The principle of owning real estate to become wealthy has never been more true today than it was back then. Simply think of the many investors who have built enormous wealth and rose up to create their own legacy from it. In this two-part series, we go deep into the ways these real estate tycoons were able to succeed. We cover the seven powerful tools that they’ve used to create legacy wealth, starting with why cashflow is king and how you can introduce leverage into the equation. We also delve into the benefits and power of real estate with Kirk Chisholm, a Wealth Manager and Principal at Innovative Advisory Group. Kirk takes us into what they do over at the company, sharing some advice on investing and more.
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Marshall Field once said, “Buying real estate is not only the best way, the quickest way, the safest way, but the only way to become wealthy.” Marshall Field was an American entrepreneur who lived in the 1800s. His quote was obviously made it an era before tech stocks, hedge funds and excess money printing by the Federal Reserve. However, the principle of owning real estate to become wealthy still holds true now. In fact, we can make a strong case that it is far truer now than it was back then. Real estate is arguably the best asset class if you want to build enormous wealth. While you often hear about well-known real estate investors such as Donald Trump or even Sam Zell, there are countless more who are relatively unknown and very wealthy. What we’re going to cover in this show are the seven powerful tools that these real estate tycoons were able to use to build legacy wealth from real estate.
While most of these tools apply to both the real estate investors and homeowners, there are more benefits to owning real estate as an investor rather than a homeowner. As we jump into that interview, I want to remind you of two quick things. First, if this resonates with you and everything we talk about on this show, by all means contact one of our investment counselors and set up a free strategy session for yourself. That way you can discuss where you are now, where you want to go, what that would look like in terms of a roadmap or a plan of action. Then breaking that into a criteria to follow that will make it super easy for you to identify the markets and properties that will meet your investment criteria. That is something we do virtually every day with real estate investors all around the country. Lastly, if you haven’t already done so, please remember to subscribe to the show, whether it’s on Google Play or iTunes, just subscribe. If you can, by all means leave us a rating and review. We will certainly appreciate that.
If you missed our last episode, be sure to listen to Lessons Learned Going From Local To Nationwide Investing – A Client Interview.
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7 Powerful Tools To Create Legacy Wealth From Real Estate
It’s my pleasure to welcome Kirk Chisholm to the show. He is a Principal and Wealth Manager at Innovative Advisory Group, an independent registered investment advisor. He’s located in Lexington, Massachusetts and he’s been providing financial advice to individuals and families since 1999. His influence and innovation have promoted change in many areas of wealth management and the industry itself. He was acknowledged as the number seven most influential financial advisor on Investopedia’s Top 100. Kirk, welcome to the show.
Thanks for having me on, Marco.
It’s my pleasure. I don’t have registered investment advisors on the show all that often. It’s always interesting to hear other people’s perspectives in a different part of the financial world. We all need to learn about everything that we can, not just about real estate but what is outside of this asset class. You are an interesting person because you like real estate. You are a real estate investor yourself. You obviously understand the benefits and the power of it and how it all ties in with other investment classes and investment strategies. I want to start off by talking a little bit about you. Tell us a little bit more about yourself. Also help my audience understand for those that don’t know what a registered investment advisor is and what you guys do.
A registered investment advisor is probably not a term that many people have heard before. The wealth management industry is broken into two parts. One part is the broker-dealer side. It’s the Morgan Stanleys, Merrill Lynch and the UBS. Those are the broker dealers that people have probably heard of. Their role is to sell a product. They get paid commissions and they sell the product. They might do other things, but that’s essentially the simple version of what they do. The other side of the industry is the investment advisory side or the RIA side. An RIA is a fiduciary. That means we have an extremely high standard of care when we work with clients.
As a fiduciary, we have to put our client’s interest above our own. On the broker-dealer side, they don’t have to do. They have a know-your-client rule and they have some standards that aren’t quite as stringent. As an investment advisor, on top of being a fiduciary, we don’t get paid commissions. We are in 100% transparency and unbiased in everything that we do. I’ve spent some time on the BD side and it is what it is. It’s not something that’s part of the way I like to do things. I like this side better because it allows me to focus my clients and making their lives better rather than just trying to sell the product.
You are a believer and an investor in real estate, so you spread yourself across different types of asset classes and investments.
