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You Don't Own Real Estate. Real Estate Owns You.

By Logan Flatt, CFA

    Many Americans believe that real estate can do no wrong as an asset class upon which they can build wealth. I disagree. Building wealth through real estate depends on your ability to distinguish among the three types of real estate ownership – investment, speculative, and personal. If you don’t know the differences, you may soon discover that you don’t own real estate, real estate owns you.

Investment Real Estate Puts More Cash in Your Pocket Than It Takes Out

    Investment real estate refers to the ownership and operation of income-producing real estate whereby the income generated by the property – usually, rent payments from tenants – more than covers all the costs of owning and operating the property. If the income is high enough to cover all the costs of ownership and operation plus leave cash left over for the property owner, the property is said to be cash flow positive. If the income fails to cover all the costs of ownership and operation, the property is said to be cash flow negative, whereby the property owner must dig into his or her pockets to come up with the cash to pay for the remaining, uncovered costs.

    A bona fide real estate investment puts more cash in your pocket than it takes out, on a repeatable, consistent basis. As such, a cash flow negative investment property is really not much of an investment at all. If you continue to hold on to a cash flow negative investment property out of pride or any other emotional attachment to the property, you are not maintaining an investment; you are maintaining a hobby. A rational real estate investor would put a stop to the repeated, consistent cash drain ASAP. In many cases, it is simply best to swallow your pride and sell a cash flow negative investment property. That way, you can let a new owner cope with the income shortfall each month while you put your sale proceeds to work in a cash flow positive investment property you can find elsewhere.

Speculative Real Estate Is a Bet Against the Odds

    When buying real estate at or near the prevailing market price, many people firmly believe they will make a profit upon the future sale of their real estate. Unfortunately, there is wishful thinking and there is reality. Wishful thinking plays a prominent, defining role in speculative real estate. A new property owner may hope to sell his property at a higher market price in the future, but in reality, he has no idea what the future market price will be. Nobody does – all future market prices are unknown to everyone. That is, until the future arrives.

    In the face of such uncertainty at the time of purchase, all the new property owner  can know is that there are three outcomes for a future market price: significantly lower than, similar to, or significantly higher than the current market price. In other words, unable to know at the time of purchase what future market prices will be, the new property owner has only 1 in 3 outcomes where he can sell his property at a future market price significantly higher than the current market price. If each outcome is equally likely, the new property owner's odds of selling his property at a highly inflated market price are low.

    Unfortunately, the odds of making a profit on a property purchased at the prevailing market price are made even worse by the high transaction costs of buying and selling real estate. Even if a new owner sells his property at the similar future market price, he still loses money thanks to brokers’ commissions, legal fees, and other closing costs incurred to sell the property. He also loses money selling the property at a significantly higher future market price if that future market price is not quite high enough to cover the high transaction costs. Clearly, the odds of making a profit are against those who buy real estate at the prevailing market price and hope to sell later at a higher market price. Such is the nature of speculation and the wishful thinking that leads to it.

Personal Real Estate is Simply a Purchase, Not an Investment

    Personal real estate is real estate you buy primarily because you believe you and your family will enjoy living there. Making money, if at all possible, is secondary. In fact, it is hard to make money with personal real estate. To make it your home, you must take cash out of your pocket each month to finance it, insure it, maintain it, fix it, furnish it, and pay property taxes on it. Unlike investment real estate, your home generates no income to offset these out-of-pocket expenses. So, while you likely derive much pleasure from owning your home, you lose money on it every month. Don’t fool yourself – your home is not an investment. It is simply a purchase.

    Nevertheless, despite draining you of cash every month, owning personal real estate generally beats renting a house, condo, or apartment for an extended period of time. Owning personal real estate gives you at least two options that renting does not. These options provide you with real value.

    First, unlike renting, ownership of personal real estate gives you the option to keep more of your income out of the hands of career federal politicians in Washington, D.C. Current U.S. federal tax laws allow you the opportunity to deduct mortgage interest and local property taxes from your taxable income. This helps reduce your U.S. federal income taxes. So, when you own personal real estate, more of your outgoing cash ends up helping your surrounding community, its schools, and its hospitals instead of largely going to waste in Washington, D.C. This is especially true if the investors in your mortgage are also local and in your community; such investors are more likely to reinvest your interest payments locally as well.

