Decreasing Spending versus Increasing Income

Many so-called “personal finance experts” are too focused on decreasing expenses. In general, decreasing “bad spending” is good. I just think that you should focus more on increasing your income by acquiring positive cash flow assets.

A positive cash flow asset is something that puts money into your pocket after all expenses and debt service. A liability is something that takes money from your pocket, and generally depreciates in value. A car is a liability, because it depreciates over time and consumes your money for fuel, maintenance, insurance, and taxes.

Poor and financially illiterate people trade their time and effort for a paycheck from an employer. Retirement funds are first taken from the paycheck, then taxes, then the employee receives whatever is left. Everyone else gets paid first before the employee gets paid.

Wealthy and financially educated people do not work for a paycheck. Instead, they work to build or buy positive cash flow assets that continue to pay them after the work is completed. We all know that wealthy people buy things that depreciate in value, and many folks try incorrectly to emulate the wealthy by buying expensive things, like houses, cars, and boats. Financially illiterate folks use consumer debt to buy those liabilities and use their paychecks to repay the debt with interest while the liability is decreasing in value faster than the debt is repaid.

Wealthy and financially educated folks will instead buy a positive cash flow asset to pay for the liability. For example, buying a fancy car for $30,000: A poor or financially illiterate person will use debt or a savings plan to buy the car, and then pay for the fuel, maintenance, and taxes from their paycheck. A wealthy person will build or buy an asset that will completely pay for the car, as well as paying for the fuel, maintenance, taxes, and a monthly positive cash flow. The wealthy person is paid to buy the liability.

This is why increasing income is far better than decreasing expenses. By increasing income, not by working more hours, but rather by building or buying cash flowing assets provides a multiplier effect to pay down your bad consumer debt. Increased income from positive cash flow assets can be applied to your bad consumer debt to pay off that bad debt much faster. After the bad debt is paid off, the asset continues to generate income for you to buy or build more assets.

A simple example is suppose you have $10,000 in bad (consumer) student loan debt. You could find a good rental income property owned by a distressed landlord. The landlord wants to sell the property and move up, down, left, right, north, south, east, or west (it doesn’t matter). The landlord is a “don’t wanter” and he is willing to make a deal just to be rid of it and move on with his life. The property is a 2-bed, 1-bath house that rents for $800 per month. Your market research shows that a 3-bed, 2-bath house will rent for $1,600 per month.

An unsophisticated buyer would pay the comparable sales price for the property, rather than calculating the income valuation. Comparable sales price is based on what an owner-occupant would pay, rather than according to what a tenant would pay to cover all expenses, debt service, and cash flow. Instead, you will calculate an offer using future income valuation.

You get free estimates from 3 licensed experienced general contractors. (The winning bidder gets the job when you buy the property.) They each write a “scope of work” estimate for converting the 2-bed, 1-bath into a 3-bed, 2-bath. The cost, including pulling construction permits, is about $20,000. When you get the property under contract, the winner bidder GC will also write a “draw schedule” that has the task milestones, the amount of draw, and the time to complete. You will need this schedule for your private financier to pay progress payments to the GC after successful completion of each task.

You get quotes from insurance agents for the insurance cost for the project and the finished property. You get quotes from mortgage brokers for refinancing the remodeled property.

You calculate that the remodeled rental house will be worth $173,515, based on the cost and structure of a refinance mortgage loan at 80% Loan to Value (LTV) at 6.0% annual interest amortized over 360 months (30 years) with a Debt Coverage Ratio (DCR) of at least 1.5. The DCR is very important, because it is the ratio of the Net Operating Income (NOI) divided by the Annual Debt Service (ADS). The NOI is simply the Effective Gross Income minus the Gross Operating Expenses (excluding debt service).

