In four words: Cash Flow, Control, & Security
For many stock market investors, the last two months have felt like sunbathing on the deck of the Titanic while fellow sunbather Clark Griswold nonchalantly informs you that Hannibal Lecter is being transported on the ship, the Tasmanian Devil is running loose somewhere aboard, and oh, by the way, he just overheard the captain say the ship is sinking.
History of Stock Markets
Before we delve into the motivations of the True Investor, let’s first review a few major events in stock market history. Let me preface this by stating I am not saying, “Don’t invest in the stock market.” But I am saying none of us have control over markets and there are safer investments we do have control over which provide greater return, consistent cash flow, and are insulated from the stock market.
The fall of every great empire begins with the government’s fiscal irresponsibility.
I am surprised by how many educated people are either not aware of or disregard significant historical events. Namely, the 1990 crash and still yet to recover Japanese stock market. Let’s take a close look at the chart below, and check out the caption details:
To recap this ongoing saga: the Nikkei 225 Index, which is equivalent to the S&P 500, hit its all-time high in Dec. of 1989, fell for the next 19 years, bottoming in Oct. 2008 having lost 82% of its value, and today more than 30 years later is valued at approximately 50% of its all-time high. That’s a mouthful!
Let’s put this in perspective: imagine the S&P 500 falling to 610 and staying depressed for over 30 years, ending up at 1700 in the year 2050. It seems unimaginable, and yet that’s exactly what happened in Japan.
How do you think Japanese folks who retired in Jan. 1990 fared if their entire investment portfolio was in stocks, bonds, and mutual funds? It goes without saying, not very well. Unfortunately, if one’s entire net worth is in securities, then all their eggs are in one basket.
Wait a minute! I thought as long as I hold a diversified portfolio of stocks, bonds, and mutual funds, then I am protected by spreading my risk. That’s the fallacy. Those are all paper assets which is only one asset class. Therefore, that portfolio is not diversified across asset classes.
The 4 asset classes are:
- Business
- Real Estate
- Commodities (Gold & Silver, Oil, Natural Gas, Coal, Corn, Wheat, Soybeans, etc.)
- Paper Assets (Stock, Bonds, Mutual Funds, ETFs, etc.)
All the actions the US Federal Reserve (Fed) just started doing during the pandemic (like buying corporate bonds), the Bank of Japan has been doing since 2010. Today, the Bank of Japan owns 75% of the ETF market and 4% of their overall stock market. Is it a good thing that the Fed is buying corporate bonds (or any securities for that matter) to keep the markets propped up?
Upon summarizing the above events to an educated person invested primarily in the US stock market, they typically respond with either a deer-in-the-headlights stare, or they say something like, “Well, that’s Japan, not the US markets”, as if Japan is a 3rd world country and any comparison between the two markets is not relevant.
Japan was the #2 economy in the world at the time and is still quite the powerhouse at #3 behind the US and China. So why do they make such a statement? On the surface this appears to be arrogance, the belief that US markets are immune from sustained market crashes. A deeper look reveals there is no other alternative for them, no opportunity cost.
That’s the truth behind it. They put all their money in the stock market because that is the only thing they know how to do. They don’t possess the knowledge, skill-set, or ambition to pursue alternative investments, so they put their head in the sand and have faith that their life savings will be fine in the world’s largest gambling casino. So far, this approach has paid off, but will the winning streak continue?
I enjoy observing and examining the psychology of the way people think. The “buy and hold” proponents say things like “you can’t ‘time’ the markets” and “you can’t predict the markets”, and yet they unequivocally predict that the stock market always goes up over the long term. Tell that to the Japanese!
Isn’t that a contradiction? Of course it is. Yet it suits their perspective and abilities. Investing in the stock market requires the least amount of financial education, so it’s a good instrument for the average person. Who wants to be average!
