Unfair Advantage -The Power of Financial Education (13 page)

I left his office a little dejected. I had no idea where to find any real estate-investor education. I knew there were courses to become a real estate agent, but I knew real estate agents are not investors. I knew this because my rich dad often made jokes about stockbrokers and real estate brokers, saying, “The reason they’re called brokers is because they’re broker than you are.” Explaining further, he said, “Most real estate brokers take courses to get their license to sell real estate, not invest in real estate. A real estate license allows them to sell houses and earn money in the S quadrant. Most real estate agents know little to nothing about real estate in the I quadrant.” Leaving his office, I knew I needed to find real estate education for the I quadrant. I knew I did not want to be a real estate broker in the S quadrant.

Late one night, as I prepared for an early morning flight at the Marine Air Station, an infomercial came on TV, enticing viewers to sign up for a real estate-investment course. I dialed the number on the screen and signed up for a free preview to be held in a few days. At the free seminar, I heard exactly what I wanted to hear and paid $385 for a three-day course to be held in a few weeks. At the time, $385 was a fortune for a Marine Corps pilot whose flight pay was less than $900 gross a month. Like most people, I had a mortgage, car payment, and other expenses. My mind went crazy as I wondered if I was being smart or foolish. I wondered if I was being taken and if I would walk away with nothing.

That $385 turned out to be one of the best investments I have ever made. That course has made me multimillions of dollars, over and over again, much of it tax-free. More important than the money is the impact that course has had on our lives. Investing in our education, through that course, is one of the reasons Kim and I were able to become financially free, Kim at 37 and me at 47.

In 1973, I did exactly what the instructor of the real estate course taught us to do. I spent weeks looking at different investments. At every real estate office, the real estate agents told me the same thing, “You cannot find those deals in Hawaii. Hawaii is too expensive.”

I was prepared for this closed-minded chatter from real estate agents because the course instructor had warned us, saying, “That is why they are real estate agents and not real estate investors. If they were investors, they would not need to be sales people.”

After weeks of searching and hearing over and over, “You can’t do that here. What you want does not exist,” I finally found a tiny real estate office on a back street of Waikiki and found the answers I had been searching for. When I said to the broker, “I’m looking for an investment property in a great area, low priced, very little to zero down, and something that has positive cash flow,” he smiled and said, “I have what you’re looking for. In fact, I have nearly 35 of them.”

Three days later, I flew to the island of Maui, rented a car and drove 45 minutes to the property. Once there, I could not believe my eyes. The project was spectacular. It was across the street from a beautiful, isolated sandy beach, just like in the post cards of old Hawaii. The reason the prices were so good is because the entire property was in foreclosure. Everything was for sale. Like a kid in a candy store, I went from unit to unit, looking for the one I wanted. Finally, I chose one. The price for any unit was $18,000. The terms: 10 percent down, or $1800, with the seller financing the balance.

This meant I did not to have to qualify for a bank loan. It was everything all the other real estate brokers said did not exist, and it was on the island of Maui, near one of the most desirable resorts on the island.

Once I knew the property would generate cash flow, even with 100 percent financing, I pulled out my credit card, putting the $1,800 down payment on the card. I had none of my own money in the investment, and I still made money. Eventually, I bought a total of three of these properties. I would have bought more, but my credit card was at its limit.

Things went well for about six months. Then all hell broke loose. The septic system in the project broke, raw sewage rolled into my best unit, and I learned about negative cash flow and the dangers of being in too much debt. The moment the septic system broke and my tenant moved out, my asset turned into a liability. Rather than making $20 a month, I was losing $300 a month. I was facing the nightmare that keeps most investors out of real estate: property management and negative cash flow.

My real-life education had begun. Thank God my two other units were still operating. I was learning how to use debt to become rich and how debt can make you poor. It was the start of a priceless education in the power of debt.

Today, real estate brokers continue to say to Kim and me, “You can’t do that.” They say that, even though they see us buying 300-to 500-unit apartment complexes with debt and making millions tax-free. Most real estate agents can’t do what we do because they were educated in the S quadrant, rather than the I quadrant.

Since debt can be lethal, we recommend you start small. Buy a number of small deals, as Kim did when she bought her first 20 units. Learn how to manage debt and manage real estate.

As most people know, getting into debt is easy. Managing debt is hard.

Why Are So Many People in Trouble?

FAQ

Why are so many people in trouble with debt?

Short Answer

They use debt to buy liabilities. The rich use debt to buy assets.

Explanation

In
Rich Dad Poor Dad,
I stated that your house is not an asset. The reason most homes are not assets is simply because the owner pays the mortgage, taxes, insurance, and upkeep. With our properties, the tenants pay for those expenses, plus our profit.

We use debt to finance assets, things that put money in our pockets. It doesn’t have to be real estate. For example, Kim and I own a 58-foot sailboat. For most people, a boat is a big liability, a hole in the water you pour money into. Our boat is an asset because the boat is in a charter business, so tourists pay for the debt, insurance, upkeep, and boat slip rental. We make money every month and use the boat when we please.

