Six Ways to Make Money is Better Than One
I’ve made several comments over the years recommending real estate investing as the most powerful form of passive income.
The reason it’s so powerful compared to other passive income sources such as stocks, blogging, or bulk candy vending is: there are six ways it makes you money.
Stocks, by contrast, only share one of these sources (two if you’re getting dividends).
Income Sources of Different Passive Income-Producing Assets
Once you understand how all six of these income sources work, you will begin to see the tremendous wealth-building power of real estate bought and managed correctly.
I Said Correctly
Quick Disclaimer: These six income sources only apply to real estate bought and managed the way my mentors taught me:
A) with equity,
B) with cash flow,
C) in “bread and butter” neighborhoods,
and D) managed with best practices.
If your knee-jerk reaction is that real estate investing is too risky, you have not yet been taught how to minimize the risk. The way I was taught to invest in real estate is not the same way that many of the “gurus” teach. Most of those programs are far to risky for my taste.
Multiple Streams of Income
One neat thing about having so many different income streams is that real estate can be forgiving. Many people I know (including myself) screwed up on their first deal, but still made money. That’s because one income stream can make up for a lack of another.
Now, I don’t recommend screwing it up. You might as well do it right as long as you’re getting in the business. That way you won’t ruin your taste for the most powerful wealth-building tool available to the average person.
Let’s run down the list of the six ways:
1. Cash Flow
Cashflow is the reason we seek passive income-producing assets. Without cash flow, you don’t have income… meaning: you can’t quit your job without cash flow.
All of the assets on my comparison chart have cash flow (I’m assuming your stocks have dividends). If it doesn’t cash flow, I don’t consider it.
We don’t buy a piece of real estate unless the rental income is greater than the monthly expenses by a decent margin. For example: when your tenant pays you $1,000 a month and your monthly expenses including principal, interest, taxes, insurance, and maintenance/occupancy reserve are $800 a month. The $200 difference is now income in your pocket.
2. Equity Capture
Equity capture is when you buy an asset for less than it’s worth. In real estate, it’s when you buy a house in a $100k neighborhood for $50k, fix it up for $20k and you’re “all in” for $70k.
You just captured $30k in equity which goes directly towards your net worth. Few other investment vehicles can create wealth so quickly
In fact, of the six assets on my comparison chart, real estate investing is the only one that allows you to capture equity. Stocks are sold to the average person “at market” which, by definition, means there is no captured equity.
Without equity, you are exposing yourself to the risk of a falling market. We always buy assets with equity so that we are never hurt by a down market.
Online businesses, network marketing, and vending can be good sources of cash flow; but they don’t offer an opportunity to buy an asset for less than it’s worth.
3. Forced Appreciation
The ability to change the value of an asset by your own efforts is a very attractive reason for choosing an asset for self-determinists like me. Most of the businesses that I have ever started relied heavily on my creativity and work ethic to gain in value.
In real estate, you have the opportunity to physically change the value of an asset. In single-family investing, we take a distressed asset and raise the value back up to where it supposed to be with a proper rehab.
Multi-family investing lets us take this concept to a new level. While the value of a single-family house is constrained by the comparable sales in the neighborhood, the value of an apartment complex is based on the profits. That means you are only limited by your ability to increase the income and decrease the expenses.
The value of a vending or online business is also based on the profit margin that you can personally control.
Unfortunately, stocks do not allow you to control the value (that’s in the hands of the execs), and network marketing businesses typically can not be sold (so they don’t have a market value).
4. Market Appreciation
Real estate doubles in value every twenty years. It might fluctuate in the short term, but it is forced to rise over the long term with inflation of building materials, labor, and scarcity of land.
The main reason most people buy stocks today is for market appreciation while it’s only the 4th most important reason we buy real estate. Do you see the difference?
While stock investors live and die by market appreciation, real estate investors see it as a nice bonus to pile on top of the other five ways we make money.
