 years ago. I don’t remember. Like most people, I didn’t start paying attention to real estate until I decided I wanted to buy a house. For me, that was at about 22 years old.
When I was 22, real estate prices in my hometown of Manteca, CA were increasing 26 cents per minute. It was 2005. We were smack dab in the middle of one of the craziest real estate markets anyone had ever seen. Loans were being given way with no due diligence and then sold to mortgage backed securities as fast as they could be. Everyone — and I do mean almost everyone — was of the mindset prices were going to just keep climbing and climbing. No one was talking prudence. No one was saying, "Let's wait for prices to drop." It was just a feeding frenzy.
Many people were making good money at this time (a large part of them were real estate agents, loan officers, etc.) and wanted to "invest" their money. The problem was, they believed they understood real estate and how it worked because they made their living from it. Prices were going up so fast and so consistently that people believed that "investing" meant buying a house with no money down, then selling it for large gains a few years later. I'm not kidding. This is what people were doing.
If you bought a house for $400,000, then sold it next year for $500,000, you felt like the smartest person in the world. People felt comfortable doing this because they were making so much money at work. Their own home values were also going up, causing them to feel wealthier than they really were. ALL people were talking about was how much they were going to sell the place for. No one was looking into city development plans. No one was looking into rental rates. No one was considering value add strategies. It was buy, wait, sell, repeat.
In a surprise to no one with common sense, the market crashed when loans couldn’t be refinanced. Home prices dropped, and people lost their “investments” and their residences alike. This inspired others to just walk away from their properties even if they weren’t in distress because it didn’t make sense to keep paying a mortgage on something worth half of what you owed. The whole financial world came to a grinding halt, and the government started quantitative easing to help keep the economy afloat.
Fast forward a few years, and we're in the middle of a terrible recession where homes are ridiculously cheap. Deals were abundant, but people were afraid to buy them because we were all waiting around for the bottom to drop out again. We had become a nation of shell shocked investors who weren't sure if it was safe to come out and play again.
The Fallout of the Great Recession
Now, it is from this environment that much of the real estate advice, literature, and theories we’ve all been reading was born. In order to help reassure people they wouldn’t lose their homes, authors began pointing out the virtues of cash flow. What it is, why it’s important, and how to make sure you have it.
It made total sense.
People could have helped keep their homes if only the rent had covered the mortgage. People could have avoided catastrophe if only they had understood even the basic fundamentals of what they were doing. People weren’t investing. They were speculating. And many got burned.
I 100 percent agree that for the majority of people, you should not buy a home unless it cash flows. Let me make that clear.
However, I disagree with the fact that for the majority of people, cash flow is all that matters. Cash flow is cool, but nobody is really building great wealth off cash flow. This is true, and if you ask the big dogs, most of them will agree. The people who made great money in real estate didn’t do it by buying a butt load of cash flowing properties and saving up all that was left over.
They did it by improving a properties value while the loan was being paid down. This can happen many ways (buying a run down property for cheap and fixing it up, adding to the ROI of a multifamily building, buying in an area where prices later rise, etc.). What is important to note is that if you want to build wealth, it's increasing your equity that's going to do it.
The Secret the Wealthy Understand
Now, with that being said, it’s my opinion cash flow is mainly good for two things:
- Income in retirement (or when you are no longer working)
- As a defense to make sure you have enough money coming in that you will not lose your investment
These are two pretty important things. I’m not against cash flow. Everything I have ever bought has cash flowed positive, and I’ll disclose that now. But let me present you with a secret that wealthy people understand — something that a lot of people who are trying to get to the top may not have learned yet. The people who already know this aren’t usually spending much time sharing it with people they don’t know. You aren’t going to hear them say it unless you know them.
The secret the wealthy understand is that cash flow doesn’t build wealth. Equity does.
To some of you, this is a familiar concept. To others, this may be your first time hearing this. Let me explain in a little more depth how equity works to build wealth (and eventually to create stronger cash flow).
Real estate can make you (or cost you) money in several ways. The two biggest are cash flow and equity. Equity is defined as the difference between what you owe on a property and what it is worth. As your property rises in value, you gain equity. As you pay down your loan, you gain equity. When you can get both working together in harmony, you gain lots of equity.
Rental property can also make you money through rent collected. When you collect more rent than it costs to own the property, you make money. Pretty simple so far.
Now, if you’re looking to not lose money, cash flow is king. Cash flow keeps you safe. If you lose your job, have unexpected expenses, etc., cash flow will keep you afloat. That’s what it’s meant for. It is not good, however, at building you wealth.
Real, compelling wealth is created by owning properties that are worth significantly more than what you invested to buy them. There are so many ways you can increase equity. The only real way to increase cash flow is to raise rents or somehow reduce expenses. If you are buying single family properties, there is realistically only so much you can do to reduce expenses.
The nasty truth no one tells you about single family residential (SFR) investing is just how much of a chunk repairs and maintenance take out of your bottom line. You can easily take half of the money you think will be yours as cash flow and watch it disappear as it goes to pay the plumber, HVAC tech, termite guy, landscaper, pool boy, etc. Even if you don’t run into problems like this, it’s going to take a LONG time before that $300 a month you’re making turns into anything worthwhile.
Allow me present you with a different concept.
Cash Flow vs. Equity
You buy a property from a wholesaler that needs too much work for the seller to afford. The home needs a brand new kitchen and some other issues and won’t be eligible for buyer financing. The seller agrees to sell the property for $55,000 (the balance of their note). The wholesaler takes $5,000 for their trouble, and you purchase this property for $60,000 (not unreasonable numbers at all for a large part of the country).
