Most investors are dumb!
Notice, I didn’t say stupid — I said dumb. The difference is that while stupid people don’t know how to think, the dumb — while quite capable of rationale thought — indeed lack a certain perspective on their thoughts. Does this sound like you, by chance?
Don’t feel bad; after all, what sets you apart from the masses is that you are here at BiggerPockets, which means you are acutely aware of your “dumbness” and are trying to do something about it!
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Let’s Talk About You
One fine morning at the ripe old age of somewhere between 23 and 33, you rolled out of bed with a bit of a headache from the night before, peed, and washed your hands (I hope). You then walked over to the sink and splashed your face, looked in the mirror, and it suddenly hit you that the guy staring at you will never be able to retire unless he does something drastic, and soon!
You finally began to internalize the meaning of that Jimmy Buffett verse from “Holiday”:
Stop trying to make impressions on your corporate climb;
It might come as quite a shock,
But you can’t really own that rock,
It’s just a waste of time…
Yep, you say to yourself, and you mean it — time to do something. But what..?! You’ve just not seen anything good happen to anyone in your family, whose retirement planning involves working for as long as possible, while “investing” in index funds. You want faster. You want better. And you want certain guarantees…
Faced with needing to make a plan that has a chance of working better for you than your parent’s plan worked for them, you did what any reasonable 23-year-old would do: You Googled it.
Enter BiggerPockets, where it’s all about real estate and everyone seems to be making money hand over fist. By attending Brandon Turner’s webinars and reading Ben Leybovich’s articles, you quickly formulated a strategy involving acquisition of passive cash flow via income-producing property, which will eventually replace your W2 income. It’s worked for other people; why can’t it work for you?
I’ll Be Nice to You Today…
I don’t even know why, seeing as “nice” is not necessarily in my nature. Quite inexplicably, seeing you go through the mental, emotional, and financial contortions involved with trying to figure this game out gives me strange satisfaction. But alas, I have a soft spot in my heart for people who are trying, and now that you are here, you are indeed trying. So I am going to save you some heartache today…
Note: I am not in business of spelling things out. As a teacher, whether it be violin or real estate, I see my job as saying enough to get you to think. Your job is to read between the lines and find your own truth.
The Myth & The Big Picture
The myth of passive cash flow through income-producing real estate is by and large just that – a myth. Ninety-nine times out of 100, it doesn’t work!
We buy income property for two reasons:
- To generate stable income with which to replace earned income and thus retire.
- To generate value — and with it, wealth.
The key component to the income is “stable.” Income that’s here today and gone tomorrow is no good for us; we can’t rely on it. How are you supposed to use this cash flow to substitute for your W2 income if it’s not predictable like clockwork?
The reason I say that 99 times out of 100 long-term hold strategy doesn’t work is because 99 out of 100 buildings out there aren’t capable of producing stable cash flow. More on this in a sec.
And as far as putting zeros on your balance sheet, unless you are in a high growth market, this is a function of something called value-add, whereby YOU pull the zeros out of thin air. And let me tell you something; while you have one chance in 100 to stumble on some cash flow that is truly stable, your chances of finding real value-add are about one in 1,000.
What all this means is that while you may be on the right track thinking that cash flow can replace your W2 income and appreciation can make you rich, finding property that will actually accommodate is a matter of much knowledge and perspective.
How Most Investors Analyze Income Property
The model used by most investors to analyze income-producing property is based on false premise that the income and loss statement is static. In other words, to perform analysis, folks enter all of the income in the left-hand column and all of the expenses in the right-hand column, and then reconcile into a cash flow number. This cash flow number is what defines the value of the investment opportunity to most and serves as the trigger for a buy decision.
What’s Wrong With That?
What’s wrong with this is two-fold:
- Neither income nor expenses are static and will vary over time. Relative to income, there will be times of high growth, resulting in low economic losses and therefore higher income, and there will be the opposite. And as to expenses – those will just keep going up.
- The value of cash flow is not static and will decrease over time due to macro-economic forces and other opportunities available to you.
Therefore, in order to gain a meaningful perspective on the worth of an investment, you have to project cash flows for each year of the presumed hold period, taking into consideration the following:
- Fluctuations of income that are likely to take place relative to both the market conditions and your management strategy. This is that “perspective” piece I was talking about earlier. In other words, are you buying something that is likely to be stable, and if not, how do you discount the instability, for how long, and by how much?
- Increases in costs, which are a guaranteed reality.
- Depreciating value of cash flow.
As part of this process, you need to get a handle on your exit. The exit will hopefully be the biggest positive cash flow event in the life of this investment (or not). If it’s not, the investment is worthless, since I’m telling you right now, you’ll never be able to drive returns strictly on organic cash flow. You need appreciation!
Additionally, if the strategy involves a refinance at any point, it’s your job to underwrite what it might look like. The sooner, the better, since value of cash depreciates each year, and the sooner you take it off the table and make available for re-investment, the better…
The numbers are a sword that cuts both ways. If you know how to read them, they can tell an invaluable story. But if you don’t, they can and will lie to you all day long… and twice on Sunday!
I hope to have saved you some heartache today.
Investors: How do YOU analyze income property? Do you agree with my assessment?
Leave your opinions below!