Converting Net Worth into Cash Flow

by FI Fighter on August 10, 2015

in Real Estate Thoughts, Stock Investing Thoughts, Thoughts

Screen Shot 2015-08-10 at 9.37.10 AM

When it comes to early financial independence, we all realize that cash flow is the name of the game. However, the path from ZERO to HERO does not have to only traject along a linear path; after all, there are multiple ways to skin a cat.

Cash flow is absolutely essential, yes, but not critical until the day of reckoning — the day when you FINALLY decide to quit your day job and become fully dependent on passive income!

By becoming too fixated on cash flow in the early stages, it is possible for an investor to miss out on great investment opportunities in the pursuit of yield.

How do I know this? I’ve made that very mistake many times before in the past…

Early Mistakes

In the quest to early FI, we always want to feel like we are making strides forward and pushing in the right direction.

For instance, that first $100/month in passive income is a most liberating feeling. You might say to yourself:

All my hard work is paying off! I’m $100 closer to no longer needing my day job. $100 each and every month will take care of my cellphone bill and perhaps more!

This progress feels wonderful! I’ve gotta keep on marching forward!

Now don’t get me wrong, I don’t mean to dismiss a very noteworthy achievement. In fact, I’ve “been there and done that” so I know that very feeling all too well. And although baby steps are needed to get to early FI, the problem with the pure cash flow mentality is that it can become too narrowly focused.

In the pursuit of the next $100, $200, etc., an investor might fall into the trap of chasing yield… In my own journey, once I cleared the $200/month mark in passive income, I got more aggressive and wanted to attack $300/month. In the process, I made some stupid investment decisions, such as buying shares of Linn Energy (LNCO) because the dividend yield was pushing north of 5% at the time…

If I can get to $300 so quickly, why don’t I get more aggressive and aim for $400?

Lucky for me, I sold out of LNCO in early 2013… Otherwise, I would be in a world of hurt right now!

But sometimes lessons are not learned immediately, and it takes a few mistakes before we can see what strategies really work…

Early Mistakes II

In 2013, I was obsessed with cash flow… After I sold out of LNCO, I allocated even more funds towards downpayments into two rental properties out-of-state. Why did I make these moves? Because the paper cash flow looked tremendous and the projected returns were putting my local Bay Area numbers to shame…

Again, I had tunnel vision, and I was fixated on only ONE thing — high yielding passive income! I wanted to get to early FI ASAP and I thought that I needed some heavy hitting cash flow investments to take me there.

In retrospect, these turnkey investments sort-of provide the type of cash flow I was looking for (more details in a future post!), but I’ve learned a few lessons along the way:

1) When you chase high yield (I don’t care if it’s with stocks, real estate, etc.), you will NEVER be buying up assets that have strong appreciation potential. In other words, your assets won’t become increasingly valuable over time and you will be effectively limiting your future exit strategy options.

2) High yield most often implies a low-income growth rate. Sure, you’ll generate higher cash flow returns on Day 1… but if it’s really indefinite early FI that you are after, believe me, it’s not Day 1 cash flow that matters! You’ll care much more about the cash flow generated in Year 10, Year 20, etc…

The Case for Net Worth

Net Worth is a very underrated barometer of success for many who are on the journey to early FI. In fact, most folks who are starting out today are only focused on cash flow.

I was no different myself when I first started out…

But I’ve learned that true progress towards early FI should be measured with respect to Net Worth, not Cash Flow.

In 2012, I purchased my first rental property for $315,000. Since that time, the property has only continued to appreciate, and today it is worth about $500,000.

In 2013, I purchased my second rental property for $290,000. Today, it could probably sell in the open market for about $520,000.

In 2014, I partnered into my first two side hustle deals. The first side hustle property was purchased for $490,000. Now, it is worth about $600,000. The second side hustle property was purchased for $521,000. Fair market value is about $620,000.

I don’t believe that it is any coincidence that my most valuable properties are also my best performing cash flow investments as well…

What I’ve learned over the past few years is this — there’s a reason assets become more valuable over time! People will always pay a premium for high quality. Paper gains aside, with my Class A properties, I get the following attributes that I cannot claim to be true for any of my out-of-state rentals:

  • Wonderful tenants who pay on time each and every month.
  • Low maintenance and even lower turnover tenants.
  • Extremely strong demand from renters.
  • Even stronger demand from prospective homebuyers (easy exit strategy!).
  • Robust price appreciation.
  • Strong rent appreciation.
  • Peace of mind.

The list goes on and on…

Ironically enough, my rationale for purchasing out-of-state rentals was because I wanted to achieve some higher cash flow. As it turns out, instead, in a span of 2-3 years, my Net Worth properties have completely outperformed my Cash Flow properties as it pertains to CASH FLOW!

An Example

Let’s use a real example to illustrate the importance of targeting Net Worth assets.

With Rental Property #4, I purchased it because paper Cash Flow indicated a 15%+ return on investment! Here’s what market rent looks like through the years:

Year 1 (2013): $1,075/month
Year 2 (2014): $1,075/month
Year 3 (2015): $995/month

That’s right, I’ve had to DECREASE rent this year in hopes of landing a new tenant… So much for hitting that 15% cash flow target…

In contrast, here’s what Rental Property #2’s market rent looks like:

Year 1 (2013): $2,150/month
Year 2 (2014): $2,400/month
Year 3 (2015): $2,800/month

At the time of purchase, Rental Property #2 showed me cash flow returns of less than 8%! When I purchased my property in Indianapolis, I mistakenly thought that I would be doubling my cash flow relative to my Bay Area properties!