Now let’s review the events of the Great Depression in the chart below:
In summary, the market peaked in Sept. 1929, proceeded to fall 86% over roughly a 3 years period, yet took a total of 25 years to recapture the previous high in 1954. Do you think those who retired in 1929, and who were 100% invested in securities had to go back to work?
The eye-opening truth is that the Japanese market crash was actually worse than the Great Depression market crash because it has never recovered!
Below is a chart of the S&P 500 2020 Bear Market:
So far, the S&P 500 peaked in Feb. 2020, and subsequently experienced the fastest fall and highest volatility in stock market history from 2/19/20 to 3/23/20. The market fell 35.4% in just over a month and that rate of decline is unprecedented.
What is volatility? Volatility is the rate at which prices rise and fall. There have been many articles comparing today’s volatility with the Great Depression. We don’t need to be market experts to know that healthy markets don’t behave in this manner. Healthy markets also don’t require unprecedented actions by the Fed.
The stock market has been propelled the last 11 years by 4 things:
- Quantitative Easing (QE) — i.e. printing money (Fed Balance Sheet $6.7 Trillion)
- Low Interest Rates — Fed Funds Rate, Lowest for Longest in History
- Highest Household Debt in History ($14 Trillion)
- Highest Investor Margin in History ($700 Billion @peak)
Basically, an unprecedented amount of artificial money and leverage.
There is a reason the smart money is largely on the sidelines. Warren Buffet is holding $137 billion in cash, roughly 25% of Berkshire Hathaway’s portfolio. Jeffrey Gundlach, one of the most knowledgeable guys in the financial industry, is 50% cash.
Even prior to COVID, financial pundits said we had a healthy economy. If that’s true, then why was the Fed lowering interest rates beginning in Dec. 2018? In a healthy economy with markets hitting all-time highs, the Fed should have been raising rates to 4-5%.
After reviewing the data in all 7 charts above, ask yourself:
Do I want to risk my future by entrusting my life savings in an environment in which I have no control?
Wealth should be Measured in Cash Flow Not Net Worth
The ultimate goal in retirement is to generate enough monthly income to sustain a comfortable and enjoyable life. So why are we so concerned with our net worth? Most people work their whole lives building up their nest egg, only to wind up poor in the end because they never acquired the knowledge to turn that nest egg into a perpetual income generating machine.
If you had no debt and passive income of $100,000 per year for the rest of your life, would it matter how much you had in the bank (i.e. your net worth)? Of course not! Provided you’re not gluttonously materialistic and require a yacht and new Ferrari every year.
The point is we wouldn’t care about our net worth as long as we can do what we want to do. So the real value is not in our net worth, but in how we can turn that sum of money into monthly income. Here’s a simplified example to illustrate the value of monthly income from rental property vs net worth:
Suppose you take your $1 million net worth and put it as a down payment on a $4 million apartment building which provides annual net positive cash flow of $200,000. A year after purchasing the property, the real estate market tanks, and the property is now worth $3 million.
Ouch! Your net worth just dropped from $1 million to a big fat $0! You had $1 million in equity and now your equity is zero. However!… You still have $200,000 annual income in perpetuity! You’re not homeless and your lifestyle actually doesn’t change one single bit. You have the security of owning an asset that generates an annual income of $200,000, regardless of the value of that property.
The value of each of my rental properties could suddenly drop to $1.00, and yet they each still provide the same consistent cash flow.
Real Estate vs. Business
In the movie The Founder, the true story of Ray Kroc and McDonald’s, Ray discovers the power of income generation from owning real estate. After working hard selling franchises, he was still struggling to make any real money because the profit margin selling burgers and fries was so low.
The individual McDonald’s restaurants were generating enough for franchise owners, but the percentage going back to the corporation was not enough to accelerate growth. His lawyer or accountant suggests purchasing land in prime locations, then leasing the land to future franchise owners.
Here’s the brilliance of why owning the real estate (land in this case) is better than owning the business on the land (particularly for low margin businesses):
Owning and Leasing the land produces consistent fixed income regardless of the amount of profit from the business. So if the business only makes a small profit or breaks even, the land owner still makes a predetermined handsome income.