For me it’s, it’s interesting. We started our company back in ‘08 and I’ve been doing this for twenty years, but our current iteration is in ‘08. One of the reasons we did it is we wanted to focus on non-traditional assets. Things like real estate, alternate investments, things that are outside of the stock market. One of the reasons we did that is because there are so many great investments out there. I’m sure you’ve interviewed a lot of good people on the show that are excellent real estate investors. They probably have some interesting strategies that most advisors can’t access because they’re focused on mutual funds. Back in ‘08, we saw the writing on the wall and we wanted to see how we can take advantage of some of this cheap real estate that people were just offloading for a song. Within the other channels, people couldn’t do that. Personally, I love real estate. It’s one of my favorite asset classes for many reasons. It’s one of those investments that everybody understands at some level.
You’ve either bought a house or you’ve rented a house or you’ve invested in real estate. Everybody has some exposure, unless you’re living in a teepee in the woods, you probably know what real estate’s all about. We wanted to capitalize on that because a lot of our clients invest in real estate and a variety of capacities and we’re agnostic. I’m agnostic to when we’re working with clients. I don’t care if you’re in stocks, bonds or mutual funds or horses, houses and gold. As long as it’s a good investment, that’s what’s important to me. You can make a bad investment in a public company, let’s say for an example, Lehman Brothers or you can make a good investment in real estate or vice versa. It’s totally dependent upon the investment itself and that’s what we focus on.
Some investment advisors don’t consider real estate an investment. They call it something like “alternative investment.” You consider real estate as an investment. Does an investment have to produce income or cashflow to be an investment or can an investment be something that is more speculative or based on capital appreciation or maybe precious metals that to me, more of a store of value? They don’t actually generate monthly income, annual income, dividends, distributions or anything like that.
Any investment that we work with, you have to, you have to have a good starting strategy. It means you have to buy it right and you have to have an exit strategy in mind. Your goal might be to buy real estate and hold it for a hundred years and just live off the income. That’s a strategy. It might be you buy a piece of real estate because you think there’s going to be a new Target that is going to open up down the street. You want to go for appreciation. Every strategy is different. Some people might buy it for tax benefits. Some people buy oil and gas properties for the tax benefits. There’s no single right a strategy. There are a lot of wrong strategies, but there’s no single right one. It depends on what your goal is, as long as you’re meeting it. That’s what’s important. I personally have a preference. I think that if you’re going to buy real estate, it needs to be cashflowing. Otherwise, you’re speculating and real estate is expensive to speculate. The risks are higher. It’s illiquid. You can speculate in stock, but you can get in and out in a day and it costs you $5 each way. Real estate will cost you 6%. Personally, if I’m going to buy real estate, I want it to be cashflowing. That’s my preference.
It’s far less liquid, slower moving asset class and has other types of risk. Although one thing real estate doesn’t have is counterparty risk. When you’re a direct owner, you eliminate the counterparty risk and that is something that’s nearly impossible to get rid of if you’re investing in equities or the stock market.
Technically there’s always counterparty risk but it’s so infinitesimally small in real estate that it’s almost not worth considering. The US Treasury has technically considered a risk-free rate as they call them. You could actually say if you buy it from the Treasury and it matures, you can guarantee that they won’t lose money. Technically they can, but the risk is so infinitesimally small of the US government defaulting on their debt that it’s not worth considering. Real estate is low-risk if you’re doing your homework because you can touch it, you can feel it, you know what you own. You can go to the registry. You can see that you own it. Bear Stearns, Lehman Brothers, AIG, you have no idea what you’re investing in.
You look at GE as an example and I don’t want to bring out individual companies, but the company is so complicated. It’s hard to figure out what’s going where. I’ve talked to analysts. GE is not the only one. There are a lot of companies that have that size, but they get to such a big size that it’s hard to go through the financials and understand where all the money’s flowing because it’s all paper. In real estate, if you want to put on a new roof, you put on a new roof. If you don’t, you don’t. It’s totally up to you. I agree with you. The risks are a lot less in some ways with real estate.