But as is often the case, reality deviates greatly from paper returns. In comparison, however, the Class A property in the Bay Area has witnessed rent appreciation of over 30% in a span of only 3 years! Although I definitely do not expect such an outrageous trend to continue, the evidence is none-the-less clear-cut: the Net Worth property is already outperforming the Cash Flow property by leaps and bounds… in the Cash Flow department.

And we are only 2 years into my original thought experiment

When you factor in the price appreciation, it’s quite evident which investment has been the vastly superior one so far…

What About Stocks?

The above example looked at real estate, but I think the same ideas can very much apply to income investing with stocks as well.

Not too long ago, I made a purchase to acquire shares of Emerson Electric (EMR), as I worked towards rebuilding back up my dividend growth portfolio. EMR is a good example of chasing Day 1 yield… The company offers a very compelling dividend yield of ~3.7%, has a wonderful track record of providing consistent income, and the share price looks “affordable” using standard valuation metrics.

Now don’t get me wrong, I’m not saying EMR is a bad investment (or trying to knock the company); it’s just not much different from a typical Cash Flow type of property. You can utilize an investment such as EMR to help get you to early FI, but it most definitely won’t get you there quickly (not unless you plan on contributing a ton of capital along the way!).

I wouldn’t go as far as to compare EMR to my very own Midwest Cash Flow properties, though, as EMR is definitely a higher quality type of company with a much more reliable history of generating passive income than my out-of-state rentals. A direct comparison would be like comparing apples to oranges… Nonetheless, the growth potential of both types of investments are similar — there is none.

EMR is not a growth stock. Revenue is static. Earnings growth is anemic. And the share price reflects all of that. Yes, the 5-year dividend growth rate of 5.5% is very solid, but that just implies the following:

This type of investment is best suited for someone who has already (or just) reached early FI… It’s not as beneficial an investment for someone looking to get to early FI.

The same logic applies to companies such as: Coca-Cola (KO), Procter and Gamble (PG), McDonald’s (MCD), etc.

Low growth translates into dismal share price appreciation. It’s the “slow and steady” approach to getting to early FI. Again, there’s absolutely nothing wrong with going this route, but as an investor, just please don’t be deluded into thinking that you can get to early FI quickly by utilizing these types of investments.

Yesterday’s dividend superstars are highly revered in the dividend growth community because of their past performance and overall reliability. I get that. But if you are someone young and looking to get to early FI sometime in the near future (like say age 30), what you really need are GROWTH investments to catapult you there. This doesn’t mean that you have to invest in any risky hyper-growth stocks, but you should be mainly focused on acquiring shares of future dividend rockstars, instead!

If EMR, KO, PG, MCD, etc. are discounted, then sure pick up a few shares… When they inevitably rise again, though, I would elect to sell high (make a quick buck) and swap the proceeds into tomorrow’s Aristocrats (e.g. Starbucks (SBUX), Apple (AAPL), Disney (DIS), etc. ).

Companies such as Google (GOOG) and Chipotle (CMG) don’t yet pay a dividend today… But it isn’t tough to imagine a future in which they do, is it?

You get ahead by planning ahead. If you don’t need the passive income immediately today, why not focus more on future income? 5, 10, 15, 20 years from now, it’s very likely that any future Dividend Aristocrats will provide much stronger passive income (and passive income growth) than today’s companies. So, by the time you actually need the Cash Flow, it will be available to you in abundance. Further, you’ll probably pick up a ton more appreciation (Net Worth) as well… And Net Worth can always be converted into Cash Flow, but not the other way around!

The Forest and the Trees

If you can’t learn to see the forest for the trees, you will make the journey to early FI that much more difficult for yourself.

All too often, an investor who is seeking early FI will start their journey off by immediately jumping into the cash flow fray in search of yield. In the process, that same investor will forsake higher quality investments that offer far more future growth prospects for an investment that promises nothing more than a higher payout today…

I’ve made that very mistake many times before in the past…

Don’t fixate too much on cash flow today. A 6% yield does you no good if the company you are investing in takes a 30% haircut and has to suspend their dividend entirely. It will takes you many years to recoup those losses… which could indefinitely delay your early FI progress! On the other hand, realizing 200%+ in capital gains will help accelerate your progress up the mountain in no time…

So, if you aren’t planning on retiring today, don’t settle for ZERO growth and high Day 1 yield alone! It’s a trap… If your time horizon is 5, 10, 15, or 20 years out into the future, what you really need are investments that will shine and outperform for the next 5, 10, 15, or 20 years…

In my own journey, it was ironic for me to discover that my best Cash Flow investments turned out to come via the form of my strong appreciating Net Worth investments! This was a surprise to me because when I first started off buying Cash Flow investments, I was too focused on Day 1 paper gains and mistakenly thought that those numbers would always hold true (and improve over time)… But stagnant growth is stagnant growth… and high-yielding, non-appreciating assets will offer that to you in spades!

Stagnant growth can also introduce more risks to your overall gameplan; you’ll definitely need to over-budget your Cash Flow targets to insure you have enough post-FI!