    Second, if you ever have to move due to a job change or relocation, personal real estate ownership gives you the option to hold on to your personal real estate and rent it to tenants after you move out. Exercising this option gives you the opportunity to turn your personal real estate into investment real estate. Of course, exercising this option might not make sense given your personal interests or financial situation at the time of your move, but it is an option you would not have had if you were simply renting the roof over your head. When moving out of a rental unit, despite all the monthly payments you made to your landlord, you walk away with no ownership in any real estate asset whatsoever. The advantage goes to personal real estate ownership.

You Don't Really Own Real Estate If It Can Be Taken Away From You

    The differences among investment, speculative, and personal real estate ownership are clear. However, you don’t really own real estate. You only think you own it. Even if you have paid off your mortgage in full, a county, city, or local public school district can still take your property away from you. Just stop paying the tax bills these governments send you each year and you will quickly discover who really owns your real estate.

    Paying property taxes is all you need to do to keep your real estate out of government hands, right? Sorry, but no. You could pay property tax bills in full year in, year out for decades and still lose your property to eminent domain, whereby a government expropriates your real estate to use it for what it claims to be society’s “greater good” – your personal property rights be damned.

    Clearly, while many Americans believe that real estate can do no wrong as a way to build wealth, it sure is hard to build wealth with real estate when, in so many different ways, you don’t own real estate, real estate owns you.

Copyright 2007 PowerWealth.com. All rights reserved.

Change The Game: Replace Your Credit Score with Your PowerWealth Debit Score™

By Logan Flatt, CFA

    In addition to their income and material possessions, many Americans use their credit scores as a way to evaluate and judge their financial success in life. Through decades of marketing, product innovation, and the passing of personal finance myths from one consumer generation to the next, America’s financial services industry has most of us conditioned to focus our attention on improving the credit scores computed and maintained for each of us by America’s four major credit bureaus, Experian, Equifax, Innovis, and Transunion. Such effective conditioning comes as no surprise – it is, after all, the financial services industry that profits handsomely from us taking out mortgages, using credit cards, obtaining car loans, and otherwise borrowing money for just about anything we want to buy or do to enhance our lifestyles.

Your Credit Score Helps the Financial Services Industry, Not You

    Alas, the more we consumers borrow cash from the financial services industry, the wealthier the industry becomes and the poorer we become. This can readily be seen in the simplest definition of your wealth, which is determined by your net worth:

Your Net Worth = What You Own – What You Owe

    The more you borrow from the financial services industry, the more debts you owe. The more you owe, the lower your net worth sinks toward zero, or even into negative territory. The financial services industry has a net worth too. But, what is true for your net worth is exactly the opposite for the financial services industry’s net worth – the loan you must repay to the industry is an asset the industry owns. The more the industry lends cash to you and other consumers, the more assets the industry owns. The more the industry owns, the higher the industry’s net worth rises.

    From the financial services industry’s perspective, your focus on your credit score is a great thing. Your behavior helps the industry grow wealthier over time. The financial services industry has it good – the product it sells is cash, the price of its product is a given interest rate, the interest payments we make are the industry’s revenues, and thanks to the industry’s unique ability to scale by simply recycling our interest payments into still more revenue-generating product, the industry’s profits are hefty. The industry has made the rules of the game, and the ball used to “win” in that game is your credit score. So, as conditioned, you focus on the ball, trying to move it up the field toward the goal. But, clearly, your behavior – your focus on your credit score – is not such a great thing for you and your family’s wealth. While having ready access to cheap credit can be a good situation in which to be, obsessing about your credit score so that you can borrow more and more from the financial services industry could ultimately preclude you and your family from achieving true financial freedom and security in your lifetime.

Rolling a New Ball into the Game – the PowerWealth Debit Score™

    I submit to you that you and your family don’t have to play the financial service industry’s game. You have a choice. You can change the game. You can freely elect to change your behavior. You can remove your focus on your credit score and, instead, focus your attention and effort on a new score with which you can better evaluate and judge your financial success in life. Herewith, I roll a new ball into the financial service industry’s game: the PowerWealth Debit Score™.