Once you close, you go in and put a brand new sparkly kitchen in. You also rebuild the bathrooms, put in new flooring and paint, and clean up the ugly yard. Lets say this costs you $20,000.
You are now all in for $80,000. You have the property appraised, and it comes back at a handsome value of $125,000. In addition to having lots of options (refinance to recover your money, sell the house as a flip, use a lease option strategy, etc.), you also now have $45,000 in equity. Again, that's $45,000!
If You Keep It as a Rental
Let's say you get $1,000 a month in rent, and after expenses, you keep $300 for cash flow. The cash flow is nice, but the $45,000 you just added to your net worth is much nicer. Let's also assume you were looking in this area originally because you know a lot of people are planning to move here. This is a suburb to a big city where lots of jobs are moving, and you know increased demand will increase the future prices. If the property goes up in value an average of 5% a year over a period of 5 years, it would be worth roughly $160,000.
So to recap, you were all in for $80,000 on a property that is now worth almost $160,000. Your equity is now $80,000. If rents increased $25 a year, you would now be collecting $425 a month in cash flow (assuming all other expenses remained the same).
Now, $425 a month is nothing to shake a stick at. But if you could take that same $80,000 in equity and earn a 15% return on it, that would be $1,000 a month. That’s starting to look a lot nicer.
In this example, we anticipated a 5% value appreciation a year. That’s likely higher than average, but it’s much lower than what to expect in a situation where prices really take off. Every single property I’ve bought so far has increased in value at a rate greater than that.
What if you repeated this exact same process twice a year over a period of 10 years? You would have $8,500 a month in cash flow. Not too shabby. Might even be enough to allow you to retire and not have to work anymore. That $8,500 a month is very healthy, but I’m not sure you would consider this a number that is a real game changer.
What is my point? My point is that while this cash flow is nice, it pales in comparison to the value of the equity you have built. In the same example I just gave, you could expect to have 1.6 million in equity. One point freakin’ six millllllion dollars (insert Dr. Evil laugh here).
Why Does This Matter?
Now, you may be asking me why this matters. Cash flow is money in the bank. Equity is numbers on a page. And you know what? You’re right. Equity in itself doesn’t have any inherent value. But think about the options it gives you.
- Imagine what you could do flipping homes with 1.5 million dollars.
- Imagine how many more houses you could go buy with that.
- Imagine what types of loans you could get with that.
- Imagine the opportunity it would provide you if you wanted to go spend it.
- Imagine what kinds of investments you would now be eligible to partake in as an accredited investor per SEC (Securities Exchange Commission) standards.
Not excited yet? OK. Let’s go back to our cash flow example. If you were to take that equity and re-invest it at 15%, we would now be looking at return of $20,000 a month.
Don’t Just Think About Cash Flow
What am I getting at? If you’re looking to build cash flow, don’t just think about cash flow. Think about how to build equity and then convert that into cash flow later. In real estate investing, we don’t have a lot of control over what rents will be. We take what the market gives us. We don’t have a lot of control over what expenses will be. We take what the tenants do to the property. We don’t have a lot of control over reducing carrying costs. We pay whatever the taxes, insurance, and mortgage will be.
What we DO have control over is what we pay (buying right), what we spend money on to upgrade (managing contractors), where we buy (finding places demand is reasonably expected to grow), and when we sell (timing the market).
All these factors we control make building equity something that is within our grasp.
Now, nothing is guaranteed. We can’t predict the future. But we can play the cards we are dealt. And sometimes we can give ourselves an advantage into how many of those cards we get. What we have a much harder time controlling is what our repairs will be and what market rents will be. Recurring expenses and market rents are the two things that have the most to do with cash flow.
Buying at a good price, carefully managing the rehab budget, and selling when the time is right are the things that have to do most with building equity.
What makes more sense — to focus on what you can control, or what you cant?
I always tell people, “If the market goes South, I don’t care.” My properties cash flow, and they will be paid for. That’s what cash flow is for! I don’t fear a market downturn. You shouldn’t either.
BUT, if the market goes “North” and increases in value, my equity will grow quickly (much quicker than my cash flow will grow). If I manage this equity carefully, sell when the market is right, and go buy more properties with built in equity, my wealth will start to grow at a supercharged rate.
This is how the wealthy built their empires through real estate. This is how you can, too. If you think about growing your wealth like you are climbing a mountain, your cash flow is your belay (that thing you stick into the rock face with the rope attached to you so if you fall it catches you). It keeps you safe. It prevents you from falling all the way to the bottom and losing all the height you've gained up that point. It prevents foreclosure or having to sell at a bad time.
Your equity is the gains you make upwards towards the top of the mountain. Sometimes the market gets hot and carries you quickly upwards. Be glad for those moments! Sometimes the market just steadily climbs and you make slow progress. That’s awesome, too.
The point is, if all you focus on is cash flow, you will miss out on opportunities to really build life changing wealth. Don’t spend your time staring at your belay in the rock face. Keep your eyes focused upwards, towards the mountain summit, and have a plan in place for what you will do if you find yourself climbing much more rapidly than you originally thought possible.
And know that the power of equity is in the options it gives you, and one of those options is higher cash flow.
[Editor’s Note: We are republishing to help out our newer members.]
Investors: What’s your opinion? Do you invest for the cash flow, equity, or a combination of the two?
Let me know your thoughts with a comment!