I’ve since learned that over time the Net Worth investments will STILL come out ahead in the Cash Flow department, even if the starting Day 1 yield initially leaves a lot to be desired…

Growth is key.

You’ve got to always remember to take a step back and observe the total picture; it isn’t always crystal clear when observing through today’s lens.

Net Worth = Cash Flow

The journey to early FI is all about Cash Flow, right? If we don’t have sufficient Cash Flow, we can’t declare early financial freedom, right?

Nope.

Net Worth = Cash Flow.

Because Net Worth can be converted into Cash Flow. Acquire the right (GROWTH!) investments. Watch them thrive. And then decide what to do…

If the Net Worth assets start to generate sufficient income after a few years due to robust passive income appreciation (e.g. Rental Property #2), then you can continue to hold and reap the benefits… In a way, they’ve now morphed into a hybrid Cash Flow investment but will most likely still retain their Net Worth appreciating component into the future. A truly wonderful problem for any investor to have!

However, if you’re right on the cusp of freedom and require a stronger yield to support your lifestyle post-FI, it is only at this time that it becomes appropriate to sacrifice growth for yield.

In the latter case, you can then sell off your Net Worth assets and convert the proceeds into acquiring higher-yielding, but lower growth investments. Finally, we’ve come full circle and arrived back where we started from! Like I mentioned before, I don’t think that investments such as EMR, PG, MCD, etc. are bad investments… I just think that they are better suited for the person who is actually in retirement as opposed to someone who is working on getting there.

Once retired, reliability and stability of the income stream become absolutely paramount to the early FI investor, so at this time, I would say go ahead and make the switch into the renowned Dividend Aristocrats.

But if you aren’t there yet, well, the only real shortcut to early FI is to focus on acquiring Net Worth investments which will appreciate substantially into the future.

Conclusion

Bottom line — It’s a lot easier to convert a high Net Worth (e.g. $2MM) into quality income producing assets at a later time than it is to slowly and methodically build up a passive income stream comprised of low-growth entities, branch by branch.

Then, you can take your $2MM, wait for a sale (e.g. KMI = 6.0% yield today; XOM = 3.7% yield today; CVX = 5.0% yield today; T = 5.4% yield today) and then strike while the iron is hot.

You’ve now got your reliable stream of passive income secured!

On the journey to early FI, don’t underestimate the importance of Net Worth — It provides you the purchasing power necessary to obtain Cash Flow whenever you want!

It took me a few years to learn this very important lesson, but at last, I’ve arrived to that conclusion! And I don’t see myself ever deviating from this approach again…

 

Happy Investing!

{ 32 comments… read them below or add one }

1 Fervent FinanceNo Gravatar August 10, 2015 at 11:31 am

Great post! Right now I’m concentrating on wealth accumulation through growth and my route is low-cost index funds. Maybe in 10 years when I transition out of a traditional 9-5 job and want more income (real estate, dividends, etc.) then I can make that transition then.

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2 FI FighterNo Gravatar August 10, 2015 at 3:40 pm

FF,

Thanks! Index funds are a great way to build up wealth for the long haul. The major indices have done exceptionally well over the last 5-6 years or so.

Best wishes!

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3 Alexander @ CashFlowDiariesNo Gravatar August 10, 2015 at 2:49 pm

You make solid points in regards to the Class A properties. It’s just difficult to find cash flowing Class A properties. I would hate to buy a class A property with no cash flow and just the speculation that it will appreciate over time. Just too risky for me. Im sure it can be done in many markets though.

But I definitely agree that your net worth will look much better in the long run with those types of assets. Lucky for me I was able to acquire one Class A asset here in Austin and the other one is a “B” which is still good but the days of finding those types of deals are over here. At least for now. The rest of mine are Class Cs. Those however are performing great right now so I’ll keep my fingers crossed.

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4 FI FighterNo Gravatar August 10, 2015 at 3:44 pm

Alex,

Acquiring cash flowing Class A properties is definitely not easy and can be a challenge for anyone… You really have to play market cycles in order to capitalize in on this niche space… but if you can get in, it will help your early FI progress tremendously.

I do believe there’s a place in the portfolio for all type of assets and Class C is definitely most affordable; I have a few Class C properties myself.

But as I’ve had to learn myself over the last few years, ultimately, I’ve realized that it’s my Class A assets that are the ones that will not only create generational wealth but increase my odds for early FI success the greatest. They are my best performers in all regards — cash flow, appreciation, exit strategy, etc.

Moving forward, I may attempt to acquire some more Class B, or Class C, but I know that the fundamental blueprint of my portfolio must rest on Class A. That’s my bread and butter.

Best wishes!

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5 Midwestern LandlordNo Gravatar August 10, 2015 at 5:46 pm

Fi Fighter,
Interesting and thought provoking post. I agree with you, buying high quality, well located, class A properties for the long haul is a great strategy and has certainly worked out well for you. I have the following thoughts to offer:

1) Timing plays a very important role in real estate investing versus hitting a homerun, hitting a single, or striking out. Bay area real estate went down in value approximately 27% from 2008 to 2011. From 2012 to mid 2015 it has increased around 60% – 65%. So if you bought in 2008 and sold in 2011, it did not work out real well. The market right now in the Bay area is red hot, so it does not surprise me that your investments that were made at the bottom of the market are working wonderfully. But what about the investor now in August, 2015? At what point do the escalating prices form a bubble? At what point do we have concerns about sustainability? You know the market much better than I do and it is certainly possible that the Bay area real estate market has a ways to go yet. But just like the stock market that we have talked about, at some point valuations just become too high from a risk reward standpoint. So what I am saying is that a fantastic investment for you in the Bay area in 2012 might not be a fantastic investment for someone else in say 2016 or 2017 or even now? And it all boiled down to market timing.