5. Principal Pay Down
Here’s a neat way we make money in real estate that most people don’t even think of. We naturally accumulate equity in our houses as the notes get paid down.
Even if you weren’t making money any other way, your tenants would be paying down your mortgage a little bit each month. It starts out small, like fifty or a hundred dollars a month, but it grows over time and adds to your equity in the house.
The other asset classes typically don’t have mortgages, so this wouldn’t apply.
6. Tax Advantage
Real estate investors pay the lowest takes of any for-profit group in the United States. The IRS allows us to reduce our earned income tax on cash flow by taking a depreciation deduction against the house. We can avoid capital gains tax when we sell by using a 1031 tax exchange.
How long can you avoid taxes with a 1031? If you pass the property to your children, they will take over at the new cost basis, which wipes out all of the capital gains over the life of that asset.
None of the other assets can claim such a huge tax advantage.
Does it Make Sense?
Are you starting to understand why I talk up real estate investing so much? It’s the only asset class that I know of that can create rapid wealth. All the others make money in one or two ways, but not six.
I have made money in real estate speculation during the boom, it was not easy money. I currently own a warehouse which we lease out, I can make more money on the web without the aggravation property taxes, building inspectors, difficult neighbors, insurance, and ……
I agree! You need to have several sources of income and never settle on just one. So when something happens to one of those sources, you’ll still have others to rely on!
This is my first time to read stuff about real estate investing. I’m always been curious about it but I am quite clueless when it comes to anything related to finance, business or investments. I actually intend to take a course on investments and maybe i could start doing things like these.
Brian,
Thanks for the post and thanks for sharing. Wifey and I bought a vacation rental property as our first jump into real estate. The cash flow is there, not to mention the free beachhouse, but i think the next calculated risk is in a bread and butter property or two. Now, i have seen the main obstacle right now as being the down payment and loan because the banks want 20-25% down. I read your Trinity post about wholesalers and rehabbers. I want to enter the game in the rehabber circle but I am still having a hard time understanding how the hard money circle really works? Say I have $15,000 to put in play for a bread and butter that i can pick up for 60K. Banks require 20% down or 12K which leaves me tapping credit to make the rehab happen. There is not enough cash flow to pay down the credit in any reasonable amount of time. I don’t want to touch the 6 month emergency fund we have either. Also the banks want more down if I try to purchase as an LLC. FICO score is no issue whatsoever.
Thoughts?
Killer posts on here by the way. I’d be happy to share your blog.
The piece you are missing is that hard money lenders offer 70% of the After Repair Value. That means if your 60k purchase will be worth 100k after repair, you will get 70k on the loan, which will cover purchase and most of the repairs.
Hi, Brian. I live in Toronto, and the houses here are crazy expensive. Single family home or typical bread and butter home is mostly $300000 to $500000, and only tiny fraction is $200000 to $300000. Although I am very attracted by the idea of real estate investment for passive income, I don’t know if it can earn cashflow each month. The rent for a house should be maybe $1500 or maximum $2000 here. Besides, I just graduated and have been at a job for only 2 months. Does it make financial sense for me to start thinking about real estate investment, or should I wait until I have a stable job, okay salary, and first home to live in?
You are right: homes at that price level will not cashflow. Most of us stay out of the big cities for our “bread and butter” deals. Maybe you can find something closer in the suburbs.
I think you are at the perfect time to start thinking about RE. I started buying investment houses before I bought a personal residence.
Realize that buying a house for yourself is a big expense, buying a house to rent out actually makes you money.
You’ll need your job and credit to qualify for loans, so don’t drop those.
That makes sense… thanks, I’m glad I asked instead of drowning in my own inexperience.
Yes, bread-and-butter… I’ve heard you mention that before and it sounds very ideal so long as I do right as you said of screening applicants. What would be the best way to find an applicant? I imagine the newspaper classifieds are not very effective, don’t get me wrong though, we can read here in East Texas haha.
