Unfair Advantage -The Power of Financial Education (14 page)

On most of our investments, we have no money of our own in the property. If we do have money in the property, we are always in the process of getting that money back. In most cases, it takes a year to five years for our money to return.

Once we get our money back, we move it to acquire more assets. This is a formula known as “the velocity of money.” I wrote about the velocity of money in greater detail in Rich Dad’s
Who Took My Money? Why Slow Investors Lose and Fast Money Wins!,
published in 2004. Our formula has not changed, and it has picked up velocity in this horrible economy. If you had taken the action suggested in
Who Took My Money?
before the crash, you might be getting your money back today.

Ken McElroy Shares How to Use Debt

Have you ever wondered why your checking account is free? Banks need your deposits so they can lend money. Banks can’t make money until they have your money to lend. At this point, you have two choices: Use bank debt to make you rich, or use bank debt to make others rich.

Great wealth is founded on the use of debt. There is good debt, and there is bad debt.

If you borrow money and spend it on something that goes up in value, that’s good debt. If you borrow money and spend it on something that will go down in value, that’s bad debt. You use good debt to enhance your situation and increase your net worth. You should avoid bad debt altogether.

Debt is leverage. Everything you use it for will be magnified, good or bad. If you borrow money for a liability like a car that will eventually be worthless, you are magnifying your cost negatively. Bad debt creates a liability that takes money out of your pocket.

Using debt as leverage can also be an extremely positive experience when you are buying assets.

My business uses debt and leverage to create wealth for my investors by purchasing assets, specifically multi-family property. These properties not only produce a monthly cash flow, but they grow in value over time using sound management principles.

A good example of using good debt and leverage is when a group of investors, including Robert and Kim Kiyosaki, bought a 288-unit property located in Broken Arrow, Oklahoma, a suburb of Tulsa. This property was well located, and we had several opportunities to increase the revenue and decrease the expenses.

At purchase, the property appraised for over $14 million. Value is always based on the net cash flow. Using the appraisal, the bank allowed us to assume the first mortgage of $9,750,000 at 4.99 percent interest rate. We also applied and were approved for a second mortgage of $1,090,000 at a 6.5 percent interest rate. This is an example of good debt.

The bank gave us these loans because the property had a high occupancy rate, and they knew the rents we would collect from the residents would more than pay the monthly mortgage payments.

We raised $3.4 million from investors for the down payment and for capital needs.

All along, our strategy was to install new washers and dryers in all the units, which could eventually get us an additional $25 in rent per unit, a total of $86,400 in additional income annually. (Math: 288 units x $25 x 12 months = $86,400).

In just three and a half years, we have been able to increase this property’s annual net operating income by over $300,000. The original mortgage has decreased more than $600,000 because we paid the mortgage using the residents’ rental payments during that same period of time.

Today, this property is now worth about $20 million. The value is increased because the net cash flow increased.

By using good debt and leverage and with just $3.4 million down, this property’s value has increased by over $6 million, nearly $2 million a year. The annual cash flow also increased by over $300,000 and is distributed to the investors.

The original business plan was always to refinance using new debt and to leverage and return the original investor equity. In late 2011, we plan on refinancing this property with new debt and leverage with a new $15 million low-interest fixed-rate loan, which will pay off the existing $10 million in loans and leave $5 million to distribute.

There is nothing better than returning investors’ money. In this case, if the proceeds are $5 million, we will return not only the original $3.4 million but an additional $1.6 million. Don’t forget the investors also receive a nice monthly cash flow while the money is invested!

Once the investors receive their money back in full, their investment in this property will be zero. The “returned original investment” and additional proceeds are tax-free because it is a refinance.

In 2012 with a new loan in place, the property will continue to pay out cash flow to all the investors, which will create an infinite return.

I do want to emphasize that this scenario was planned from the beginning. Investors using leverage and debt are able to reap the rewards of the increased value on the “loaned” amount.

If you use good debt and buy assets that generate cash flow, you can become very wealthy.

Tom Wheelwright on Love from the Government

The tax law is a series of stimulus packages for business owners and investors. Nowhere is this more true than for real estate investors. I’m not talking about people who fix and flip real estate. They are not investors. I’m talking about those who buy, improve, and hold on to real estate for long-term investment.

As an incentive for investors to buy, improve, and hold real estate, the government gives two primary tax benefits. The first and largest is depreciation. Depreciation is a deduction you receive over time for the cost of the property, whether you bought it with your money or with someone else’s money (debt). Here is how it works.

Suppose you purchase a rental property for $200,000, using $20,000 or 10 percent of your own money and $180,000 or 90 percent of the bank’s money. What did you really buy? You bought land worth, say, $40,000 and improvements, including a building, landscaping and fixtures, of $160,000.

The government lets you take a deduction, called depreciation, for the wear and tear on the building. If this is a residential property, your deduction is about 3.64 percent per year in the United States. (It’s more in some other countries.)