The business owner only makes a profit after paying all their expenses first, one of which is rent paid to the landlord. So the landlord only has to be concerned with whether their tenant is running a viable and sustainable business rather than the amount the business is actually making.
The income from rent has been predetermined to generate net positive cash flow for the landlord. See my next article on how to assess and evaluate rental property.
The beauty of rental property is it’s largely passive income. Would you rather be flipping burgers or just collect a rent check? That’s obviously an oversimplification of the process, but understanding that principle is key to building wealth. Ray Kroc started out selling franchises and ultimately became a True Investor.
Ray once asked a group of college students, “What business am I in?”. After bewildered hesitation one student shouts, “You’re in the hamburger business!” Ray replied, “No, I’m in the real estate business.” To this day, McDonald’s owns some of the highest valued real estate all across the world.
What is a True Investor?
The True Investor invests primarily for cash flow not appreciation or capital gains.
The deal is done, the money is made, at the moment you enter the investment. Nothing else out of your control has to happen for you to make money on the deal. If the property happens to appreciate in value, that’s a bonus, but smart investors do not rely on appreciation to make money.
It’s simply a numbers game. We assess a property being considered for purchase using basic math skills and a tool like my Free Deal Analyzer to determine if the property sufficiently cash flows. If the numbers don’t work at the price the seller is willing to sell, then we don’t make the purchase. So we predetermine that the property generates income and meets our rate of return requirements.
In contrast, for stock market “investors”, something out of their control has to happen in order to make money. A stock is bought at price X and then the price has to appreciate in value to make money. So the deal must be entered and exited before you make money.
Have you ever heard someone whose stock price declined proclaim “It’s only a paper loss“. Likewise, if your stock’s price goes up, it’s only a paper gain unless you sell the stock.
If you’ve ever watched your stock go up 50% only to later have it come all the way back down to where you bought it, then you’ll know what I’m talking about. Because you failed to sell the stock and lock-in the gain, you didn’t make any money, even though the price actually moved in your favor.
Wait a minute! That’s not true! Some stocks pay dividends whether the price appreciates or not. True. However, there are still 2 problems:
1. We have no control whether the dividend is reduced or totally cut in the future
Yes, but we can sell a stock when they cut the dividend and switch to another stock. Sure we can, but I have never seen a company cut their dividend while the price is rising. The price is typically falling long before a dividend cut; and therefore, we’ve likely already lost money.
2. A stable, low-risk portfolio like Warren Buffet’s pays a grand total of around 3% dividends
Most people who are not already wealthy cannot live off 3% of their portfolio. If you are one of the lucky ones who have amassed a few/several million dollars, then perhaps a dividend portfolio of safe, stable stocks will meet your needs. For the rest of us, well, we need to make more than 3%.
Valuing Cash Flow in Net Worth Terms
I have been thinking about this for years ever since I became fascinated with creating passive income streams, yet I have only read one other blogger who recently kinda sorta has drawn the analogy I am about to reveal. First, we need to discuss the 4% Rule.
Most of you are probably familiar with the 4% Rule, but for those who aren’t, the 4% Rule is a mainstream principle among traditional securities investors that says if you withdraw 4% from your liquid net worth every year, you will likely never run out of money before you die regardless of how long you live. This is common knowledge among all Certified Financial Planners and anyone with general portfolio management skills.
Based on this principle, if you retired with a liquid net worth of $1 million, you could withdraw $40,000 every year to live on and be able to withstand the ups and downs of the stock market.
So here’s the revelation: simply reverse that formula to convert an income stream into net worth. Divide the Annual Cash Flow by 0.04. Therefore, if you own rental property which is generating $40,000/year, that’s equivalent to a lump sum of $1 million (40,000/0.04)
In other words, using the 4% Rule, it would require a savings of $1 million to generate an annual income stream (i.e. cash flow) of $40,000. That’s mathematically very simple, yet a powerful analogy. Why?
