April 29, 2021

JF2431: Cashflow or Equity Gains, Which Strategy is Best?

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Today Theo and Travis will be sharing about investing in cash flow vs. equity gain. Theo and Travis discuss the pros and cons, as well as compare the two. 80% of people in the United States are probably in the mindset of investing for equity gains: the “buy low, sell high” mentality. The bigger picture is when your passive income streams exceed your lifestyle expenses, you have financial independence, time freedom. At the end of the day, you have flexibility.

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Theo Hicks: Hello Best Ever listeners and welcome back to another episode of the Actively Passive Investing Show. As always, I’m your co-host, Theo Hicks, with Travis Watts. Travis, how are you doing today?

Travis Watts: Theo, doing great, man. Let’s rock and roll.

Theo Hicks: Today we are going to be talking about the differences, the pros and cons, the benefits of cash flow versus equity gains. Which is the best passive investing strategy? Should you invest for cash flow or should you invest for equity gains? As always, before we dive into those pros and cons and kind of compare the two, Travis is going to let us know why we are talking about this topic today.

Travis Watts: Sure, Theo. I think we’ve covered this in a multitude of ways, but never directly, and never in depth. I thought we’re a good match to discuss this topic. I’m a full-time passive investor and we’ve both done a lot of equity stuff, so I just kind of want to get two different opinions on it and share other people’s opinions as well… Like Robert Kiyosaki’s opinion on this, things like that; things that initially changed my mindset in the direction that I ended up going. I would say – this is not an official statistic by any means, it’s just my opinion… I would say roughly 80% of people in general, at least in the United States, are probably in the mindset of investing for equity, for gains; the buy low sell high mentality. I’ll get into why that is. But what changed my mindset so many years ago is Robert Kiyosaki pointing out that the wealthy invest for cash flow. That’s why he invented the cash flow board game. That’s why he’s written all the books he’s written, they’re all cash flow themes, and all his advisors are advocates of cash flow. It makes a lot of sense, so I want to dig into why that is. But more importantly, to the point of the topic of this episode, is one better than the other? What are the pros and cons? Which is right for you? We’re not financial advisors, please seek licensed advice there. But we’re going to share some opinions and some education topics with you. So let’s find out. Before I roll into it, do you have anything else to add Theo?

Theo Hicks: No, jump into it. Let’s talk about cash flow investing.

Travis Watts: I’m going to start talking about cash flow, and then I’ll turn it over to you, I guess, for equity. We’ll kind of compare and contrast that way. Being that I’m a full-time cash flow investor myself, I felt like this would be the segment that I would cover.

When you invest for cash flow, what are you really doing? You’re buying income streams, that’s how I look at it. It’s less about the buy low, sell high, it’s more about “If I put this much money here, how much do I get every month in return from that?” The bigger picture here is when your passive income streams exceed your lifestyle expenses, you have financial independence, or financial freedom, or retirement, or time freedom; there’s all these different terms that you could use. But at the end of the day, you have flexibility, let’s call it that; you have more options.

My goal and mission is just to help educate people in this sector. It’s been absolutely revolutionary in my life, for my wife and I, and our family. These are things I just want to put out there to the world and help others with that mission. Here’s the number example. Let’s say that your goal is $100,000 per year in passive income that rolls in without you having to do labor, or physical activity, or whatever; go to a nine-to-five job, etc. How much do you need to invest? Well, if you had a million dollars invested at –just using a simple example purpose numbers– 10% a year return, then that’s $100,000 per year in cash flow. But again, what if your real estate only cash flows 8%? Well just do the math, 1.25 million invested at 8% is 100,000 per year.

So you kind of get to choose your own yield, what makes sense to you with your own portfolio and your own risk tolerance, and that’s kind of how you run the numbers. But at the end of the day, why does Robert Kiyosaki say the wealthy invest for cash flow? Well, it’s simply because the wealthy have capital, they have money. So at the point where you have a million dollars plus to go invest, then wouldn’t $100,000 a year be pretty life-changing? Or if you had 2 million, wouldn’t 200,000 a year, or 300, or 400, etc, you get the point. It’s kind of the lifeblood of big business, true wealth, legacy wealth, generational wealth, and all these kinds of things.

So why is it then that 80% of people, in my personal opinion, are investing for equity? Well, I want to get into the pros and the cons of that first, and then I’ll answer that question here in a bit. So I’ll turn it over to you, Theo.

Theo Hicks: Exactly. The equity gain is the opposite of cash flow. As opposed to investing your capital and then making a return on that capital, you’re making an ongoing return on that capital; you’re investing the money into something, and then it kind of just sits there, and the hope is that the value of that increases over time, and then at some point, a year later, five years later, when you cash out, you pull out a larger amount of money than you put in.