Gross Schedule Income (GSI)               $19,200
Vacancy and Credit Loss                   –$2,420
Actual Rental Income                      $16,780
Other Income                                   $0
Effective Gross Income (EGI)              $16,780
Gross Operating Expense (GOE)             –$1,800
Net Operating Income (NOI)                $14,980

Debt Coverage Ratio (DCR)                    1.50
Loan to Value Rate (LTV)                    80.0%
Annual Interest Rate                         6.0%
Amortization Term (months)                    360
Annual Debt Constant (ADC)                   7.2%

Annual Debt Service (ADS)                 –$9,987
Monthly Debt Service                        –$832
Debt Present Value (DPV)                 $138,812
After Repositioning Value (ARV)          $173,515
Retained Equity to Value (ETV)            $34,703
Cash Flow before Tax Annual                $4,993
Cash Flow before Tax Monthly                 $416

Now you calculate your offer price to buy the property:

Investment to Value (ITV)                $138,812
Closing Cost to Buy                       –$2,951
Remodel and Repairs                      –$20,000
Cash Out Fee (pay off student loan)      –$10,000
Carrying Costs                              –$740
Refinance Closing Cost                    –$2,776
Finance Charge                            –$3,962
Maximum Allowable Offer (MAO)             $98,383

The Maximum Allowable Offer (MAO) is your maximum offer price to the distressed seller. (I suggest starting your negotiations about 10% to 20% less than the MAO.) You borrow your upfront cash requirement of $132,074=$98,383+$33,691 from a private lender and pay him deferred 12.00% annualized interest for the 3-month (90 days) project.

Private lenders are everywhere. Most of them have Self-Directed Individual Retirement Accounts (SDIRA) that are sleeping in mutual funds earning 3%. You can offer deferred 12% annualized interest with the security of a 1st position lien on a good piece of real estate. Your rehab project should require not more than 90 days, so you’ll only pay 3% (one quarter of one year) interest. The interest is deferred to allow for compounding, because the SDIRA cannot spend monthly interest payments and must deposit that 12% money into a 3% account.

The best way to find private financing is not to ask directly for money, but rather to brag about the latest profitable project. Then ask, “I know this is not for you, but who do you know that may be interested in earning 10% to 12% return on their money, secured by a 1st position lien on a good piece of real estate, for a short term of 6 to 9 months?“. (Use a time frame that fits your projects. If you need the money for 3 years, then say “short term of 36 to 48 months?“)

At project completion, you place a tenant at $1,600 per month and obtain a refinance loan at 80% LTV of the new value. The After Repositioning Value (ARV) is $173,515 and the Debt Present Value (DPV) is $138,812. The new debt pays off the private lender including deferred interest of $3,962, and pays the closing costs $2,776 of the new loan. Your student loan is paid off and you receive $416 per month cash flow with no net cash investment. Your “Cash on Cash Return” (yield) is infinite. Your lender has good protective equity (20% ARV) and good protective cash flow margin (33.33%) of the Net Operating Income (NOI). The comparable sales valuation will probably be higher than the ARV, which provides more protective equity for the lender.

You paid off your $10,000 student loan, gained $34,703 in your net worth, and you now receive $416 per month in cash flow with none of your own money invested. The IRS requires that you depreciate the property over 27.5 years starting from your basis of $138,812 (minus land value) in the property. The $10,000 that paid off your student loan is tax free, because it is a loan. Your tenant will pay off the refinance loan and the depreciation will shelter most of your principal portion of the Net Operating Income.

You can also put a revolving Home Equity Line of Credit (HELOC) on the property to provide quick cash for more investments. This shows the difference between good debt that makes money for you and bad debt that takes money from you.

You are thrilled, your lenders are thrilled, and you’re ready to do it again.

The first such project is the hardest, because you’ll need to learn the business of house rehabbing. After you successfully complete your first project, your subsequent projects will be quicker and easier to finance on the front and back, because you’ll have a cash flowing asset on your financial statement and experience on your résumé. You can accumulate a portfolio of cash flowing assets with none of your own money invested. See my product “Property Analysis Worksheet Short Form” at for more details.