2) “And Net Worth can always be converted into Cash Flow, but not the other way around!”.

I definitely agree that high net worth can be transformed into more cash flow if that net worth is not producing a very good return. But a couple of things need to be kept in mind if converting real estate equity to dividend income. 1) Real estate has relatively high transaction cost so this will take a slice of the equity away. 2) If one has accumulated a lot of real estate equity, uncle sam will want a piece of it after the sale (unless personal residence). This does not hold true if one keeps the property and pulls out money tax free (like you did). However, one will not get at the remaining 20-25% equity in this case. Also, while I understand someone converting net worth into higher cash flow, I don’t understand the other way around. If one already has sufficient monthly cash flow, there is no need to try and convert that into a higher net worth.

3) “But if you aren’t there yet, well, the only real shortcut to early FI is to focus on acquiring Net Worth investments which will appreciate substantially into the future”.

Relative to real estate investing, I think this really depends on what market you are in. If you are in the Bay area market, appreciation is your ticket, assuming you get on the bus before prices get so high things don’t make any sense anymore. If you are in my market (midwest area), appreciation is not really the game plan; whatever you get is a fringe benefit. It is about getting enough high quality investments in place that provide enough cash flow to live on. Even without great appreciation growth, on average, rents should keep up with inflation. So if you have margin on day one, you will continue to have margin for as long as you keep the property. Particularly if you are fortunate enough to have a lot of low interest 30 year fixed mortgages in place.

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6 FI FighterNo Gravatar August 10, 2015 at 6:11 pm

Midwestern Landlord,

As always, thanks for the excellent comments and thoughts. Let me see if I can address each point:

1) Absolutely, I agree with you that timing has a HUGE influence on the results of an investment, particularly one that is highly volatile and price sensitive like Bay Area real estate. As an investor, you definitely need to be entering closer to the bottom than the top…

As it pertains to the here and now, I would strongly caution anyone thinking about getting into the Bay Area game right now… The upside is minimal and downside is outright scary! In general, it’s never the best idea to be getting in when prices are setting record highs…

But Bay Area real estate, and real estate in general is cyclical. There will be another entry point in the future, I am certain of it.

Also, with respect to the Midwest and out-of-state markets, I would say that the downside risk (relative to market timing) is much smaller because prices don’t swing as violently. Cash flow properties in the Midwest quite possibly would make for the best play for an investor who insists on getting in right now…

2) Great point on the tax consequences of selling out of real estate and into stocks… I used the conversion to dividend stocks as an example because dividend stock yields are more concrete than trying to guesstimate what cash-on-cash returns might be since that is more market dependent… But the reality for most real estate investors would be to stick to real estate to avoid the tax man and Uncle Sam… This means 1031 exchanges, most likely… or the tax-exemption of either $250k or $500k off of a personal residence.

My point with the cash flow conversion (the other way around), is that you aren’t really “sacrificing” cash flow if you instead elect to focus on net worth today. Too often times, investors operate under the belief that if they aren’t building up the monthly cash flow then they aren’t making sufficient progress towards early FI… In my own case, I took like 5 steps back and am holding mostly cash right now… But I’m keeping the big picture in the back of my mind, always.

The problem with a sole focus on cash flow is that what you have is all that you have… Increasing cash flow via dividend raises or rent increases happens slowly, gradually over time. Net worth through real estate, on the other hand, is particularly realized through leveraged returns which are very much amplified. It’s very possible to 2x, 3x, 5x, or even 10x your downpayment. In other words, net worth can help you shortcut into larger cash flow gains but you can’t do the same from cash flow to net worth… There are no shortcuts the other way around… Just something an investor should consider as they build their gameplan.

3) Yes, real estate is very market dependent which is why it is so difficult to make generalizations 🙂

But even in the Midwest, most folks who I have consulted with all agree that the higher quality the asset (which will inherently carry with it some degree of appreciation), the better your odds of succeeding in early FI. Perhaps this means paying slightly more for Class B cash flow properties. The pure cash flow plays abundant in Class C properties (which turnkey is focused on) out in the Midwest do work, but they are most suited for the local investor who can manage with “boots on the ground”. An out-of-state investor like myself will be nickeled and dimed all day long until the cows come home…

I realize it’s a generality, but as a rule-of-thumb, get something a little bit nicer and your future cash flow will probably be better off.

All the best!

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7 Midwestern LandlordNo Gravatar August 10, 2015 at 6:40 pm

Agree on all points. It is a lot of fun talking investment strategy with like minded individuals. The beauty of the internet, really. Keep up the good work.

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8 FI FighterNo Gravatar August 10, 2015 at 8:47 pm

Definitely! Feel free to PM anytime if you would like to discuss more. I’m sure I could learn a ton more from you and your experiences.

Future strategies… I could talk about that for days 🙂

Cheers!

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9 No Nonsense LandlordNo Gravatar August 10, 2015 at 6:22 pm

Great points. Net worth is a precursor to some cash flow, but with cash flow your net worth can increase too. Sort if the chicken vs. the egg. One thing for sure, with higher cash flow yield, you get higher risk.