What if the cost of purchasing the rental property which results in annual cash flow of $40,000 only costs $250,000!? You have just enhanced the value of your equivalent net worth by a factor of 4. This further illustrates why Net Worth is overrated. It’s all about Cash Flow! That’s the secret power of rental property.
Those numbers are not pie-in-the-sky numbers either. In fact, my personal rate of return on my rental properties is actually higher than the above example of 16%. If I can do it, so can you! Stay tuned for my next article, “How to buy your first rental property”.
Share your personal successes and failures with real estate or the stock market. What worked and didn’t work? Bouncing ideas off each other is a great way to learn, and the more we learn and grow our knowledge, the greater our chances for achieving financial independence.
— Your brother Mike
Rick says
Your article makes total common sense. Most people invest in the stock market without ever thinking about real estate purchases and rentals as that’s what their father and grandfather did before them. It’s easier to do that than to spend time and research to perhaps find a better way to use your savings to make money. I eagerly look forward to your next article Mike.
Cash Flow Playground says
Thanks for the comment Rick! I’m seeing more and more interest in rental property, particularly among the younger generation.
Cerebral Caustic says
Real estate seems really safe until a pandemic lays off 20% of the population and cities outlaw evictions.
Cash flow is a meaningless metric unless you adjust for risk. Like, suppose, the risks caused by a recession caused by a pandemic.
Your 250,000 example fails to account for risk. It’s useless. You describe the dangers of an economy fueled by debt and leverage, then turn around and recommend leveraged debt to buy rental real estate. Make up your mind.
Cash Flow Playground says
Now that’s a caustic (pun intended) comment if I’ve ever seen one. 🙂
I appreciate that you took the time to read the entire article. Being a person of great conviction, you must have had a bad experience with rentals. I’m sorry for that. Tell me about your experience owning and managing rental property.
As far as whether folks choose to buy properties with cash or finance them and how much leverage to use, that depends on each individual’s personal financial situation and their security needs. Typically banks require at least 25% down for rental property.
Chris says
Issue with rental property, being I owned many single family homes. The local tax assessors, insurance necessary eat the profits.
My properties do not have mortgages and still a challenge to realize gains for the amount invested in each property.
A person can do cash covered puts solid blue chip companies like an att and create an income comparable to a rental property of equal value, without the risk of real property. That is not a passive income to average investors that have a few properties
Cash covered puts creates a better income and you remain liquid
Cash Flow Playground says
Good to hear from a fellow landlord! Agreed real estate is not liquid, and as you well know, is intended for long term investments, perhaps even forever.
It appears you and I have had different experiences. I’ve had challenges like all landlords, but overall it’s been very lucrative and is enabling me to retire early. Do you or the tenants pay the utilities? I only pay taxes and insurance and have tenants pay all utilities and maintain the yard and house as if it was their own. This minimizes my expenses.
As far as your covered put options trading, that’s great if you’re having success with it! I have lots of experience with stock and currency trading, with emphasis on technical analysis, but none with options. After spending more time than I care to recount trying to decipher the madness of markets, I prefer rentals as I control the numbers and know I am going to make money.
Deborah says
Awesome article. You’ve gained a new subscriber! I am new to REI but I know this is the path I must take to gain my financial freedom and build generational wealth. My most immediate goal is to secure verified and performing buyers. I’m in NJ. Any advice?
Cash Flow Playground says
Thanks for the compliment Deborah, and good to have you aboard!
You must be referring to wholesaling? I have been contacted by wholesalers, so they must have either seen my “For Rent” signs or my Facebook business page. Googling “real estate wholesaling how to find buyers” and all sorts of info comes up.
Wholesaling is a good low-risk or perhaps even risk-free way to build capital if you have the right personality for it. It’s a better means to an end than flipping. The end, of course, being passive income from rental property. The TV shows with the eye-catching “before” and “after” photos don’t tell us the real, ultimate goal.