    As you know, your credit score is an indicator of your ability to borrow, and borrowing can be damaging to your wealth. In contrast, your PowerWealth Debit Score is an indicator of your ability to lend, and as you understand from the activities of the financial services industry, lending creates assets – loans – that you can own and use to increase your wealth over time. If one of your goals in life is to build enough wealth for you and your family to achieve true financial freedom and security, doesn’t it just make sense to place more of your focus, time, and effort on improving your PowerWealth Debit Score than on improving your credit score?

Calculating and Interpreting Your PowerWealth Debit Score™

    So, how do you calculate your PowerWealth Debit Score? The proprietary PowerWealth Debit Score™ formula below shows you how:

For a given month, quarter, year, or other period:

PowerWealth Debit Score™ = 1,000 × (Your Free Cash Flow ÷ Your Total Income),

where Your Free Cash Flow ≥ $0

    You can use your calculated PowerWealth Debit Score to fully evaluate and judge your ability to lend cash to others for profit and wealth building. For example, let’s assume that your household’s Total Income is $85,000 per year, and your Free Cash Flow is $8,500 per year (don’t worry – Free Cash Flow is defined in detail below). Using the formula above, your PowerWealth Debit Score would be a 100. Likewise, let’s assume that your monthly Total Income is $4,000, and your Free Cash Flow in a given month is $500; here, your PowerWealth Debit Score for the month would be a 125. Note that if you have no Free Cash Flow or your Free Cash Flow is actually negative (i.e., below $0), your PowerWealth Debit Score is simply a 0.

    Now let’s interpret your PowerWealth Debit Score. Whenever your calculated PowerWealth Debit Score is a 0, your ability to lend money to others is non-existent -- you are not in a good position to be creating loan assets that you can own and use to increase your wealth over time. However, any positive PowerWealth Debit Score suggests that you are in a good position to be creating loan assets to increase your wealth. Furthermore, the higher your PowerWealth Debit Score, the greater your ability to lend money for profit and wealth building. Any PowerWealth Debit Score above a 0 is good. Any score above a 200 is outstanding!

The Critical Role of Free Cash Flow

    Clearly, the key driver to your PowerWealth Debit Score is your Free Cash Flow. As part and parcel to the proprietary PowerWealth Debit Score™ formula above, your Free Cash Flow can be calculated as follows:

For a given month, quarter, year, or other period:

	Your Total Income
−	Your Retirement Account Contribution*
−	Your Health, Life, & Disability Insurance Premium Payments
−	Your Federal & State Income Tax Payments
−	Your Emergency Savings Account Contribution*
−	Your Regular Payments on Mortgages, Loans, and Credit Cards
−	Your Basic Living and Lifestyle Expenses
=	Your Free Cash Flow

*Your contributions to your Retirement Account and your Emergency Savings Account should be made according to how your personal financial adviser has advised you to contribute to these important financial planning accounts.

    Ultimately, your Free Cash Flow can be used for a variety of wealth-building activities, not just for creating loan assets by lending money to others. Other important uses of your Free Cash Flow include paying off credit cards in full, making extra principal payments on mortgages and car loans, fully funding your Retirement Account and Emergency Savings Account, and making equity investments. Each of these other important uses of Free Cash Flow can increase your net worth by reducing what you owe or by increasing what you own, thus helping you build financial freedom and security for your family over time.

    Clearly, using your Free Cash Flow to create loan assets by lending money to others is but one option out of many good ones available to you. A positive PowerWealth Debit Score simply tells you when you have the luxury of taking one or more of these options to pursue an opportunity that could increase your wealth.

Use the PowerWealth Debit Score™ Right Now and Change the Game

    Why not go ahead and start using the PowerWealth Debit Score today? It is a great way to help you evaluate and judge your own financial success. By electing to focus on your PowerWealth Debit Score in lieu of (or, perhaps, in addition to) your credit score, you open up far more opportunities to increase your wealth over time precisely because you are focused on building your wealth rather than on playing the credit game that America’s financial services industry wants you to play. Take action now and change the game – you’ll be glad you did.

Copyright 2007 PowerWealth.com. All rights reserved.