With the RE market down in 2008-2012+, it was a great tome to invest in rentals. Maybe the best in the next 20 years. Investors received both cash flow and appreciation.

With my properties being worth ~50% more than I paid, plus an income that is well over 6-figures, it has been a nice ride.

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10 FI FighterNo Gravatar August 10, 2015 at 6:29 pm

Eric,

It’s definitely been a wonderful ride and you have done very well for yourself. Kudos to you on getting in at an opportune time!

Getting both cash flow and appreciation is the best way to go. Easier said than done, especially today.

So, one can continue chasing the market, or let the market come to you… It may take 1, 2, 3, 5 years… but at some point, the market will correct and we will have some better entry points again.

Real estate is cyclical. Always has been… As investors, we sometimes forget that on the way up…

Best wishes!

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11 ResilientMan.comNo Gravatar August 10, 2015 at 10:35 pm

Excellent post, one that should keep dividend income companies in perspective.

One thing that was slightly overlooked in my opinion is the risk reward ratio and diversification. Whilst it is impossible to cover all aspects, these are inherently linked with dividend stocks.

1. Risk.
Growth stocks are more risky, thus there should be a higher diversification. ETFs are great at this. (Low Cost one). The risk in growth stocks is higher than dividend income is because of the “economic moat” which well established companies have, this creates less risk.

Thus your risk profile, can shift you to dividend stocks from an early start to your FI inheritance. Say you inherited 100,000 , your annual income is 40,000 US dollars of which you manage to save 5,000 us dollars. Replacing that 100k if you loose is going to take a lot of time.

2.Diversification
Going into dividend stocks, or having a high allocation rate makes sense. In this case capital preservation is key, rather than growth. Growth comes with more risk than well established companies.

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12 FI FighterNo Gravatar August 11, 2015 at 7:20 am

ResilientMan,

Thanks for the comment. Growth stocks can be more risky, and I agree that an ETF such as VUG is a good way to play it.

If you want to go with individual companies, ones like Google (GOOG) or Chipotle (CMG) probably are just as risky as any high quality dividend stock out there… They have wide moats and I don’t think anyone can really foresee them going away anytime soon…

Diversification is usually a good thing to mitigate risks.

Take care!

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13 george puckNo Gravatar August 10, 2015 at 10:52 pm

I generally agree with your point. That the focus shouldnt be on cash flow from day one.

Early on when you are just getting started, Total appreciation is key. Buying high quality properties that will go up in price will also most likely have better than expected rent increases.

Perhaps a new property shows marginal cash flow early on, but compounding price appreciation along with yearly rent increases gives you a total return that as you correctly point out can often lead to the much better investment.

The other thing that makes real estate so great is that the cash flow if purchased correctly services the mortgage until you are near retirement. Then boom the mortgage is paid off and the property turns into a pure cash flow machine.

With real estate I dont think you have to choose an either or scenario, which is the point you are making. Buy properties where you think the price AND rents will go up.

As far as stocks go, I agree that chasing yield for the sake of yield is wrong. I think when you are young and trying to achieve FI, total appreciation is most important. With a heavier emphasis on growth stocks.

As you said a company like Disney likely will end up with a huge dividend if you hold it for 30 years. And I wouldnt be surprised if Chipolte ended up as a dividend aristocratic in 40 years.

I will say I think diversification is more important with stocks than it is with real estate. Money managers move from sector to sector. If you only have high dividend yielding stocks, you are at risk of losing in a rising interest rate environment. If the economy is picking up, money managers will overweight in dividend paying cyclical stocks. There are times growth, or international or healthcare etc are out of favor. IMO its best to have a diversified portfolio and then near retirement turn it into a mostly high dividend portfolio.

Its nearly impossible to know where you are in a cycle, and having some money available allows you to pick up additional stocks when they go on sale. KMI, Disney, Apple, the oils have all gone on sale of late. But imo all of those companies are well run, and one has to think over the course of time you will do well buying a stock that is broken of a company that is working.

Like you, I also like KMI for the yield, but mostly because I like the business model, there is a huge moat around it to keep out new competitors, its in an secular growth industry. And I like the idea that today we are getting 6% and in 5 years according to the companies stated goals, we should be getting just about 10%/yr in dividends. (plus any capital appreciation) IMO that is a fantastic TOTAL return for what I think is relatively low risk.

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14 FI FighterNo Gravatar August 11, 2015 at 7:24 am

George,

Total returns will help an early investor most, I agree. It’s kind of funny, not too long ago investors were clamoring for both cash flow and price appreciation and still nitpicking on which houses to buy… It was a total buyer’s market.

How the tide has turned…

These days, investors have to pick one or the other, and the upside remaining for each is very limited.

Diversification is usually a good thing. Even in real estate, having all my properties in one location gives me some unease… You just never know, right? It’s one thing to keep milking a good idea, but I’ve never felt comfortable with putting the entirety (or large bulk) of my portfolio is just one good idea, no matter how wonderful that idea is…

Agreed with your thoughts on stocks. If you buy the RIGHT companies, timing is less important. Companies like AAPL, DIS, KMI, etc. will still be around many decades from now, most likely.

Market cycles and timing are more important with real estate, however, and buying wrong can decimate an investor on the downfall.

