We are constantly bombarded by dangerous sound bites, mantras and oversimplified inaccuracies. They come from gurus, advertisements, viral one-line Facebook posts and other sources. An age-old sound bite is “accumulate assets.” This 2-word inspirational command is insidious because it’s partially true and the crucial omission can be easily overlooked and often is by newbies. Last month we addressed the Compounding Myth and in the past we covered other dangerous pitches such as “Gold Is Money on Steroids” and “If you don’t have cash and you don’t have credit, wholesaling is for you!” This month we will address the classic “accumulate assets.” All of these sound bites have in common an element of compelling truth that is presented as a standalone justified guideline.
The first time I heard the misleading “accumulate assets” command, it was disguised very well in a Carleton Sheets tape I popped into my VCR many years ago. A 20-something was giving a testimonial with Hawaiian palm trees gently waving in the background (required to establish the credible image that all real estate investors live on exclusive beaches) and he said “I control $2 million in real estate.” That is a brilliant marketing tactic. After all, most newbies watching that tape don’t control what they do at work every day, let alone control $2 million in real estate. Yup, most people want to be like him. And the vivid visual on the videotape was much more effective than the same material on a TDK audio cassette tape I bought for $250. The words “I control $2 million in real estate” is the same tactic that draws people on the Jersey Shore boardwalk to pay $5 for three throws of a basketball into a non-regulation hoop by placing an oversized stuffed animal under a sign “easy to win.” What’s the problem with the motivational statement “I control $2 million in real estate?” The problem is that the 20-something “controls” several single family homes and a 12-unit multi with several options in which he invested cash of $100-$1,000 each. The guy didn’t actually own any of this property. He wasn’t a millionaire. Frankly, he didn’t really have true control of the properties because he didn’t have the deeds to these properties. The actual title owners of these properties could have a hiccup in their financial lives (which they already had and which is why they gave options to the investor) and have liens attached to his properties under option. When that happens, the lienholders can take control of the property and the investor, who perceived he controls the properties, can’t do anything about it. To be fair, this 20-something probably WAS making a few thousand dollars per month on the spread between the what the owners were paying in mortgages, property taxes and insurance and what his tenant-buyers were paying in option consideration and rent. But when the next downturn comes, he might not have any equity left and the cash flow could dry up due to vacancy. This is not hypothetical, this has devastated many people in my inner circle. Real estate investing is primarily about equity and cash flow. Sure, assets must be involved to generate cash flow and equity. It follows that “accumulating assets” is a good thing. Accumulating assets is also supported by the fact that the overwhelming majority of rich people own real estate. But that does not mean that owning real estate results in you becoming rich. Correlation is not causation. Let’s focus on equity. The old Carleton sheets program was called “No Money Down.” The content was actually pretty solid. Sheets taught more than a dozen ways to buy or control real estate with little to no cash out of pocket and many of us eventually got this to work. One of the methods was to get 80% financing from one source and 20% financing from another source (this was well before the lending crisis in the late 2000’s). In this way, the investor needed little to no cash to do the deal. To illustrate with an example, let’s say you could buy a duplex in a C-minus neighborhood worth $100,000, at a purchase price of $80,000 using a $64,000 first mortgage and a $16,000 second mortgage. You would have none of your own money in the deal (ignoring buying costs and holding costs), $20,000 in equity and cash flow from the low end rental. Sounds great and it is…for a while. Every once in a while, the real estate market suffers a downturn of some magnitude. The average interval between real estate market drops is 11 years, though the actual interval varies widely. When the market drops 20% and if the C-minus neighborhood doesn’t appreciate much since purchase (common for C-minus neighborhoods), the equity may totally disappear in the next downturn. I know many people who had 20% equity in their properties with a net worth of several million dollars, who lost EVERYTHING in Chapter 7 within 1-2 years of the 2008-2009 real estate bubble crash. This is an important point because when you hear the promising sound bite “accumulate assets – assets are the key” (as one Facebook post proudly declared a few days ago), assets are simply not enough. Assets alone are NOT the key. There are two “keys.” One key is equity (assets minus liabilities) from the standpoint of net worth. The second key is the hopefully positive cash flow from the income-producing asset. For example, many investors manage dozens of tenants making $250 per month per door and have maybe 20%-30% equity in each property. If you have less than 20% equity in a property, you can lose it all in one of the inevitable downturns that occurs from time to time. It has been more a decade since the last downturn. Investors today with 10 years or less of successful investing experience in rentals are aware only of the positive cash flow with equity and many have not estimated the impact of a potential downturn. I show investors how to calculate the negative effect on viability in my lecture “Leverage of OPM: The Good, The Bad and The Ugly in Real Estate Investing.” In this lecture, I show how you can inoculate your rental portfolio so it will survive the downturns and thrive during the lengthy intervals between downturns. The basic concept is to run the numbers for each rental you buy under the assumption that a downturn will happen. Most investors run the numbers only for the current market conditions. It takes 10 minutes or less to do the analysis using reduced rent numbers and depreciation of the underlying value of the asset. If you still have equity and still have positive cash flow if you assume a 20% drop in rent revenue (don’t forget about economic vacancy) and a simultaneous 20% drop in ARV, you are not likely to lose everything in a downturn. You can plug in any number you want for the next real estate recession based on the historical numbers for your specific location (you may need to use 40% drops in some geographies). When you run your numbers, you may get to the point at which you decide to be so fiscally conservative that you own some free and clear rentals in addition to your financed rentals in order to achieve a portfolio-wide leverage of less than 70% or other number you feel will enable you to survive a downturn in your market. For example, my self-directed Roth owns a few free and clear single family home rentals that generate more than $1,000 per month per door, tax-free, on top of a lot of tax-free equity. While a downturn would hurt the equity and cash flow, the rentals will still be viable. Some investors like to say that they “control” $2 million of property. If they have $200,000 of equity in that $2 million property value (10% equity), they might find one day that they don’t control the property anymore if the market drops by more than 10%. Has it happened? Absolutely yes, almost everywhere in the US and not too long ago. Beware of accumulating too many assets with little to no equity. Don’t get me wrong, leverage of other people’s money is almost always necessary to build significant net worth. But please do not confuse accumulating assets with accumulating net worth. Accumulating assets is very good if you are not over-leveraged. But the perception of accumulating assets through options or highly leveraged real estate with less than 20% equity may work well for a while, but eventually not be able to weather a downturn. I know because I have seen people lose everything after a decade or more of prosperity simply because they did not have enough equity in the assets they accumulated. Accumulating assets is very important but the efficiency of those assets in terms of cash flow and equity is crucial. Make sure you have a specific and measurable target for the equity and cash flow of your assets and make sure that the target will successfully survive a temporary downturn. Now watch the video “Leverage of OPM: The Good, The Bad and The Ugly in Real Estate Investing.”