My 1st Million At 33 – yes, you can do it too

I’m sure everyone understands the difference between a positive cashflow and a positive earning, right? This post is just a brief summary for investors, and a friendly reminder for the real estate investors out there.

On Stock Market Investing

When you look at the financial reports of any public traded companies, there are income statement, cashflow statement, and balance sheet. The cashflow statement indicates how the company manages its cash, while the income statement tells you how the company is earning/losing its money. Normally, you would like to see both good positive earning and cashflow. However, both cases of a positive earning with a negative cashflow, and a negative earning with a positive cashflow are possible. And it is important to understand the difference.

A positive cashflow simply means that incoming cash is greater than outgoing cash. It means that the entire process of the business has enough cash to self-sustained itself. However, how much it earns from the process is an entirely different story. The earning or income is the actual real profits assuming that all booked entries can be collected from customers. It is all of your revenues minus all of your expenses. So when the collectibles pile up without any trend of going down, or that the revenues are generated through vendor financing, it is a big sign of danger ahead for possible big “extraordinary” write-off of past booked revenues. Such booked revenues are of low-quality revenues which usually don’t translate into positive cashflow. Some companies do this kind of extraordinary write-offs of past booked revenues regularly, and it’s almost like a regular recurring expense. You should never invest in such companies.

On Real Estate Investing

In the case of real estate investing, if you can generate both positive cashflow and positive earning, it is a great investment indeed. But if you generate positive earning with a negative cashflow, I think it is still pretty good. Such scenario can arise when the rent you collected cannot cover the all the expenses including mortgage. Since mortgage payment has two components: principal and interest. If your collected rent covers beyond the amount of interest charge, but does not cover fully the principal paid down, I think it is still very good real estate investment. The only downside is that you will be forced to put your saving away into the principal balance of this mortgage. You should also account for tax reduction that you can get properly. It’s best if you file a W-4 to reduce the your withholding amount if you work full-time, but is also a part-time real estate investor. Otherwise, you should manage the cashflow carefully on an annual basis (for tax refund), instead of monthly basis.

But if you are a real estate investor who uses negative amortization loan to improve your cashflow, while counting on housing market to go up 7+% every year, I advise you to look at your “income statement” carefully. A positive cashflow does NOT equal to positive earning. Your net earning is reduced by the amount of additional interest debt accumulated. I assume that you understand the difference between payment rate and interest rate in a negative amortization loan. Any advertised rate that is below 1% + 10-year treasury bond yield (about 1+4.7% now) is most likely a payment rate, not the actual interest rate. Payment rate is the teaser rate you will be paying initially. It’s not the interest rate at which you are charged for. To find out your net earning, you should probably use the interest rate and simply calculate how much you would earn on a presumed interest-only loan without any principal paid. When your net earning is not positive, I would only advise positively on such deals under two kinds of scenarios:

1. A very good reason to believe that your collected rent can soon catch up to produce a positive earning.
2. A very good reason to believe that the housing price can keep going up to make up the shortfall of your negative earning.

Usually, it’s not that easy to predict either the rental or housing markets with very high accuracy. I’m more conservative, and therefore my suggestion for most circumstances whether to invest in a real estate deal is when you can produce a positive earning or breakeven right from the beginning, and not relying on the increases in either rental or housing markets. Or at the minimum, your breakeven collected rent should not be more than 5 to 10% of your starting rent. At 10%, you will need to increase your rent by 5% for consecutive two years to get to the breakeven point. That may be quite a lot to ask from your tenants.

Many real estate workshops or books emphasizes two points: No Money Down and Postive Cashflow. I can understand why those are their key selling points, because to sell to the mass who may have money/cashflow problem themselves, the two points are music to their ears. I’m not saying that those two points are not important. But I think a positive earning is the MOST important thing than anything else.

And the last important thing that many real estate investors don’t account for is calculating the cost of down payment. Some people don’t even pay attention to down payment. They think if they put down more and borrow less, they can make a real estate deal to be earning-positive. That is certainly a wrong perspective. The more down payment you put down, the less loan you borrowed, but the more invisible opportunity cost you pay. You can use my Rent vs Buy Calculator to determine how much opportunity cost you are paying. It accounts for the opportunity cost by allowing you to enter your own assumed investment return and your own tax rate. It will accurately account for the opportunity cost that you will pay (using your own assumption). You can put in your assumed collected rent to find out whether the deal will positively earn you money (along with assumptions of rent & housing inflation).