All the best!

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15 george puckNo Gravatar August 10, 2015 at 11:01 pm

One thing I like about real estate is that there are an almost an infinite number of ways to play the game.

Buy the dips, fix and flip, single family, duplex, wholesale, foreclosures etc etc.

I think perhaps the low hanging fruit is gone. Here in Dallas we bought in the summer of 2013, I think we may have a property that has gone up 20-25% in value, plus the rents have gone up nearly 40%/month since we purchased.

Our early strategy was to buy a really solid property in an up and coming neighborhood that is walking distance from trendy restaurants/bars etc. And we hit it in spades.

Our next purchase is a house we live in now that we intend on turning into a rental in another trendy neighborhood.

I think in the future we will have to look a little harder for deals, maybe buy in all cash, or get involved with a foreclosure or find someone who is wholesaling a property that we can fix up.

I think deals are still there, you just have to look a little harder. The days of having 500-$1,000 from a rental ready property are gone.

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16 FI FighterNo Gravatar August 11, 2015 at 7:30 am

George,

There are definitely many ways to succeed with real estate. Buy and Hold tends to be the most popular and that will give an investor a wonderful foundation. Fix and flips are something I will definitely attempt in the future; it’s a wonderful way to earn some active income.

The low hanging fruit probably went away in 2013 here, but there was still some good pickings in 2014… I purchased my last property early this year in 2015 and that house has appreciated by over $80,000 since…

Returns were tight on my numbers back in January, so there’s no way they would work in today’s environment. And that’s just fine with me. I realize that a good thing has to end sometime…

I’ve always been intrigued by Dallas and know a few locals who only buy in Dallas. They seem to be doing very well.

I like your strategy of buying in up and coming neighborhoods. Now only do they make for good rentals, but the exit strategy to resell to a homebuyer is also very viable.

Deals may be tough to locate in most markets now, but that’s just how real estate goes. The same was true in 2006-2007… Many investors that I know refuse to stop chasing after deals. My strategy is a bit more simple — be patient and let the market come back to you.

I do miss the days of $500+/month cash flow, though!

Cheers!

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17 JonNo Gravatar August 11, 2015 at 1:34 am

I can’t comment on the real estate point, but I disagree with you on equities.

You say: “when you chase high yield (I don’t care if it’s with stocks, real estate, etc.), you will NEVER be buying up assets that have strong appreciation potential.”

High yield, by definition, implies a low price relative to cash flow… So what you are buying IS assets that have a strong appreciation potential. There were plenty of high yielding equities in 2009 that have appreciated tremendously in the last 6 years.

In addition, studies show that these boring dividend aristocrats return more over the long run than the broader market on a total return basis.

Sure, you have done very well over the last few years, predominantly through your bay area real estate…but what do you suggest beginners on the road to FI do with our hard earned money now? Try to spot the next speculative real estate bubble? Invest in tech stocks? This seems to say the opposite of your other recent posts espousing safety and conservatism in this seemingly frothy environment.

I think I will stick to the advice of Buffett and the value investors who have seen it all and still manage to significantly outperform the market.

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18 FI FighterNo Gravatar August 11, 2015 at 7:42 am

Jon,

Thanks for your comments and thoughts.

Dividend Aristocrats make for great investments and they provide not only quality but safety as well (a good track record goes a long ways).

In regards to appreciation, typically you will get some with the well established dividend payers, but the odds of landing a 5x or 10x bagger are not as common. Since 2009, almost all equities are up BIG, so in a sense you could say a rising tide has lifted all boats.

I don’t mean to knock on high-yielding stocks at all, but I just feel that a young investor who wants to get to early FI through the use of stocks will need the help of massive appreciation. For instance, back in 2009, I would have wished that I loaded up on: CMG, GOOG, AAPL, etc…

Often times, I think we make investing in QUALITY companies far too difficult than it needs to be. Dividend Aristocrats and Champions, Contenders, etc. will always have their appeal because of track record…

But if you want to look forward into the future, it’s more important, I think to spend the time trying to identify the next “best of breed” companies. PG, MCD, EMR, T, KO, etc. were wonderful investments of the PAST, very stable today, but you will most likely underperform with these holdings if you are looking far out into the FUTURE. The growth aspect is simply not there.

What to buy for tomorrow’s gains? No one has a crystal ball, but I don’t think it’s “speculative” to suggest that companies such as: SBUX, GOOG, AAPL, DIS, etc. will most likely outperform those aforementioned dividend stalwarts by leaps and bounds.

Who knows? Maybe in 20-30 years, the Millennial generation will be preaching to the next generation on how great SBUX, GOOG, AAPL, DIS, etc. are and how EVERY investor needs to own them.

Again, I’m not knocking the Aristocrats or other high quality dividend growth stocks. But there are a ton of Future Aristocrats out there that people need to consider as well. Riding these companies and their future growth in revenue/earnings/profits,etc. will serve an investor well.

If that’s still too speculative, then a growth ETF or index may be more appropriate.

If you’re more risky (like me), gamble a bit on future growth… Now this would be speculative but potentially rewarding:

BABA, TSLA, and solar in general. Maybe a few biotechs like GILD, AMGN when valuations are favorable.

Whether it’s real estate or stocks, to get to early FI, you need your investments to GROW by leaps and bounds to get there quickly. The safe and steady approach works as well, for sure, but it will just take a bit longer.

