013 | Creating Lasting Wealth – Beyond Entrepreneurial Myths and Real Estate Hype

00:01 – Patrick Lonergan (Host)
Welcome to the Vital Strategies Podcast. I’m excited about today’s episode because we’re going to dig deep into the formula it takes to build real wealth. There’s myths out there of what the internet gurus are telling you about how to build cash flow and a successful business, and they make it sound much easier than it is. There are many, many ways to build wealth. We’re going to outline what we see as the ideal strategy for you to build wealth pay less tax and create the freedom to walk away from it all and still have the income that you desire to live the life that you want. We’re going to dive into the details and discuss why each of these three pieces are critical to maximizing wealth building. The three categories that you need to work on to build tremendous wealth are a profitable business, portfolio assets and own cash flowing real estate. We’re going to look at these one at a time and discuss the pluses and minuses and why they work so well together. First, let’s look at a profitable business. Now, this is by far the hardest one to execute on. In reality, if you haven’t started a business, don’t.

01:10
As someone that helps our clients manage risk, the best advice I can give you is stay away from starting a business. Statistically speaking, you’re better off to go get a job. Most of the people that start a business end up back in a job. Whatever you do, don’t think that starting a business is the easy way to make a living. Another thing that I hear people say is that they’re going to buy a business and let a manager run it and collect the cash flow. I’m sure that’s happened, but I’m not aware of any owners that were able to just write a check, have a manager put in place and just create cash flow without ever having to step foot in the business.

01:45
Owning a business is the hard way. Most people think. When you have a business you get all of the money and all of the free time. The reality is you’re the last to get paid and if something needs to get done that isn’t getting done, it becomes your job to do it. I’ve also seen the mental, emotional and physical toll, both personally and professionally, watching our clients struggle with the challenges of running successful businesses. According to the SBA, only 30% of businesses make it past 10 years. It generally takes a few years to become profitable to the point that you can take home really any income at all. So it’s nice to have a side hustle, which might be a regular W2 job to help support you while you’re getting your business started.

02:27
Another option is to have a spouse that works and you can live off the income that they’re bringing in while you build your business. Now, the key part of that is just controlling your expenses. The thought that you can start a business and replace your income in short order is very hard to do. Be wary of the internet gurus that haven’t actually done anything over a sustained period of time telling you how to create tens of thousands of dollars of income. Just because they own a Lamborghini and have flown on a private jet doesn’t mean they’ve actually made it. Also, network marketing schemes need caution. They’re a product distribution system like Walmart. How many Walmart employees are millionaires? Just be cautious of anyone trying to sell you on the premise that you can grow your income $10,000 a month in a few short months.

03:11
Business is hard. Almost every day in business you’re going to have to do hard things. You need to make that part of your identity doing the hard things. Building hard things into your life helps build grit. I recommend checking out Angela Duckworth’s book called Grit for more information on the power of passion and perseverance. Doing hard things might be waking up before 5 am to work out. For others it might be weekly trips into the cold plunge, doing 75 hard or committing to regular marriage counseling with your spouse.

03:43
In the United States, there are 335 million people and roughly 8.25% of the population owns a small business. So out of the 27,670,000 people that own small businesses, the IRS reports only 160,000 people make over a million dollars a year in 2021. Considering that not all 160,000 were small business owners, some were highly compensated employees. The maximum percentage of business owners that were making over a million dollars per year is only.57%, or about one half of 1% of all business owners. Said another way, only.05% of the entire population makes over a million dollars as a business owner. It is very hard to do Now. If you’re still listening and you own your own business or want to start one, you have probably known since you were a kid that you were an entrepreneur. You were looking for opportunities to make money and do it on your terms by bringing value to the marketplace. Again, just because you have this desire or wiring to run a business doesn’t mean it’s going to work out. The failure rate in business is high For those of you making 500 to a million to 10 million dollars or more, congratulations. If put yourself in an exclusive company, I know the grind and you should be proud of showing up doing the hard work every day.

