Why is building capital more important than cashflow?

Question

I was listening to podcast #17 and at point 25:00 minutes, Brandon Turner and Jeff  Brown were agreeing that cashflow wasn't the most important thing to focus on when you're young, but building your capital.

The biggest highlights to me were these below...

“Cashflow is a yield on a pile of gold”

“Get as much real estate as you can safely and prudently, with cash reserves, so you're building that capital for when you retire.  At that point when you retire, you start to convert to cashflow.”

“I used to be all about cashflow.  Rather than living off my cashflow, I'm saving and re-investing my cashflow just to build up capital”

“Recycle that cashflow”

I can't wrap my head around this for some reason, but the way I understand it is that every time we get cashflow, we shovel it towards our capital/pile of gold.  Once the pile of gold gets big enough, you retire and live off that cashflow?  Is that what they're trying to say?

Should building capital be the primary focus regardless if you're starting out or been real-estate investing for over 10 years?

Why is living off your cashflow not the primary focus?  Isn't the way to get out of the rat race is to have cashflow greater than expenses?

What's the benefit of the building capital end goal vs living off your cashflow?

Sorry for the bombardment of questions, it's just this podcast, and possibly this thread, might flip my perspective a whole 180 degrees!

Ned Carey · Answer

@Clayton Rokosh I think what they are saying is simply, reinvest your cash flow if you want to maximize you longer term returns. If you spend all your cash flow you get today,  your cash flow isn't going to grow.

Bryan Hancock · Answer

Games like Robert Kyosaki's Cash Flow are misleading because they fail to account for a number real world items; like risk, the distortion that comes with financing, etc.

Whether or not cash flow is a dominant factor for you as an investor depends on a number of things.  Your tolerance for funding negative cash flow, your cash reserves, your credit, your access to outside capital, etc. will all influence where your focus of investing should be.  Most people when they start out have very limited access to seller financed projects, cash, access to outside capital, and tolerance for negative cash flow.  Thus many well-meaning posters erroneously tell posters that cash flow is the only thing to focus on.  This is simply not how the math works in the real world.

You can become financially free by having your net worth (or equity) exceed your annual expenses by a factor of 25.  From there you can easily trade your accumulated equity for small ownership shares of companies or bonds in a sensible split and use a tool like cFIREsim to precisely model the behavior of your portfolio for hundreds of periods with different economic climates.  Real estate suffers from many idiosyncratic risks that this type of approach to investing does not suffer from.  However, real estate also offers many unique characteristics that other types of investing don't have the ability to offer.  One of the main items is the ability to place large amount of debt on the projects at low interest rates along with tax shields.  Thus the proper amount of leverage discussion drives a lot of discussion on what is proper.  This inevitably leads to discussion of whether or not cash flow is needed or necessary.  This discussion necessarily needs to involve elements of one's personal circumstances, but posters tend to project their own personal needs into the discussion and fail to realize others have different setups, initial conditions, goals, etc.

This is a long-winded way of saying that the accumulation of equity is what is really important.  You can get "cash flow" out of projects with accumulated equity by refinancing, selling, etc.  If your goal is financial independence and a more battle-tested path to financial independence with the ability to avoid focusing on your investments at all while sitting on the beach or pursuing other things you're more passionate about you probably will want to sell your real estate anyway and place the capital in other investments.

Bill Gulley · Answer

@Ben Leybovich

interesting, I've never heard of "stability" being a function of equity, in finance or economics, or real estate valuations, can you define stability? Now, I do understand stability being translated into variance statistically. Under that umbrella, very few, if any, on BP have a population that will provide a statistically valid variance. Not trying to put you on the spot, if this is a Ben Theory, okay.    Whatever. :)

Speaking of cash flow and equity in the same breath isn't an accurate approach.

In any business, the goal is to build capital, also called retained earnings or owner's equity.

There are four basic aspects of financial activities that summarize any business:

"Cash flow" is the revenue received from operations and transactions, this is shown on an "Income Statement". Key components are sales (or revenue), operating expenses and non-operating expenses. Simple formula, gross profit equals sales minus "costs of goods sold" or what it casts you to generate that income. Net income is equals revenues minus costs of goods sold, operating expenses and taxes. This financial performance is measured over a period of time, what monthly, quarterly or annual income may be.

The excess of net income then goes to a Statement of Owner's Equity which also includes additional investments made by the owner.

Also called Statement of Change of Financial Conditions, as Owner's Equity is measuring the change from the last financial position to the current position. This shows the increase of wealth created by a company over time.

There is the Statement of Cash Flow or Use of Funds that show cash coming in and going out of a company, how funds are utilized in paying its obligations and shows the difference cash inflows and cash out flows as Net Cash Flow, this analysis also is measured over a period of time.

The Balance Sheet includes assets, liabilities and owner's equity at a certain point in time, not over time as the other statements. The goal is to reduce liabilities that increase assets and thereby increasing owner's equity. Assets must equal liabilities and owner's equity. If assets are less than liabilities and owner's equity, you are legally bankrupt.