All the best!

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19 george puckNo Gravatar August 11, 2015 at 7:37 pm

I actually disagree with the statement that the definition of high yield implies high cash flow.

A company like Berkshire Hathaway has no yield but has a huge cash flow

Google and Apple have huge cash flows, but relatively modest dividends.

Typically high yields are found in slower growing companies that are throwing off cash. It is possible to have a very successful total return if the dividend is safe and the the yield high enough.

Faster growing companies are usually bid up in price and rarely carry large dividends, with those companies you end up making money on the dividend because the company grows it over time.

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20 JonNo Gravatar August 12, 2015 at 2:42 am

You can’t really disagree with the definition…that’s the definition!

Berkshire Hathaway’s yield is 0%…as they don’t pay a dividend. Yes, the COMPANY generates cash. But, as an INVESTOR, they generate 0 cash flow per share.

I disagree that higher yields are found in slower growth companies. If we look at total returns over time for dividend aristocrats vs. the overall market, the dividend aristocrats outperform.

But please, if you guys can forecast the next 10 bagger please let me know! It’s a bit more difficult than saying: “Google seems pretty big right now. Same with Chipotle – I go there all the time! These guys will be huge in the future!”

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21 kyithNo Gravatar August 11, 2015 at 8:14 am

i would agree with much the last poster Jon said. There is this part where you talk about going for growth instead of high yield since it is low growth. to a certain extend that is stereotyping stocks into these two buckets.

there are more to this. you cited dividend aristocrats and they do provide growth, yet their yields can still be decent.

the factor that rules them all isnt growth, or yield. its value.

when you are a competent valuer, and purchase a dividend stock that does not require much capex and can pay a decent div, yet it can grow at 10% for the next 10 years, you got something decent. incidentally that sounds like MCD before their recent problems.

if they have bought some of those ‘great’ companies that provide tremendous growth now, and in 5 years time they were exposed with known unknowns that due to our deficiency in prospecting skills, we failed to see, we are going to lose money.

the main reason you can reach a high networth is mainly attributed to leverage, which you couldn’t with equities. a close alternative to property leverage, is by purchasing high yield bonds on leverage, or buying a medalion taxi on leverage. if things work out well for you, because you caught everything at the right time, without any of the bad thing happening then kudos to you.

but i can see the risk of a person going for growth, trying to build an accmulative networth by going for supposed growth companies and buying bay area properties at high prices, and saw the networth cut by 30%.

in general i do agree with not overly focus on cash flow at accumulation phase. the dividend is important, only because for certain companies, it lets you, the shareholder know that you are compensated for not being an owner operator, whether the owner could devalue your investments.

i also agree with that your assets, if liquid is fungible.

but at the end of the day, it is still your ability to execute value purchase.

you could have seen the light and liquidate your whole property portfolio and pay off the debt and put the 1 mil net worth in the dividend stocks that you mentioned. when a 30% correction comes along, your theoretical net worth is cut, and hopefully the dividends are not cut.

the lesson for me here to self, is that if i am successful, i have to be clear that what i achieve is highly likely due to luck like what howard marks say, that i was caught in a midst of the right situation. it might be better to learn the lesson after i do well in a more psychological painful investing period.

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22 FI FighterNo Gravatar August 11, 2015 at 8:48 am

Kyith,

Thanks for stopping by. In the world of dividend stocks there are simply far too many companies to allow for a sweeping generalization. I mentioned Dividend Aristocrats in the article but my thoughts/analysis did not imply to lump the entirety of the group. You’ll always have exceptions, outliers, etc…

More specifically, I pointed out low growth stocks such as: PG, EMR, MCD, etc. And I still stand by my claims that although those stocks will provide an investor decent income on Day 1, the income growth and future share price appreciation will leave a lot to be desired (most likely). Those companies have peaked and there is little room to grow revenue…

I would disagree that there is more “risk” and it’s more “speculative” to invest in other high quality dividend paying stocks such as SBUX, AAPL, DIS, etc.

GOOG doesn’t pay a dividend, but is it really any more risky an investment than an Aristocrat like T?

The latter companies have a lot more room to grow, I think most investors would agree, and they have strong economic moats which should keep them around for decades to come (although nothing is guaranteed of course).

Yes, I built my net worth through leveraged real estate, but at this time I’m not buying any more properties. I’m sitting in mostly cash because I see the risks in investing at all-time highs. There’s a belief out there that an investor must always be invested in the markets — I don’t agree. I find it quite normal and ok to sit on the sidelines from time-to-time, especially now.

My main point with stocks (and in general) is that an investor needs to see the big picture and not go around chasing cash flow/yield only. Yes, it feels good when a company periodically deposits a dividend in your account… I’ve experienced that as well. But progress is accelerated greatly when an investor can realize not only passive income, but tremendous price appreciation as well.

On the path to early FI, growth should never be dismissed and ignored in favor of passive income, no matter how large the payout may be on Day 1. You must factor in long-term performance and try to anticipate what that payout might be in Year 10, 20, etc.

I learned from my Midwest cash flow properties that a high paying Day 1 yield does not tell the entire story. But the rent appreciation (GROWTH) from my Class A is what will make early FI possible for me.

And yes, I’m patiently waiting for a 30%+ correction! I love to buy low 🙂

All the best!