Examples of this in real estate would be flipping a house; you buy the house, you invest capital into it, and then the goal is that what you make when you sell is more than the amount of money it costs to buy the house and fix the house up. Stocks are an example of this, like trading stocks; you buy a stock at $1 and want to sell it at $1.10, or whatever. Cryptocurrency is kind of like stocks, the same thing. It’s this the buy low, sell high, either by doing nothing and just waiting or by doing something and forcing that value up.

Overall, the focus here is on growing the capital and your nest egg. And since it’s more focused on growing the value, and you’re kind of waiting for it to happen, and it’s not necessarily fully in your control, there’s a lot more risk associated with this strategy. But like most investments, the more risk involved, then the higher potential reward, but also a downside as well.

Sometimes, when you’re investing in equity gains, there’s more risk, so hopefully, the return you get is going to be significantly higher than what you would get if you were investing at a lower-risk cash flow type of investment. Here’s an example – and I’ll follow with an example of a rental property or a real estate example. If you buy a home for $100,000, and you put down 20%, so you’ve got $20,000 invested into the deal so far. Keep in mind, they’re going to be very simple numbers, because there are more expenses involved, so this is the best-case scenario. So you’re putting down $20,000, and then let’s say you plan to improve the property. You end up improving it and you sell the property for $175,000.

After calculating all the repair costs, all of the closing costs associated with selling the deal, then you profit at the end at $20,000. So you invested 20 grand, you profit 20 grand; that’s a 100% return on your money. Let’s say you do this in one year, and one day to pay capital gains tax, you’ll pay a really high tax on it. It’s not 100%, but still, a high double-digit return on your money, which sounds amazing. People will do fix and flips, these type of strategies. But there’s a lot of risks involved in this strategy. A little bit less risk, since it’s a rental home in this scenario, because since it’s a rental home, you could rent it out and get that cash flow at the same time… But if it was a fix and flip and there was no opportunity to rent it, say this is not an area where people rent and your only chance is to sell it to someone to own, a lot can happen in a year. The most common horror story you hear from 2008 is people who were fix and flipping homes, things are going great until all those homes they had that they were in the process of flipping, maybe they were three to six months into that strategy, and then the market collapsed. They were stuck holding all of these properties and they couldn’t sell them for the price that they needed to.

So when you’re investing for equity, as I mentioned before, higher risk, higher reward, also higher downside. If you aren’t able to sell it for that higher number, then you’re going to lose money, and you’re going to make less money than you would have made when you are investing for cash flow.

Going back to what Travis said, and he might go into it a little bit more, but what happens if you don’t have a million dollars to passively invest? That could be your end goal. So you could have an active business and then you can use that to grow your equity, hopefully also having some cash flow as well by doing rental properties or some sort. Growing your equity until you have enough properties where you have either enough properties that you can sell them all and have a million dollars, or even better, having enough properties that through refinances and cash flow you have that million dollars or so, and then do both at the same time depending on what your goals are.

Maybe I’m getting ahead of myself, but overall, that’s an example of what it means to invest for equity. You’re investing capital into something, and then you’re either waiting and doing nothing, or you’re waiting and doing a little something, with the hope of that equity growing so that when you cash out, you get your nest egg back a little bit bigger than the last time.

Break: [00:09:58][00:12:00]

Travis Watts: I was just recently on YouTube, I was listening to Warren Buffett and Charlie Munger talk at the Berkshire Hathaway meeting. I don’t know how many years ago it was or if it was the most recent, I can’t remember. Warren obviously got started very young, very early; I think it was like in the 30s or something, and he was talking about what he was doing through the 40s and 50s in the stock market, and he was saying to the point of he was doing these kinds of crazy returns back then not because the market was booming, but there’s a lot of possibilities with little amounts of capital. For example, could I 5x my money overnight with $1? Probably. I could go to a garage sale and buy a coffee mug and then go sell it on eBay for five bucks. So I 5x my capital, that’s amazing. But that’s because I was only using $1, or $5, or $10. The point he was making is he was making these 20, 30, 40% annualized returns back then, but it’s because he was working with, in most cases, under $1 million of capital. So he had a lot of possibilities and strategies he could implement.

Now as he sits on billions and billions of dollars, you can’t just 5x your money overnight. There’s a drastic drop off in the curve of possibilities with that amount of capital. That’s why I think a lot of these wealthy individuals eventually turn to cash flow, as he has done. If anyone’s familiar with how he bought Coca-Cola stock on Black Monday in the 80’s as it fell apart – that’s a dividend-paying blue-chip stock – he’s never sold it. So his cash flow today off his basis of when he bought is 40 or 50% cash flow; it’s incredible. So he turned into a cash flow guy, but he wasn’t always that way. Neither was Charlie Munger, his partner. He used to do real estate stuff as well. Anyway, I digress, that was just a thought I had.

