#1 Reason Why the Rich Are RICH
I attended my first real estate investment class in 1974. The two-day program cost me $385, which was a fortune at the time since my salary was less than $1,000 a month.
After months of searching for my first investment property, I found a tiny, one-bedroom, one-bath condo in Lahaina, Maui, the world-famous beach resort. The condo was priced at $18,000. Not having any money, I used my credit card to finance the 10 percent down payment of $1,800.
In other words, I used 100 percent debt to buy the property.
Even though I was leveraged 100 percent, which I do not recommend even though I did it, I was netting approximately $20 a month positive cash flow after all expenses and debt were paid. At the age of 27, I owned a condo in Waikiki, in which I lived, and a condo in Lahaina, which I rented. My real estate investing career was launched and I was in debt up to my eyeballs.
My friends thought I was crazy for using 100 percent debt.
My wife Kim had a similar experience. She bought her first property in 1988. It was a small two-bedroom, one-bath home in a great neighborhood in Portland, Oregon. The purchase price was $45,000. She put $5,000 down and earned approximately $25 a month after expenses and debt service.
Some of her girlfriends made the same comments my friends did. They thought $25 a month was not worth the risk of borrowing money. What her girlfriends failed to understand is that it wasn’t the money that was important at that point. It was the experience.
Using that experience, my wife bought a piece of commercial property 16 years later for $7 million. Since the property was such a great investment, a banker gave her most of the money—yes, as debt. Every month, after paying all expenses, the net income into her bank account is approximately $29,000. That’s more than many people earn in a year.
In her talks, she often asks people, “How long would it take you to save $7 million?”
Most people admit that it would take a while to save that much money if they could do it. She then points out that to save $7 million would require earning nearly $14 million before taxes to net $7 million in savings. The thought of earning $14 million is beyond what most people can do in a lifetime. She tells her listeners that it took her two weeks to find the $7 million as debt financing, which is tax-free money.
This formula is exactly what Kim and I used when we purchased real estate during the financial crisis in 2008. The reason the rich get richer is because they know how to use debt and pay no taxes.
The rich use good debt to grow their worth and they invest in cash-flowing assets using Other People’s Money (OPM)—both the bank’s and investors’.
OPM is a fundamental concept of Rich Dad and a sign of high financial intelligence. By using both good debt and OPM, you can dramatically increase your Return on Investment (ROI)—and you can even achieve infinite returns.
Good debt is a type of OPM. The downside to debt is that you can generally only borrow a certain percentage of an asset’s purchase price. Because of this, you have two choices when you find a worthy investment: use your own money or use other people’s money. Provided you structure the deal well, the more you can use other people’s money, the higher your return will be.
Many people think it’s a fantasy world that people would just give you money to invest, but that couldn’t be further from the truth. The reality is that most people don’t have time to find good deals. Instead, they rely on people with proper financial education, skill set, and drive to bring deals to them.
My real estate advisor, Ken McElroy, has perfected using OPM. He does all the hard work of finding deals, doing the due diligence, negotiating with owners and lenders, and handling management. In return, people line up hoping to invest their money with him.
Today, Ken does big deals that require a certain type of investor. Not just anyone can invest with Ken. Together, we started with small deals and worked our way up to big deals.
Here’s an example from real estate on how the rich use good debt as money to create wealth…
Using the bank to leverage my investments, I can leverage my money. Using simple math, let’s assume I have $100,000 and am looking to invest it in a $100,000 property that rents for around $800 per month. You can find many properties like this if you look diligently.
I could use all my money to purchase one property for $100,000, or I could use good debt to buy five $100,000 properties.
The bank would lend me $80,000 for each property and I would divide my $100,000 into five $20,000 down payments.
At 5 percent interest, the payment on the loans would be around $500, including taxes and insurance. So, my cash flow on each property would be $300 a month ($800 in rent – $500 in debt payment = $300 per month) for a total of $1,500 ($300 x 5 = $1,500) per month—an 18 percent annual return.
Now, here’s an example of why using good debt, coupled with OPM, is an even more powerful investment tool for the rich.
Using OPM, I can increase my return and secure even more assets. Let’s say that instead of having to put down 20 percent on five properties, I can use my $100,000 to put down 5 percent on 20 properties. I can do this by finding 20 great deals and lining up investors to invest in them.
Here’s how the math works out…
The bank would lend $80,000 for each property, and I would divide my $100,000 into twenty $5,000 segments, using OPM to raise the other $15,000 needed for each property. Again, at 5 percent interest, the payment on the loans would be around $500 per month. Let’s assume that we’ll pay a little more for our investors’ money and give them 7 percent interest. The money owed to them would be a little less than $100 per month—but we’ll go with $100 to make it simple. So, our total costs would be about $600 per month.
That means we’ll have a cash flow of about $200 per month, which we’ll split with our investors 50/50. We’ll pocket $100 per month or $1,200 per year, and our investors will pocket $100 per month or $1,200 per year.
Adding up the total return for all 20 deals, that’s $24,000 per year cash flow, a return of 24 percent. Not only am I making 6 percent more per year than if I just used my money, but I also have ownership in 20 assets instead of just 5. Later I can refinance these properties, pay off my investors, get my investment back, and continue to receive cash flow from the 20 properties—an infinite return.
Again, I’m using very simple math here. In real life, the numbers are more complicated and much larger. But the principles are the same. Investing with OPM takes a high level of financial intelligence.
When it comes to taxes, the rich understand that governments write tax codes to encourage specific types of behavior. If governments want you to build affordable housing, they give you a tax cut. If they want to encourage oil exploration, they give you a tax cut. If they want to see higher employment, they give you a tax cut.
The secret is that most tax benefits are made to help entrepreneurs and investors. With the right financial education, you too can utilize the tax code to not only get richer but also pay nothing in taxes.
Utilizing good debt and getting richer through taxes takes a high level of financial intelligence. But everyone can learn and put these principles into practice.
Choose the Right Teachers
If you’re a young person on your way to university or a parent with teenagers getting ready for college, I suggest you think long and hard about what you expect to get from your education and why you want it.
I’m not saying that higher education is all bad. There are certain things that can’t be done without it. For instance, I’d never visit a doctor who didn’t attend medical school. But the old rule of money that said everyone should go to a good school is an obsolete rule—and one that shackles families with bad debt.
In order to thrive in the new economy, you need to understand the value of a good education—and that a good education is one that includes comprehensive financial education. Unfortunately, you can’t get a good financial education in school, nor will you be able to for a long time. So, a ‘good’ education at a ‘good’ school is really an incomplete—and expensive—education.
More important than a good financial education is finding the right teacher. The right teacher is someone who has actually invested in real estate using debt—not some teacher in a classroom that’s never even purchased a home. I am sick and tired of financial experts giving advice on real estate, especially when they do not actually invest in real estate.
If you want to be financially successful, it’s key that you choose your teachers wisely.
Editor, Rich Dad Poor Dad Daily