“Cash flow makes you rich, appreciation makes you wealthy” – proverb
One of the most common problems investors eventually face is this:
Do you invest in an income generating opportunity with high cashflow OR do you invest in an appreciating opportunity with low or no cashflow.
This decision is crucial to your success as an investor.
In today’s blog we’re going to cover these things:
Cash flow is the regular distributions an investment will give.
Appreciation is the increase in value of an investment.
Some investments only produce cash flow, some only appreciate, but most sit somewhere in between and have a little bit of each.
That’s where the idea of a Cash Flow and Appreciation Line comes in.
In most investments, as the cash flow increases, the anticipated appreciation decreases. And Vice-Versa.
Some examples are:
It’s important to understand where on this line an investment sits so you can learn how to select investment opportunities that will fit your portfolio at the right time.
Before we can answer how the wealthy get wealthier, we need to think about the opposite… and avoid it like the plague.
Everyone knows who Robert Kiyosaki is.
He is one of the most well known finance gurus out there.
One topic he talks about is the use of income and debt by each “class” (poor, middle class, rich)
You can read more about his thoughts here.
Note: The diagrams below are based off of his.
When you’re living paycheque to paycheque it’s because your income is equivalent to your expenses. Your finances are always super tight and it goes out as soon as it comes in.
This isn’t a great place to be as it’s impossible to save.
To make it worse, what if something happens? What if you get injured, sick, or have a large unexpected expense?
Building wealth is a huge challenge when this is the case. If you’re here, your #1 priority is to increase your income so you can save money month after month.
The middle class feels much better but… most still operate on a month to month basis.
What happens here is as income increases, lifestyle creep builds. The expenses become higher as the quality of stuff you buy goes up.
You end up getting a big mortgage on a house, getting a vehicle loan, and using credit cards buy stuff.
In this instance, your cash comes in, you pay your expenses as normal but now you’re also paying debt!
Maybe you’re able to save a bit but most are not.
This is what some call the “Rat Race”. It’s a trap.
Now, how do the reach differ from the poor and middle class? And more importantly, how can you benefit from doing the same?
They use their excess income to buy assets! An asset is something that increases their net worth over time.
They keep their expenses and consumer liability low and take the extra savings to invest in assets.
Since these assets produce more income, their net worth snowballs.
Eventually, the rich person has enough income from their assets that it completely pays their expenses. Now their regular income can go completely towards buying more investments and assets.
This also buys them a certain amount of freedom from being chained by their liabilities.
They can even invest in opportunities that won’t see any income for long periods of time because their bills are already covered.
This brings us to the master plan:
Phase 1 is all about getting you from where you are to a position of financial freedom.
Your aim is to start savings up for 2 things:
First the liquidity requirement
Right now.
The reason to save for a rainy day isn’t about continuing to have fun. It’s actually about having something called “Liquidity”.
It’s the ability to pay an expense that comes up that might be unknown.
For example, if your laptop stopped working and you need to buy a new one. If you had no liquid cash to buy this new one, you would either have to take on debt or wait and save to buy a new one.
If you use your laptop to make money, this can put you in a tough position!
What’s worse is if you are in that position and the only way for you to cover that expense is by taking money out of your investments.
This is a cardinal sin in investing: don’t touch your compounding investments!
Typically, it’s suggested to save 3 months of your expenses. This is a good rule of thumb. Two additions to make are:
Now that the rainy day fund is set up, we can move to the other important piece during this phase:
Now, what we want to aim to do is put our extra savings into cash flow positive investments.
This could be:
By doing this, we can slowly start building up a portfolio that will pay our monthly expenses.
This part can take a lot of time depending on what your income is.
To speed this up, you will want to do one of two things:
The BRRRR strategy is a real estate investing strategy that helps you recycle your investment capital.
I wrote an article which you can read here on how it works.
Ok, let’s say you’ve now replaced your expenses (big task, I know)
This phase, is where the big bucks are made.
Once you’ve been able to replace your expenses, and effectively live with financial freedom, we can start to invest our capital in Net Worth building assets.
These can be higher risk opportunities, or opportunities that use leverage to grow over time. They can be investments where you don’t need to see regular income, but can enjoy the benefits of capital gains and appreciation.
The base principle here is that because your cash flows are covered, you can investment with minimal concern about your “Risk of Ruin”.
That’s the basics.
Here’s where things get interesting: long term planning.
As a business or investor, you’ll have mis matched cash flows. Sometimes revenues are sporadic and expenses are too.
In some cases you may invest in something that has a negative cash flow but a high end of cycle yield. Some examples are:
In these cases you need to be concerned about matching up your cash in flows with your cash out flows.
One interesting way to do this is to invest some of the capital in cash flow positive investments at the same time as the cash flow negative investments. This can either help with the liquidity burden or cover the cash flow challenge completely.
One example in real estate is, let’s say you invest in a Vancouver duplex. Because rents are low compared to prices, the property ends up in a cash flow deficit of about $500 per month.
Now, what you could do is find another investment property that has positive $500 per month cash flow that subsidizes the negative cash flow.
Of course, you will still want a liquidity buffer in case there are payment delays or anything like that. This is where the rainy day fund comes in.
And this is how a lot of companies are structured.
They build a cash flowing entity first.
Once that’s built, they invest in high leverage opportunities.
Since there is sufficient cash flow, they don’t have to stress about making payments, expenses, or other bills.
This structure should be thought about regardless of your size. Even as an individual planning your personal finances, this can be a huge positive change.
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