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…
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!
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?
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.
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…