Monday, March 17, 2008

Cashflow: The Only Sensible Investment Strategy for the Twenty-first Century

First the Disclaimer: This is a thought-provoking article that draws upon real world examples, articles, books and websites that are readily available to the public. This article is not intended to offer investment advice. Any actions that you take in the market place should be the result of your own financial education and consultation with a licensed professional.

This is the conclusion of my 3 part series that began with Home Ownership: The Biggest Financial Scam of the Twentieth Century and was followed up by parts one and two of The Stock Market: The Second Biggest Financial Scam of the Twentieth Century.

What is Cashflow? Cashflow simply put is the flow of money. Positive cashflow is the revenue or income that a person receives from a job, investment or business. The majority of people derive their cashflow from their jobs. To the extent that they come to derive cashflow from investments and or businesses is the extent to which they will become financially free when their working years are over. Negative cashflow is the revenue that a person loses due to an investment or business.

Most people are taught to invest for capital gains rather than positive cashflow. Investment success depends on appreciation of the underlying “asset” rather than income production. This is the basis for “investing” in a primary residence or the stock market for wealth creation. Yet, success of the capital gains investment strategy is by no means assured. No one can guaranty that an asset will appreciate in value, despite the tendency to quote historical gains as justification for an investment today. The current housing and market crises highlight the fallacy of depending on capital gains to create wealth. The housing crisis alone will destroy billions of dollars of personal wealth. From the October 25, 2007 Joint Economic Committee report:

The JEC report found that the subprime catastrophe is likely to accelerate the downward spiral of house prices. Based on state-level data, the report estimates that by 2009:
• 2 million foreclosures will occur by the time the riskiest subprime adjustable rate mortgages (ARMs) reset over the course of this year and next.
• Approximately $71 billion in housing wealth will be directly destroyed because each foreclosure reduces the value of a home.
• More than $32 billion dollars in housing wealth will be indirectly destroyed by the spillover effect of foreclosures, which reduce the value of neighboring properties.
• States will lose more than $917 million in property tax revenue as a result of the destruction of housing wealth caused by subprime foreclosures.
• The ten states with the greatest number of estimated foreclosures are California, Florida, Ohio, New York, Michigan, Texas, Illinois, Arizona and Pennsylvania. But there are several others that are close behind in the rankings.
• On top of the losses due to foreclosures, which this report examines, a 10 percent decline in housing prices would lead to a $2.3 trillion economic loss.

The power of positive cashflow is that it guarantees the value of an investment regardless of the markets. Imagine the difference between a real estate investor who bought a house expecting it to go up in value versus the investor who bought for cashflow. The capital gains investor bought at very high premiums in the market such that the rents received for his investment do not cover the expenses. Now the investor must find a buyer who paid more than he did in order to make a profit. If the market goes down that investor will find that he has no staying power and will likely sustain a substantial loss to liquidate the property and limit his on-going monthly losses. The fate of the cashflow investor is much more secure. The positive cashflow yielded by the property will continue regardless of market activity. Should the market go down, the cashflow will continue, giving the investor staying power and continued profits in a down market. More importantly, most if not all of the positive cashflow will be shielded from taxes by depreciation expenses on the property. In short, the cashflow, not the capital gains, on a property will usually be tax-free. Avoidance of unnecessary taxes is one of the best wealth acceleration strategies you can employ. To quote David Swenson from Unconventional Success, “Taxes impair wealth accumulation.”

Cashflow strategies can also be applied to the stock market.

The trouble with cashflow investing is that it requires having a financial education. Cashflow investing requires the ongoing thirst for financial knowledge specific to your chosen area of cashflow generation.

The capital gains strategy encourages financial ignorance. Tempting the would-be investor to treat their investment as a money-in-money out proposition. Actively seeking financial education is the only way that a cashflow investor will be successful. Yet the odds are against him. Not because financial education is difficult to attain, no. The odds are against him because the financial sales people any would-be investor will encounter are paid commissions based on their ability to sell products and the majority of those products are for capital gains rather than cashflow. I find one or two real estate deals per year that yield sufficient positive cashflow for me to consider the deal, yet I am often encouraged by brokers to ignore my criteria for cashflow and invest instead for capital gains.

The cashflow strategy requires that you learn to work with people to form a team and generate profits for all. A capital gains strategy has people so focused on maximum gain that they ultimately succumb to greed, fail to exit an investment at an appropriate time and experience financial loss.

Even in today’s economy cash in the bank is not a source of solace as savers are seeing their returns destroyed by interest-rate-cutting policies of the Federal Reserve. People who depended on interest from savings to provide retirement income are seeing their incomes dissipate as the Federal Reserve sacrifices their incomes to bail out Wall Street, Banks and the derivatives markets.

The actions of the Fed and the behavior of Banks and Wall Street have proven that it is cashflow, not cash that is king.

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