That means that you get a deduction on your tax return of almost $6,000 per year for depreciation ($160,000 x 3.64 percent). Let’s say your cash flow is 1 percent per month on your initial investment of $20,000. That means you will have cash flow of $2,400 per year. With a tax deduction of $6,000, you will show a loss on your tax return of $3,600 per year ($2,400 minus $6,000). This $3,600 loss can be used to reduce your taxes from your salary, your business or your other investments. So depreciation protects your cash flow from taxes and produces an additional tax benefit by lowering your taxes from your other income. And remember that you get depreciation, not only on the dollars you invest, but also on the money the bank loaned.

You get a similar benefit called amortization, which refers to your costs of borrowing money from the bank, such as points and loan-origination fees. You get to take the deduction for amortization even if the bank loaned you the money to pay the fees.

These tax benefits are yours even though the property may be appreciating, or going up in value. So real estate gives you benefits through depreciation, amortization, and through appreciation in value.

There are additional tax benefits as well for real estate investors. When you sell your real estate, you have a choice on what you pay in taxes. If you decide to cash out, you can pay tax at the low capital-gains rate on any appreciation in your property. If you decide instead to use the proceeds from your sale to invest in another property, you can pay no tax. This is called a “like-kind” or 1031 exchange.

What’s more, if you sell your property at a loss, you get to take the loss as an ordinary loss. This means that you can use the loss to offset any other type of income. This is quite different than if you were selling a stock or mutual fund, where a loss would be limited to offsetting gains from other capital assets. So if your property appreciates, you pay little or no tax, and if your property loses value, you get to use the losses to offset your ordinary income. Many countries have similar rules and tax rates on the sale of real estate and other business assets.

Can you begin to see how the tax laws provide stimulus to real estate investors and business owners? (By the way, in the United States, flippers get none of these benefits and in fact, have to pay an additional tax, called self-employment tax, that investors don’t have to pay.) The tax laws are directions from your government on how they want you to use your money to improve the economy. This is especially true when you are using debt to invest in real estate and business.

I’ll let Robert share some more ideas about using debt to invest.

Different ROI

Most stockbrokers or real estate agents talk about a 10 percent return as being a good return. But in most cases, that is a 10 percent return on capital gains, not cash flow. It’s not real money. Again, that is the problem with getting your financial education in the S quadrant. (In most cases, S can stand for sales.) As an investor, I must know what kind of ROI the sales person is talking about. Is it 10 percent on cash flow or capital gains, and what are the tax consequences? Am I punished with taxes, or given tax breaks? More importantly, how do I achieve an infinite return (aka “money for nothing” or “printing my own money”)?

If you know what you are doing, debt can be an unfair advantage.

The Secret of the I Quadrant

The secret of the I quadrant is OPM: other people’s money. As you know, many people invest, but they use their own money.

To be a true I, a person needs to learn how to use OPM to invest, either from banks, pension funds, or private investors.

A smart investor can use OPM in any asset class, including stocks, precious metals such as gold, and commodities such as oil. OPM is the secret of the I quadrant, regardless of asset class. Once you learn the secret, you will see it used everywhere.

When Kim invested in her first house, she put down $5,000 and borrowed $40,000. The moment she did that, she became a true investor, using OPM to invest. When I used my credit card to buy the $18,000 units on Maui, I was using 100 percent debt to finance my investments. The moment I did this, I moved into the I quadrant.

When Kim and I invested $1 million with Ken and Ross, we did so because their business plan was to use bank money to get our money back. If they said we had to leave the $1 million in forever, we would not have invested. We got our $1 million back in three and a half years. We use OPM as much as possible because we want our money back, plus we want to keep the asset, plus we want the cash flow, and we want tax advantages. That is what true I-quadrant investors do.

When I invest in oil, I use OPM from the government and from the oil companies to buy my oil wells for me. When I invest in stocks, I use options and market momentum to buy my assets for me.

My rich dad often said, “Only lazy and foolish people use their own money.” OPM is the secret of real investors.

Final Questions

FAQ

Won’t the government plug this loophole?

Short Answer

Anything is possible, but I doubt it.

Explanation

I stated earlier that after 1971, money became debt. For the economy to grow, the economy needs debtors. This is why the government’s taxes punish savers and incentivize debtors, especially debtors who can take on large amounts of debt.

If the government took away this debt loophole, the economy would seize up immediately, chaos would break out, and the crowd would roast the politicians. If the government does close this loophole, they will open others for their friends, friends with money who finance their campaigns.

FAQ

Isn’t it cruel for people who do not know how to use debt?

Short Answer

Very cruel. I laugh and I cry every time I see someone win the lottery or a young sports athlete receive a $50 million contract to play professional sports. What is the first thing these people do? They rush out to buy a big house and nice cars, not only for themselves, but also for their family and friends. Rather than use their money to get richer, they use their money to fall deeply into debt, debt for liabilities. It is not long before their money is transferred back to the government and the rich. In the end, the foolish person is only left with debt.

FAQ

What happens if the federal government starts printing money and hyper-inflation sets in?

Short Answer

That would be wonderful. I would pay off my loans with cheaper dollars and raise my rents to keep up with inflation.

FAQ

What if you’re wrong and the economy collapses and your renters cannot pay the rent?

Short Answer

No problem.

Explanation

Most of our loans are non-recourse loans. If we cannot pay the loans, we give the property back to the bank. Non-recourse means the bank cannot go after any other assets we own.