The second thought I had – I rarely share this kind of stuff, but I was raised by two very frugal parents that taught me a lot about shopping in the clearance section, using coupons, buying the off-brand, etc. And I’m thinking about myself back when… If you don’t have a lot of capital to get started, sometimes your lifestyle choices make the biggest impact on your portfolio. What I mean is if you can trim off – and we’ve done an episode on this before on frugality among the wealthy, or building wealth through frugality, I forget what the topic was… But let’s say I could shave off $300 a month out of my budget by not going to as many restaurants, or spending frivolously on Starbucks and coffee, and things like this. Well, $300 a month is $3,600 by the end of the year. But on the flip side, let’s talk about passive investing and cash flow. Let’s say I invested –I don’t know, I’m making up a number– $5,000 at a 10% return; I’m only going to get $500, and probably a lot of that’s going to be taxed on top of that.

So sometimes, early on, if you’re young or you just absolutely don’t have capital, it’s going to be frugality, it’s going to be your budget, it’s going to be your choices of how you spend money that’s going to have the greatest impact.  As you start making a lot of wealth, all that stuff kind of goes out the window. Why have to use coupons and shop clearance racks when you’re a multimillionaire? You certainly don’t have to anyway. You might choose to, I think even Warren Buffett does still. He’s been known to use some coupons at McDonald’s, or something like that. I thought that was kind of funny.

But anyway, so the last thought before I get into the next section, I’m going to answer the question I alluded to earlier, why so many people are into equity investing versus cash flow. The Federal Reserve conducts a survey, it’s called the survey of consumer finances. If you look at that data, you’ll see that the median –not the average, but the median, that’s a more realistic number–  household net worth in the United States is around $121,000. That’s among all age groups. If you bump to the highest end of that, meaning the oldest age, which notoriously those are folks that have the most wealth, so say 75 years of age, it only bounces up to $255,000 as far as the household net worth.

Again, that’s not going to bring a substantial amount of passive income into your life. Therefore, that’s my opinion of why so many people are focused instead on buy low and sell high; it’s a quicker way to turn over capital and smaller amounts. And if the median household net worth was millions and millions of dollars, more people would be into cash flow, because it would give you more flexibility over lifestyle, things like that. Just a few thoughts there on Buffett, frugality, and why folks mostly are into the equity play.

But something you said earlier, Theo, stood out to me – when I talked to investors, whether they’re active or passive, most of them are doing something right now in life actively in hopes of generating enough wealth to then become passive. That’s usually the story that I hear. Whether that’s a doctor, a dentist, or an attorney that’s working their practice, “Yeah, one day when I retire and sell my practice, then I’ll have enough equity to where I’ll just become an investor, basically, and live off the passive income.” That’s the path that most people in my experience are striving for.

With that, here’s the Holy Grail. The thing I really wanted to share on this episode is it doesn’t have to be so black and white. It doesn’t have to be “Are you a cash flow guy? Are you an equity guy/gal?” Could you have both? Yes, you can have both. That’s the beautiful thing. It’s the holy grail of investing, at least to me. What makes me so passionate is I invest in deals that have both cash flow and equity components to them.

You take real estate, for example – I’m investing in something that’s stabilized and occupied where I’m getting monthly income off of that as we go along. Hopefully, I’m –not me personally, but the general partnership, let’s say– is improving the property, the units, the clubhouse, the branding, and the marketing to where the rents are going up, so we’re forcing some appreciation there. On top of that, hopefully, the market is lifting it up and inflation is lifting it up. So if we buy a property at –whatever, I’m making up numbers– 50 million bucks, hopefully, we later sell it at 60 or 70 million in the future. So there’s your equity, there’s your buy low, sell high, but then also, I’ve got cash flow the whole time.

That’s how I like to invest. If you’re not into real estate or that’s not where you’re at right now, think about the stock market in terms of when it corrects. About a year ago, we had a nasty correction in the markets, that it on average sold off about 30%. Some of these real estate investment trusts that pay monthly dividends – they fell 40 or 50%, so I was scooping that stuff up a year ago. Not enough, but I was putting in what I could at the time. So you’re buying at a depressed price point, and then they’re still paying out dividends, even if they had to cut their dividends a little bit and less than them. Well mow most of those, if not all of them in my portfolio, have not only recovered from pre-pandemic levels, but they’re exceeding those levels and they’re bringing their distributions back. So I got a nice equity boost there and cash flow throughout the whole period. That’s how I invest.