The other day I saw a condominium for $36.5k that had new paint/carpets/vinyl in ’08. I realize that it only takes a near five years for things to happen on the inside, but it’s location is prime in my opinion, it’s very close to the university which gives a good opportunity to have applicants quickly, the students are always looking for places like this… it just makes me wonder if sticking with a B-A-B home where the applicant would most likely be more reliable as a more mature adult compared to a possible unreliable party-animal.
And you said 50cents on the dollar… should I watch a property for a possible price drop or is there a way to check it’s actual price as a whole… sorry to be so uninformed.
Lots of great questions. If I were you, I’d get involved with a local real estate investor group to find the tips and tricks in your area.
Tenants are not hard to come by in this economy. Many people are returning to rentals as the banks won’t give them loans on houses.
You want to stick to the most “in-demand” market segment, which is 3/2/2’s worth $80-$120k that rent for $1000 or less.
Then, we put the best product on the rental market for the best price and they rent quickly with good tenants.
As for finding the deals, that’s where networking helps. Find local wholesalers that are finding these deep deals.
I agree with the person above, “Div. Gro. Inv.”, about there not being very many other RE investors to learn from, especially when others don’t want competition. I really appreciate what you’re doing for the community by offering us such intelligent and experienced information here.
I was wanting to buy a small area of land for under 10k and keep it for how ever many years till it appreciates enough in value and then hopefully resell it. Our town is expanding and I imagine it wouldn’t be too much of a problem to do so.
The thing is, should I have a set target for the best “kind” of land?
Involving: water/electric being available, cleared land, location within or out of city limits, etc.
All in all, is this really a good idea since there will not even be a building/house of value involved?
Thanks for your time
I don’t recommend speculating on land because there is no telling how long it will take for you to get your money back out. I meet investors every day that have money tied up in land and they can’t get it out.
Really, the best thing to do with $10k is to buy a bread-and-butter single family house (3/2/2 $120k or less) for 50 cents on the dollar and rehab it up to it’s full value. Never be “all in” for more than 70% of the after-repair value. Rent it out for 1-5 years and enjoy the $200+/mo. cashflow. Sell it after 1-5 years and collect $30-$50k depending on the market.
You will have tripled your original investment.
Interested in your thoughts about how the credit crunch forces changes in strategies. I’m intrigued with acquiring land in growth areas like Texas that don’t have a huge overhanging surplus to be in the right place when credit health begins to return. I know it’s not a cash flow focus, but as they say — ain’t no more of it being made.
The credit crunch has meant that we have less competition on many of our deals. It also has sparked a movement of alternative funding such as owner-financing and private lending.
Equity is tough to find these days. You are right, Cash Flow and Location are very important.
I enjoyed your article.
Thanks for commenting back. I like your blog and I am looking forward to learning more about real estate. I have analyzed a few properties, but I don’t really know any actual experienced real estate investors to learn from. Most of the real estate investment information on the internet is sales pitch to purchase expensive courses. I do appreciate what you are doing, so I will check often for updates.
That is a nice article. I do invest in stocks however, and I could tell you that stocks could also offer the other points just like real estate.
For “Equity Cap” – you could buy stocks selling below their book value. In fact some billionaires such as Warren Buffett have made billions by purchasing stocks in solid companies when they were trading below the value of their assets. Sometimes Buffett even bought stocks that traded at prices below the levels of cash in the company.
As for forced app, if you have the money and determination, you could purchase a controlling stake in a business and clean house. Buffett has been buying whole businesses like Geico and making them profitable. Other activist investors also buy whole companies and make them more efficient by cutting fat and making companies more profitable.
Individual stocks do not offer the kind of leverage you can get with real estate, unless you buy Stock Index Futures ( on indices such as S&P 500), where you can control $10 for every dollar you put down in a futures account. Individual stocks do offer instant liquidity however, and you can sell almost any time you want.