Let me ask you a question that I rarely even bring up on this show. I’m going to ask you this before we get into the powerful benefits of owning real estate, what you refer to as the powerful tools that create legacy wealth from real estate. Obviously, there are pros and cons to renting versus buying and vice versa. A lot of that has to do with where you actually live because all markets are different and affordability and price points change. I read in one of your articles that you say paying rent is not throwing money away. I know what you mean by this, but I’m going to ask you the question. What do you mean by renting is not throwing money away?
My opinion on this concept is that I think most people don’t understand it. It’s not because they can’t. I guess it’s because as a society at large, we’ve brainwashed ourselves to believe certain things. One of them is that owning real estate is an investment. For people who are young, starting a family and saying, “I need to buy a property because I need to invest.” Buying property as an investment is an investment. Buying a property to live in is not an investment. It’s a personal expense. I’ve done the math. I’ve written a few articles about this concept. It comes down to running numbers, which I don’t think people do generally speaking. They just say, “I need to own. It’s a good investment. It will appreciate.”
I run the numbers and if you’re living there and you’re not paying rent to anybody, you’re paying rent to yourself. You’re not actually investing. You’re paying rent. You have to pay it somewhere. Whereas if you’re renting, you don’t have a lot of the liabilities, you don’t have to deal with the capital expenditures and you can move anytime you want. There are different reasons to buy verse rent. The reason I wrote about it is that I wanted to challenge people to think outside the box. You don’t have to own a home. I know people that actually rent their primary property and they own a huge real estate portfolio because they don’t want to have to deal with the carpenter with a leaky roof.
Sometimes the numbers make sense to rent. Sometimes it makes sense to own. When we did the math a number of years ago, it made more sense in our area, anything above 750,000 in property value, it made sense to rent. Anything below that it made sense to own. Because of how the numbers ran, those are basically the lines where they were. We could’ve found multimillion-dollar properties for $4,000 a month or something. It was absurd. The point is you have to do the research. There’s no silver bullet. There’s no right or wrong answer but need to understand that investing in your own property that you live in is as a personal expense. They have to understand the concept of why that makes sense.
We have clients here in California and many other expensive markets where it’s cheaper for them to rent. They get more house and square footage for the same dollar. They’re further ahead renting. What’s cool about that is what they would have put down as a down payment towards a larger expensive home here in Southern California or even Northern California, that can go a long way in terms of down payments on cashflowing investment properties in the Midwest, the southeast, wherever it may be. They could quite literally create enough positive cashflow from their rentals using that down payment money, which is now investment capital to cover their living expenses here in California or wherever they live. You nailed it when you said you just have to run the numbers. If you sit down and pencil out scenario A versus scenario B, scenario B might make a lot more sense where you rent and own a large portfolio of real estate and you just live off the income where at least it contributes to your lifestyle.
This is something we push for everybody with any topic is you always have to challenge your assumptions. You can’t make blanket assumptions that things are always going to be this way. It’s like what happened in 2008, “Real estate always goes up.” That’s why that happened. People made the assumption that real estate always goes up. That’s one of many assumptions that people make. Anytime, you’re putting a lot of money on the line, these homes aren’t cheap. If you’re going to put that much money down, you need to do your homework and challenge the assumptions in any which way. You’d be surprised if you think about it. Certainly, mentioning to my wife that maybe we should rent versus own, he had her eyes rolled back in her head. We all have this assumption like owning real estate makes you successful. It’s the Keeping Up with the Joneses mentality. There’s nothing wrong with it. We all have our own opinions of things, but I think at the end of the day, if you’re talking about dollars and cents, dollars and cents are easy. That’s what spreadsheets are for. The emotional part of the decision is a different decision entirely. It may be more or less important, but you can’t combine the two. You need to make two independent decisions.
A lot of people are brought to the belief that owning your home is the American dream. It isn’t. For a lot of people, it’s the American nightmare. They don’t want to own a home. They want to be untethered and they want to be able to be mobile and live where they want, and they change careers and move around a lot. It just depends on what you want and need as a person or as a family. You’re right, it’s certainly not an investment. It’s an expense. It doesn’t always make financial sense to own versus rent and invest elsewhere.
To accentuate the point, you mentioned that owning a home is the American dream. Do you know where that started?
I am guessing the 1920s with some tax law that came into play.