Something I want to share is awesome, by John Bogle. This just blows my mind to think about. I’ll maybe say this a couple of times… Over the past 81 years, reinvested dividend income, accounted for approximately 95% of the compound long-term return earned by companies in the S&P 500. We used to not have the S&P 500 by the way, it used to be called something else, with fewer stocks in it, but more or less the index as a whole. In other words, reinvestment of dividends accounted for almost all of the stock’s long-term gains. This is about cash flow; this is totally about reinvesting, as we’ve talked about over and over on the show. Re-invest your cash flow; that’s how compounding works, that’s the wonder of the world, whoever coined that, Einstein or whatnot. That’s why Warren Buffett does this kind of stuff.

Again, over the past 81 years – I have to say this again, it’s just crazy – reinvested dividend income accounted for approximately 95% of the compound long-term return earned by companies in the S&P 500. That’s just crazy to me. So it’s just my opinion that cash flow is king. This is really the focus that we should all be at least striving for one day. If you’re not there today because of things we talked about earlier, that’s fine. But the goal should be, hopefully, do a little buy low, sell high stuff and work your highest and best, and save, save, save, and then get to a point where you can start generating cash flow. That’s all I got. That was my little passion point. I’ll get off my stool.

Break: [00:21:03][00:21:45]

Theo Hicks: I feel like, for a lot of these episodes, we have these questions, which strategy is the best? The answer at the end is always “Well, it depends,” or “Both are great.” But it’s true. Something when we first started talking, you led off with the fact that a lot of the people you speak with are currently working some sort of full-time job that’s not related to investing or real estate at all, and their goal is to eventually create enough wealth or save enough money through that so that they could eventually exit that and then become a passive investor. The whole idea here is that if you want to be a passive investor, you can either pick it from the point of “I’m going to be active in something and then I’ll become a passive investor eventually, once I’m done…” You can do it while you’re a doctor and passive-invest your gains…

There’s really a lot of different strategies when it comes to being a passive investor, active investor, investing for cash flow, investing for gains. It really depends on what your goals are. For someone who’s just starting out and has no money, you’re going to have a hard time being a cash flow passive investor. But like that Charlie Munger example you gave, when you do have a little amount of money, like a couple $1,000, you can multiply that money a lot easier than you can when you’ve got millions of dollars. The best example of this –we talked about in the show before– is the house hack. We talked about frugality, saving 30 bucks a month by just not spending money on certain things; at the end of the year you’ll have $3,600. That’s almost enough to get the ball rolling on a house hack by just cutting back your spending for a year.

Again, the equity is really good for when you’re first starting out and want to get that nest egg rolling. But I think the strategy here is to eventually transition to cash flow, maybe at the same time, and then transition fully to the cash flow. Those are my final thoughts on this topic. Travis, anything else you would want to mention before we sign off?

Travis Watts: Yeah. Just always keep in mind like I pointed out earlier, a million bucks invested at 10% a year is 100k. You can run your own math, you can disagree with the 10% figure and say, “How about 5%? 2 million bucks at 5%?” Whatever, but just realize that once you get to these capital levels is when passive investing can really kick off and take a journey of its own. It’s not too enticing — I’m asked all the time “If you were to start over from scratch day one again with no money or whatever, would you be a full-time passive investor?” Probably not. Because that means that the first money I put out there, to the point of that $5,000 example, I’m going to be getting 500 bucks a year or whatever that breaks down to; 83 bucks a month or something. That’s not very exciting. Just to be able to cover your cell phone bill isn’t life-changing per se. So no, I would probably go back to equity plays and I would be trying to hit doubles and stuff like that as quick as I could. And then again, frugality and whatnot.

There’s no right or wrong, good or bad. It’s what’s right for you given your unique circumstances, your goals, your risk tolerance, your self-discipline, your frugality, things like that. So it does depend, but that was the approach I took in full transparency – worked a high-paying job that was in the oil field, did a lot of buy low sell high, did fix and flips, had some vacation rental single-family stuff, side businesses that I would try to run, and all of this… And I was very frugal to where I built up a nest egg. I sold everything, I took that nest egg and I put it passively to work, but it’s because of frugality that I was able to pull that off at an early age. If I had had lush lifestyle preferences or if I wanted to spend a million bucks a year, I couldn’t have pulled that off. Everybody is different, but hopefully, some of that was helpful and encouraging to listeners on their journey… And I’ll quit talking.

Theo Hicks: Perfect. Travis, thank you again for joining us today. I always love hearing about your experiences. You’ve got a lot to bring to the table here. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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