The problem with stocks is that you get a price quote every day, which could play mind tricks on investors; if prices get low ad everyone believes the economy is going south investors could sell, which would be a mistake.
You cannot make 1031 exchanges in stocks. Capital gains and dividend income are tax advantaged as well however. If you are in a low tax bracket you might not even have to pay any tax on dividends and capital gains. In addition to that if you place your money in a ROTH IRA or 401K, and then purchase stocks within these accounts, you will enjoy tax free compounding for decades to come. It is very easy to buy stocks in a tax deferred account; it is extremely difficult ( if not impossible) to place individual real estate in a 401K or Roth IRA. You could put real estate investment trusts however.
I personally like REITs because management does all the work for me – dealing with tennats, buying new properties in multiple locations, dealing with fixing stuff etc. My only job is to provide capital and to collect dividend checks.
That’s great insight about Warren Buffet. In fact, we model our real estate investing strategy after his basic philosophy.
The problem is exactly what you mentioned: his style of investing isn’t accessible to the masses. Few of us have the ability to buy an entire publicly traded company.
I would agree with all of your points if were were talking about buying companies like he does, but that’s a very different beast from trading non-leveraged, at-market assets online.
The book value concept is in-line with what we are doing.. If I were investing in stocks, I would probably look to do something like that; but it’s not quite the same thing. I’m talking more about current market value, which is easily measured and available on stock tickers everywhere. That is what I would call “at market.”
To get equity capture by my measure, you would have to be able to buy that stock at less than 70% of the stock price; which as far as I know is limited to people buying the entire company or crazy inside IPO deals.
This sounds… fun! I can’t wait to break out of college and get started.
Thanks for all your great articles.
Not a bad idea…
FYI, there are a bunch of articles written by me and other real estate mentors that I hang out with posted here: http://libertyrea.com
Brian, you should do a series of posts dedicated to beginners who want to jump into real estate. How do you know if you’re doing well enough to take on such a venture? What to look out for, etc, etc.
Interesting read here.
Brian,
A (B) quadrant business would also give you all the same benefits as real estate and usually much faster. You can start a small business today with a small amount $100 or less and have it be worth millions in a few years.
Not to say one is better than the other, but rather in addition to0 real estate a well run small business will get you there too.
I assume you are referring to Kiyosaki’s cash flow quadrants? I can see cash flow and forced appreciation, but not market appreciation, principal paydown, tax advantage, or equity capture. I’m also seeing a lot more work in creating a business.
Could you explain further how it compares? I’m not quite understanding.
Great post Brian. Nice work.
Ah.. that is what I thought it meant and makes perfect sense. I look forward to seeing your blog post on the subject.
Thanks for the article, a great way to outline it. I’m twenty one and plan to get into investing when I graduate college. Real estate investing is one avenue that excites me and has always made sense.
What exactly is a bread and butter neighborhood?
Great question… Bread and butter would take a whole blog post to explain (thanks for the idea), but basically, we’re talking 3 bedroom, 2 bath, 2 car garage homes with after repair values (ARVs) in the range of $80k – $120k that rent for $1000/mo. or less.
These paramaters can fluctuate based on where you live, but the idea is to buy the type of house with the biggest renter and buyer pool.
This is really good stuff Brian. I’ve been waiting for you to outline the 6 sources of income.
One question, would you call the Forced App. a form of passive income? I think it produced income, but I am not sure how it is passive?
Thanks again.
No, I wouldn’t call it passive. It’s part of your initial effort to set up the passive income stream, which is the cash flow.
Remember that there is no such thing as a 100% passive asset and different assets have different degrees of passivity.
Single family real estate is much more passive than your job because the time it takes you to put a deal together and rehab it is small compared to the $20k in equity, $200/mo. cash flow, etc. that you made from it.
That being said, there will come a day that you are making so much money that it’s not worth even the small amount of time it takes. That’s when you move up to apartment complexes.