I can’t confirm this, but I’ve had enough people telling me this that it was Fannie Mae who started it as a marketing campaign. It was a marketing campaign to get people to buy more homes. That’s where it started.
Why am I not surprised by that?
I’d be less surprised if it was Goldman Sachs marketing it.
Cashflow
Let’s talk about these powerful tools to create legacy wealth. There are many powerful benefits to owning real estate as we all know and specifically with investment real estate. You’ve referred to them as tools, but let’s go over them or at least highlight them and the benefits of them. There are seven and I actually sorted these logically, at least in my mind logically. The first one is something we’ve already been talking about. To me, number one, cashflow is king. Can you maybe highlight or expand upon that first benefit?
Cashflow, when you were buying real estate, you’re basically buying a business. I know people look at real estate as different. I don’t. In many ways, owning real estate is like buying a business. There’s cashflow, there are expenses, there’s income. You’ve got to balance it all but ultimately you’re buying it for cashflow. You’re putting a down of let’s say $200,000 and you’re trying to get a ten cap or you’re trying to get $20,000 in rent. Let’s say at the end of the day you’re netting 5% from that. That’s something that you can predict. There’ll always be things you can’t predict. You can’t predict whether the renter is going to be a bad renter and they’re going to try to not pay rent for a number of months. You can’t predict a tornado going through your neighborhood.
There are certain things you can’t predict but for as much as you can predict with real estate, cashflow is the most predictable thing that you can find. You know going in what your cashflow is going to be before you even buy the property. Think about it, it’s like buying a CD. If you buy a CD, you know you’re going to get 3%. Nothing else is going to happen. At the end, you get your 3% interest. Buying real estate, if you do it right, you know what you’re going to get. There’s going to be variability in there, but generally speaking, you can count on that 5% income every single year. Cashflow is hugely important because if you’re not getting cashflow, then I go back to what I said earlier, you’re speculating. Cashflow is important.
Asset Appreciation
I like to refer as to cashflow as the glue that holds your deal together, because you’re going to get the tax benefits over time. You’re going to get appreciation over time. You get all these benefits. If your property isn’t carrying itself, it isn’t a holding itself together to get you through each month and every year to give you these other benefits over time, then it’s not a business. It’s just nothing more than a liability. I like to call it cashflow glue. Cashflow is powerful. I love the way you described the whole thing about cashflow. It’s a great segue to asset appreciation, which is something that a lot of people hang their hat on. They think that, “I’m buying real estate because it’s going to make me wealthy through the appreciation.” It doesn’t actually work that way. We’re going to talk about the effects of inflation. Why don’t you highlight asset appreciation, why people invest in real estate for it?
Asset appreciation is something you cannot predict. Like we talked about with cashflow, that’s very predictable. You know what you’re going to get before you go in. With appreciation, you have no idea. You can speculate, you can assume. “I know the demographics of our city are expanding and this town most likely would be the next area it expands to or I’m buying this property at a discount. I know I can get appreciation off it.” That’s wonderful. If you can do that, that’s great. You’re basically speculating because you can’t predict where the price is going to go. There’s some good long-term historical evidence of where it probably will go, but who knows? 2008 happened. From 2005 to 2010 real estate plummeted and then it’s come back. In many cases, it’s higher than it was back then. Who knows where things are going to go in the future? Maybe they keep going up or maybe we’ve hit the peak and it doesn’t go any higher. I know that I’m not smart enough to predict the future. I don’t try to predict appreciation, that’s how I look at it. I look at that as a bonus. I don’t tie that into our models. I just assume that if we get appreciation, that’s a bonus.
Appreciation is like icing on the cake. You will have it in time. You just don’t know how much and when you will have that appreciation. It’s nice to have when you do get it. I think that’s the problem. Back in 2004, 2005, the problem was a lot of people lost sight of the fact that investment should actually have cashflow and an immediate rate of return. Everybody, including the taxi driver became a so called “investor” and they were buying for appreciation. They knew that if they were able to hold onto it long enough and then flip it, it’s the greater fool theory. The last person holding the bags is the sucker that that takes the loss. Many people flip their way to a fortune and there were literally tens of thousands of people, probably millions that were stuck holding assets that were now upside down. That’s a speculator’s game. That’s the problem with banking on appreciation and ignoring cashflow and these other benefits.