Remember, it is not the asset class that determines if something (a house, boat, business, oil, or gold) is an asset or a liability. What determines if something is an asset is the direction of the cash flow. If cash flows into your pocket, it’s an asset. If cash flows out of your pocket, it’s a liability. It’s that simple, in theory. In practice is where the challenge lies.

Real-Life Real Estate

FAQ

Would you give us a real-life example of how you achieve 100 percent debt and still have positive cash flow?

Short Answer

Sure.

Real-Life Example

I’m pulling this example from a project Kim and I have with our real estate partner, Ken McElroy. Ken and his partner, Ross McAllister, put the deal together, did the work, and manage the property. Kim and I are financial partners in the project.

Project:
144 apartment units + 10 acres vacant land

Location:
Tucson, Arizona

Tucson is a city with strong job growth from the University of Arizona, the military, and government agencies such as the U.S. Border Patrol. Since many jobs are transient, there is a high demand for rental housing.

The property was not listed with real estate agents. Ken and Ross were the property managers of the property. When the owner said he wanted to sell, the project changed hands to Ken, Ross, Kim, me, and two other investors.

As you may know, most great deals are not listed. Most great deals go to insiders.

Price:
$7.6 million ($7.1 million for the 144 units and $500,000 for the vacant land)

Financing:
$2.6 million in equity from investors

$5 million via a new loan

Plan:
Build 108 new units on the 10 acres.

Financing for addition: $5 million to build the 108 new units

The existing property and the 10 acres were used as collateral for the new $5 million construction loan.

Total units:
252 units when complete

Total package:
$2.6 million equity + $10 million debt

New basis:
$12.6 million

New appraisal:
$18 million.

An increase in rents increased the appraisal.

New financing:
75 percent leverage = $13.5 million

($18 million x 75 percent = $13.5 million)

Paid off old loans:
$13.5 million - $10.0 million = $3.5 million

Return to investors:
$3.5 million

Net transaction:
Kim and I invested $1 million. From the $3.5 million return to investors, we received $1.4 million. $1.4 million is reinvested in a 350-unit property in Oklahoma.

Taxes on $1.4 million:
0

Today, Kim, Ken, Ross, and I still own the 252 units in Tucson. We receive monthly income from the property. Since we have zero invested in the property, our ROI (return on investment) is infinite.

Over the course of seven years, Kim and I have invested in over 2,500 units with Ken and Ross, using the same investment strategy. Today’s economic climate has offered us opportunities to buy even more properties because prices are low and, more importantly, interest rates are very low. Low interest rates increase our income as rental income goes up. Rental income is going up because fewer people can afford to buy their own home, so they rent.

During the real estate bubble between 2005 and 2007, Kim, Ken, Ross, and I were losing renters because they were using subprime financing to buy homes they could not afford. During that bubble, we actually made less money. But once the bubble burst, the tenants flowed back in, our cash flow increased, and our apartment properties increased in value as the values of residential homes plunged.

When banks look at large, multimillion-dollar projects, they focus on the borrower’s track record and the property itself. They make their lending decision primarily on cash flow, not the borrower.

When homeowners buy their home, banks focus on the borrower and the homeowner’s income because there is no income on a personal residence.

The good news is that the same strategy can apply to small real estate investments. I used 100 percent financing to buy my first apartments on Maui. While not all investments work that way, this is our objective: We want our down payment back, a free asset, free cash flow, and tax breaks. Kim, Ken, Ross, and I call an infinite return “printing money.”

Infinite Return

FAQ

What is an infinite return?

Short Answer

Money for nothing.

Explanation

If I have zero in the asset and I receive $1, a return on zero is infinite. It is money for nothing. The asset is free, once we get our money back.

Keeping this overly simple, I’ll use the following for an example. Let’s say a property costs $100,000 and my down payment is $20,000. If I receive $200 net positive cash-flow income after all expenses (including mortgage payment), I have a 1 percent monthly return on my investment of $20,000. That’s a 12 percent annual return or $2,400 per year.

ROI is net income, divided by down payment.

$200
1 percent per month, or12 percent per year

$20,000

Our investment strategy is to get that $20,000 back and continue to receive $200 a month. Once the $20,000 is returned, the ROI is infinite.

This is the investment scenario I was looking for when I finished the real estate course in 1973. This is what most real estate agents said was impossible. Today, we continue to strive for the impossible.

To most people, $200 a month, a 1 percent monthly return, looks sickly, certainly not exciting. Yet if you own 100 of these small deals, that is $20,000 a month in cash flow. And 1,000 properties is $200,000 a month. That is more money than most doctors and lawyers make in a month.

When Kim started out, her goal was 20 units. She accomplished that in 18 months because the economy was terrible. It’s not that different today.

Once she had her 20 properties, she sold them tax-deferred. With her tax-deferred capital gains, she purchased two larger apartment houses, one 29 units and one 18 units. Today, following the infinite-return formula, she has nearly 3,000 apartment units, commercial buildings, a luxury resort and five golf courses—all with positive cash flow, even in down markets. Her goal is to add at least 500 more units every year, using the same formula—the formula most real estate agents say does not exist. This difference in mind-set underscores the difference between real estate education in the S quadrant and the I quadrant. The real irony is that real estate agents pay taxes on the income they earn, and investors receive massive tax breaks on their income.