Apr202010

Unencumbered cashflow: the best measure of real wealth

Peace of mind is an underrated and undervalued emotional state. Most people choose lives of speculation, competition, and make believe. They erroneously believe if they arrive at some destination known as “being rich,” they will have everything they ever wanted, and that will make them happy. It won’t.cashflow_positive

There is a peace of mind that comes with wealth, but this emanates not from the pile of money, but the cashflow that pile of money gives off. The size of the pile may get bigger or smaller depending on the market winds, but if the cashflow is stable, the size of the money pile is irrelevant. The real wealth is in the income stream.

I last wrote about this subject in Real Estate, Cashflow Investment and Retirement, but it is an important topic worthy of revisiting.

Many people dream of being rich. At its core, the desire to be rich is the desire for power, and with most people, it is the desire for unlimited spending power. Of course, rich people didn’t get rich by spending all their money, but most people want money for what it buys rather than the peace of mind true wealth brings.

 

Formulas for measuring wealth

People who study accounting and finance are taught how to measure wealth. They believe wealth can be captured in a formula:

Wealth = Assets – Liabilities

That wealth measure, also known as net worth, is convenient because it is easily measured, and it provides a conceptual framework for money managers to measure performance.

It is also hopelessly inadequate. Let me explain.

Perhaps for the uber-rich, an asset and liability model is useful, but for anyone who feels compelled to work for a living — which is most people — the model is not very helpful. Focusing on the balance sheet does not solve the problems of daily life. For that, people need to examine their income statement:

Savings = Income – Expenses

That wealth measure, also known as net income, is better because it captures the real world lives of the vast majority of the population. Maximizing net income is more important than maximizing net worth.

Short of working until death, people need alternate sources of income to substitute for wage income. Some retirees may have savings or annuities from pension or investments, but many end up living only on social security. A steady stream of income from cashflow-positive real estate can make a major difference in a retiree’s standard of living.

 

What would life be like?

Take a moment to imagine your own retirement. If you follow a plan of maximizing wealth as measured in the net worth equation, if you are fortunate, you may acquire significant wealth, but you may not be able to do much with it. If you can’t easily convert this wealth to cash, you will feel limited and impoverished regarless of what your balance sheet says.

If you follow a plan of maximizing savings and net income, you may not acquire significant wealth, but you may obtain an abundant income stream to meet your daily living needs for the rest of your life. You will have spending money that no one can take away from you. It is the ultimate peace-of-mind. In addition, you will be able to pass this form of wealth to your heirs with a minimum of taxes.

That is the life I want.

One rich man’s cashflow woes

Over the last several months, I have been sharing Wednesday lunches with a man who is very wealthy by the first measure — his net worth is nearly eight figures — but he is totally broke; his assets provide him no income. This causes him stress because he has to sell assets and increase liabilities to live his life.

What’s worse, his financial advisors are telling him to sell some properties he owns with no debt — properties he could rent for significant cashflow — and increase the debt on other properties he owns that he wants to keep for his personal use. It is the worst possible advice, shameful, in my opinion.

What this man needs — what every investor needs — is unencumbered cashflow.

What is unencumbered cashflow?

The one characteristic of all true investments is positive cashflow. Any asset valued for potential cashflow or growth is speculation. Many assets blur the line between speculation and investment, but all true investments have one thing in common: they need never be sold to obtain their value.

The man I described above has a speculation problem. None of the assets he controls give off cash; therefore, in order for him to have spending money, he must sell or borrow. This is not a sound way to manage finances.

Many people bought houses during the bubble and thought that made them rich. The land barons in particular were guilty of this mistake. Acquiring assets with negative cashflow with copious amounts of debt may make people wealthy on paper for a while if the assets increase in value (Wealth = Assets – Liabilities); however, this is a huge drain on their income statements (Savings = Income – Expenses). Since asset prices are often volatile, acquiring negative-cashflow assets only works as long as lenders are willing to continually increase debt — the essence of a Ponzi Scheme.

Instead, if investors buy property and work to pay it off, they may not look as wealthy on paper, but their stable income stream provides them the benefits of real wealth; spending power and peace-of-mind. However, to really have peace-of-mind, the cashflow should be as free from claims as possible. It should be unencumbered.

Eliminating encumbrances

There are two main encumbrances to any source of cashflow: taxes and debt service. Real estate has property taxes, income taxes, and a host of expenses that lay claim to the rental income, but by far the largest claim to this income stream is the debt investors typically put on the property.

Depending on the location, rental income can be very stable and predictable which makes it an ideal source of cashflow. The goal of asset management is to minimize the claims against the property because these claims represent risk. Investors who own property without debt never face foreclosure. Speculating land barons lose all their properties to foreclosure in a market bust. The prudent use of debt is the distinguishing characteristic separating investors from speculators.

If an investor can arrange it, owning un-debted real estate — or real estate investment trust shares — in a Roth IRA is the best of both worlds. After age 59 1/2, there is no longer income tax claims on the rental income. If an investor owns the property in California, the property taxes are limited too. Personally, I want to own as much cashflow-positive real estate or other income streams in a Roth IRA. It is the focus of my investment and financial planning.