I have to say I love the movie, The Big Short. It’s a fantastic movie. In one of the scenes, they’re going around doing their due diligence and they’re driving around, I think it was Arizona. They’re talking to all these people and not one of them had a clue. They’re like, “It will go up 30% and then I’ll sell it.” They were making assumptions that this was a given. This is past the peak. This was like in ‘07. This wasn’t even ‘05 when it peaked. It’s hard. The nature of people is to speculate and to make dumb decisions at the top because they don’t want to be left out of using the money. That’s the problem. The way I look at it is if I’m doing my calculations on real estate, if I get the appreciation, I look at that as great. That’s money I was not planning on and I’m happier for it. It’s not the thing I would look forward to unless I’m doing some creative deal making and value creation, like developing a house or fix and flip. That’s a little different. Just buying and holding, I would never plan on an appreciation.
Leverage
One of my favorite things about real estate is leverage. It’s the fact that you can borrow five to one and acquire income-producing real estate. Let’s talk about leverage.
Leverage is interesting. Almost any real estate investor who’s already investing understands leverage. Basically with real estate, it’s one of the few assets that you can highly leverage. If you think about most assets, let’s say you’re buying a horse and you’re spending $100,000 for the horse, you’re putting down $100,000 cash for that horse. If you have a brokerage account, let’s say you’re buying Apple stock and you want to use leverage, maybe they’ll let you leverage it like two to one. When you put down $100,000, you can buy $200,000 worth of Apple stock because there are some limits in what they allow you to do in your brokerage account.
There are some limits there but with real estate, you can leverage yourself five to one. It’s crazy when you think about it because you have a huge amount of leverage. You’re buying a $100,000 property. You put down $20,000. That is a huge amount of leverage. That’s one of the great benefits of real estate. You can introduce that leverage into the equation. You don’t need to buy a $100,000 property. You can buy it with a fraction of that amount. If you look back in the late ‘70s or early ‘80s when real estate and asset prices started to take off and inflation started to take off, that wasn’t hard because people generally didn’t use debt as much back then as they do now. Now, you have to.
You’re in California, I’ve seen some of the costs of some of the houses out there. I don’t know how you buy one without using a mortgage unless you’re independently wealthy. For most average people, we don’t have enough to pay cash for the houses that we want to buy in the areas that we can afford. It’s almost essential that people do that at some level. One thing to point out is leverage is a two-edge sword. This is the thing that scares the crap out of me. The reason it scares me just because nobody’s thinking about it, it’s the whole Black Swan theory. The black swans only happen when people are not thinking about them and not aware of them.
Here’s my concern or at least it was a few years ago. If you look at real estate, in real estate you’re employing leverage. Leverage is a fantastic tool if prices are going up. You look back in ‘08 when leverage is worth the inverse. You put down 5% in cash and the real estate goes down 20%. If you’re upside down and you pretty much have to give back the keys because of your negative equity. That’s the downside. The upside is you use leverage. A $100,000 property goes up 10% and you put down $20,000, you made a 50% return. Leverage is great. Think about it in reverse. Here’s the thing that scares me. Look at Japan, Japan has been in deflation for the past 30 years and real estate has been going down for 30 years, just like all the rest of their prices because they’re in deflation.
That is a case where leverage is going to kill you because if it goes down 5% and you have $20,000 down, you just lost 25% of your money. At some point, you’re underwater. That’s a case where you don’t want to use leverage. The real challenge and this get into cashflow as well is inflation is highly tied to real estate. It’s closely correlated but that also applies to cashflow and rents. In Japan, asset prices are declining 4% or 5% a year, but rents are also going down a similar amount. Your expectation that we have as a country, anybody alive is only seen inflation with real estate.
In 2008, it’s a little different because that was a market crash. Sustained inflation versus sustained deflation. Japan has sustained deflation. It’s basically what we’ve had in reverse. It’s the other edge of the sword where going down it kills you. It’s important to understand the dynamics. A few years ago, I was worried about this. Now, it’s a lot less so because inflation is starting to perk its head. I’m less worried. It’s an assumption that we challenge that most people aren’t even thinking about. If you realize it, it’s dangerous. You just need to be aware of what you’re doing is the lesson I’m trying to say.
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