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23 JonNo Gravatar August 12, 2015 at 2:48 am

You can’t compare a turnkey midwest property to a dividend aristocrat stock!

Turnkey properties are the OPPOSITE of value investing. The turnkey provider knows the investor wants to see 15% cash on cash, throws some (unrealistic) assumptions onto a spreadsheet (4% vacancy, 4% maintenance) and sees how much they can charge you. They then see how much they can get the (generally) foreclosed property for and they calculate their profits. You think if something happens with the property and they manage to get it for 10k cheaper this will feed through to you in the form of a lower purchase price or extra spent on renovations? No! It goes straight into their pockets.

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24 FI FighterNo Gravatar August 12, 2015 at 9:30 pm

Jon,

As I stated in the article above:

“I wouldn’t go as far as to compare EMR to my very own Midwest Cash Flow properties, though, as EMR is definitely a higher quality type of company with a much more reliable history of generating passive income than my out-of-state rentals. A direct comparison would be like comparing apples to oranges… Nonetheless, the growth potential of both types of investments are similar — there is none.”

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25 cptmrpantsNo Gravatar August 12, 2015 at 11:31 am

At what point might you consider locking in your gains on rental 1 and/or 2?

On the BEST month, the 2 properties seem to cash flow around $800 together.

If only sold property #2 and invested the net proceeds into a index (broad/real estate or otherwise), a 4% SWR would cash flow almost as much as both properties do on their best months with zero work.

You would lock in some real estate gains at current highs and diversify, as you have plenty into San Francisco real estate.

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26 FI FighterNo Gravatar August 12, 2015 at 12:32 pm

Cptmrpants,

With those two rentals, right now my plan is to hold them for cash flow. The returns aren’t stellar but that’s primarily because I have not yet elected to raise rents to market rate…

They are wonderful cash flow investments, though, and I have great tenants. I will probably hold on to them but you are right, I do have a lot of allocation in the SF Bay Area.

Take care!

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27 Simple Is The New GreenNo Gravatar August 18, 2015 at 5:46 am

I’ve had some good luck with rental properties. We bought a couple of properties for $35k each. They are not class C, but not quite class A. I would personally live there as they are safe and clean and remodeled. We cash flow around $5,400 per year on each property. If you think about 3% withdrawal rate recommended for early retirees to make sure their accounts last in perpetuity, then that is equivalent to $180k in a retirement fund. We bought these “in cash” with a line of credit (read zero down: OPM) and had the tenant pay them down. Our ROI is through the roof, we didn’t have to actually pay for them and rents appreciate with inflation. I never consider these as ‘net worth’, even though they have tripled in price, because I never plan to sell. It is purely cash flow for us.

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28 KurtNo Gravatar August 18, 2015 at 8:05 am

“Net Worth = Cash Flow” Good insight here! I think in part you’re making an argument for keeping a long term view. Investment A may have better cash flow short term than Investment B, but when compared over their lifecycles, cumulative cash flow from Investment B may shine. Is this it? And should one account for the time value of money in such analyses, discounting projected cash flows, would you say?

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29 BrianNo Gravatar August 18, 2015 at 5:17 pm

Excellent article

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30 JimNo Gravatar August 19, 2015 at 5:13 am

Solid points on NW vs CF, I think cash flow just mirrors closely what we’re used to, income from a job. It’s also psychologically hard to not have CF and see your NW tick downward.

Buying individual stocks on discount because they represent a high yield is a solid move, one that’s possible because we had the great recession a few years back, but I’d argue that it’s probably better to stick with a dividend fund if you want decent performance without the volatility of single, or small basket of, stocks. EMR is a great dividend stock, been raising it every year since the 50s; but is down almost 19% on the year. 19% in one year, in the long run, won’t kill you but it’ll give those nearing FI’s heart a flutter. 🙂

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31 BilgefisherNo Gravatar August 20, 2015 at 11:58 am

Its funny, but I have followed a similar path to your. Bought in Denver in 2008-2011. The market got crazy, so we started looking out of state. The out of state properties have better numbers on paper, but have had greater turnover, greater headaches, and have actually depreciated in some cases for me.

I think some people fail to look at there long term costs and the ability for higher rents to offset those costs. A 20 square roof in St Louis will cost nearly the same as a 20 square roof in Denver. My St. Louis property gets 775 in rent while my Denver property gets 1500 in rent. Even if the property is fully paid off in St. Louis, I still will not recoup my costs for a long time. In simpler terms, maintenance costs are a higher percentage of rent when the rent is low.

Since we agree, whats the best step to buy higher cost properties that are in the better markets when bidding wars abound?

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32 DP @ Someday ExtraordinaryNo Gravatar August 21, 2015 at 11:43 am

Hi FI Fighter,

I just came across your blog and am intrigued. Not a lot of early retirement/financial independence writers seem to discuss stocks in so much detail. You may have covered it already in another post that I just haven’t gotten to yet, but what are your thoughts on the latest market? I see you are interested in some of the energy and oil stocks. I think there are some fantastic buys out there at the bottom of this cycle that will come storming back in the coming years. The hard part is stomaching holding some of these companies while oil and commodities keep tanking. If you have the guts, you can lock in some great yielding stocks that have potential to appreciate significantly.

I’m starting to write up a series on investing techniques on my page – the latest as a discussion on book value. Do you have a strategy that you typically employ?

Anyway, good read!

-DP

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