Now, you can see that wealth is a function of owner's equity that includes excess revenues.

So, if your business only generates enough cash flow for the owner's personal expenses, taken out as management or operating expenses, then there is nothing left to go to owner's equity in the business. Such is not a viable business but you earn enough for personal income, which is a "job".

I think what Ben was speaking to was the intrinsic, economic value of knowing income will be stable, reliable and being predictable to a better extent than the same amounts received over time but compared to income that is sporadic and unknown. You can have a better use of funds when income is predictable and this shows up in how funds are used and then are retained moving the money to owner's equity. The only financial advantage of the same amount of funds coming in regularly is your ability to use the money and interest income that may be earned to the next date income is received.

If you're a landlord, you want quality tenants to provide you with predictable cash flows. If you are on the sales side of real estate, you never really know when a sale will close until it closes.

Notice too, that it's net income that moves to owner's equity, that means taxes influence your  owner's equity or your ability to obtain wealth. Tax benefits fade away over time due to depreciation, in about 7 to 10 years over a holing period, you need to examine your use of funds and equity over time as that will indicate the time to sell or replace your inventory, with single family residential properties, you'll be better off generally replacing inventory than holding 30 years. It's not really the best goal of having a property paid for as having the ability to pay it off. That's wealth. :)

Ben Leybovich · Answer

Both are important. Generally speaking, cash flow is only of value as long as it is stable, and stability is a function of equity. For instance, if you buy a $30,000 pig that cash flows $400/month unleveraged on paper, chances are that because of what it is and where it is this cash flow will never materialize as anything remotely stable. Therefore, you can't rely on it to ultimately do what it was inteded to do, which is to get you away from W2 income.

Stable CF is a function of higher quality assets which attract higher quality tenants. This CF can actually get you out of the rat race.

Additionally, you'll never earn enough to just keep converting $ into assets into CF - you need equity to grow so that you can bridge...

It's all tied together and is a very precise formula.

Ben Leybovich · Answer

Bill - I do everything in life according to my theory. Follow me on this:

If CF is only useful as a viable substitute for W2 income if it is stable, recurring, and predictable, then we must identify asset classes which lend themselves to stable, predictable CF.

Since we know that there is very little we as owners can do to generate passive CF in real estate (it's the asset that generates the CF), the question becomes - how does an asset generate CF? Answer - by attracting appropriate audience.

How does an asset attract appropriate audience - by possessing characteristics of desirability that people who have options want. People with options are the fundamental building block underneath the stability of CF. These people have options because they behave a certain way in life - that's what it takes to have some options of some of the better things.

Question becomes - what kind of an asset attracts that type of tenant. The economic definition varies from market to market, but within each market the asset is ultimately characterized by "quality" - we are not talking about pigs here.

Well, something happens when we look at quality assets - they retain perceived value within the marketplace, and they have better chance to grow in price over time, resulting in equity.

Thus, by definition, in order to achieve the type of stability in CF that we all want, we must focus our energies on appreciating assets. Therefore, the more equity one has, the more stable ones' CF is by definition.

It's not a direct relationship obviously, Bill. But, it is a definitive relationship with quality as the focal point... Hopefully this clarifies my position.

Brian Lacey · Answer

Cash flow is the endgame. Anything else is money coming from a job. You're trading your time for money. There will come a time when you physically can no longer do that. So cash flow is vital to your success after you're done being actively involved in RE.

Justin Ericsson · Answer

Bill ... My example of $500k is an example that may come along in life. I didn't get approached by my neighbor but the point is it could happen so be ready! Without cash someone else may get it.

I'm laughing Bill at your comment about jail time. I live in areas where houses sell for $800k to $3mm... So buying a $2mm house $500k below market value is only 25% below market value. I don't buy anything over 75% of market value my friend arv. Want proof?  Here you go:

621 Windsor, glenview IL purchased for $535k net purchase price, rehabbing for $450k, and selling for $1,350,000. Got the deal from my broker in glenview that lives across the street from this house. I had the funds so I bought it!. Bill keep this thread in your history I will send you the settlement statements so you know people actually do what they say.

Justin Ericsson · Answer

Brian well put! I would add having a stock pile of cash (or access) is a good thing when a good opportunity comes along in life. For example my neighbor just approached me and wants to sell their house quickly and just wants a cash offer that gives you $500k in equity. Without cash or equity to borrow from the other neighbor gets the deal :)

Joe Villeneuve · Answer

Cash flow wins...sorry.  If you do it right, you can build both at the same time.

Brian Lacey · Answer

both are important.

Cash flow is passive income (generally speaking).

Lumps of money come from a JOB.

I enjoy my W2 job. Some don't, and start a new job in RE.

I'm a big fan of @Ben Leybovich and his approach. If it's not passive, or will result in passive income, I'm not generally interested in it (this is not an absolute rule, there are exceptions) because it becomes work.

Why is building capital more important than cashflow?

Most Popular Reply