05:03
There are three characteristics of very successful business owners. The first is they have a very compelling why. Now this can be unhealthy. There are a large number of what we would call successful people that grew up in poverty or some sort of traumatic situation and they’re compelled to continue building for more and more, trying to fill the gap from those early years. This often leaves their personal lives in shambles. There are also success stories where the owner feels called into a particular purpose in life and that purpose keeps driving them forward to make bigger impact. This compelling why allows them to be persistent, adapt to the environment and pushes them to do the hard things when it would be easy to give up otherwise. The second factor is impulse control. When business gets hard, you can stay dialed into the project at hand, not get distracted by the drink, comfort, the lover, etc.

05:52
In business there are so many variables. The third is being innovative. You see opportunities to add value to the marketplace that align with your compelling purpose, your why and you take action on those. Now, as a business owner, you’re constantly looking through the fog, hoping to take the right next step. The longer you’re in business, the clearer the picture gets, but there’s always a level of uncertainty. You’ll find success in one area of your business. The knowledge and thinking that got you to that current level of success won’t get you to the next level. If you want to keep growing, you must constantly be doing new, hard things that will challenge you. You’ll keep asking yourself is it worth it? A mentor of mine once told me that my business will grow at the rate in which I can make decisions.

06:34
The problem with decisions is often difficult to know which way is the correct way. The great thing about making decisions is that it moves you forward, and when you make mistakes, you fix them and you move on. The fail forward maxim applies here. As entrepreneurs, we often know the truth of the situation but fail to take action on it. Examples of that might be an underperforming employee, or a price increase we need to make on a product line, or a cut that we need to make to a product or service that we’re offering. Or maybe there’s a joint venture we need to pursue, but we’re just not taking action on it. Other challenges with starting and running your own business is that many people in your life will try to talk you out of it, for good reason. They care about you and business is very hard, which you need to be aware of, but that’s something you’ll contend with.

07:20
If you want the best vehicle to build wealth, hands down, it’s owning your own business. For proof, look at the Forbes list of the wealthiest people on the planet. In one way or another, they’re all involved with businesses. Building a business is the best way to leverage your time and energy to grow your wealth. The real reason that owning a business accelerates wealth building is because, if you’re making a million dollars a year, we find that the cash flow breaks down like this for most entrepreneurs you spend about $30,000 a month on lifestyle, $30,000 a month gets invested and $30,000 a month goes to taxes. When we look at that $30,000 a month that gets invested in either the markets, real estate or to acquire other businesses, it can rapidly accelerate your wealth building. Now we help our clients reduce the number they send to the IRS and allocate it to wealth building, so they might be putting $40,000 a month into that category, which just causes the balance sheet to grow even faster. The real key to any business is generating as much revenue as possible. You need to be dialed into the marketing and sales with an offering to the marketplace that delivers tremendous value. The more you can spread the word and deliver on your value proposition, the more buyers will find their way to you.

08:31
Next, we look at portfolio wealth. Portfolio wealth is really only there to replace income. I wish there was a magic formula where we could win in the stock market and you create tremendous wealth. If that were possible, you would look at the Forbes list and you’d see a long list of people that made their money strictly through, efficiently and effectively trading stocks. You only have to be right in your picks over 51% of the time to amass enormous wealth in the markets. When we comb through the Forbes list, we come across Warren Buffett as the only one that’s a master fortune that doesn’t include a separate business. Now I would also argue that Buffett has migrated from investor into business owner with the different business units inside of Berkshire Hathaway.

09:12
When we couple that with how hard it is for private equity managers to outperform indexes like the S&P 500 over a long period of time. These are some of the best stock pickers on the planet. When we think about the average investor picking their own stocks and outperforming the market, it is an unlikely scenario that they’ll be able to do it for an extended period of time. When we’re in the middle of a full bull market and the day traders come out of the woodwork with their strategies to beat the market, most get wiped out. When the markets turn down and effectively zero maintain their success long term. With that in mind, you should build a portfolio designed for long term growth to manage the risk.

09:50
The thing with portfolio wealth is it’s best at truly passive income replacement. It’s the only asset class that you can sit on the beach anywhere in the world and collect checks. You don’t have to worry about staff quitting, a key contract canceling or a recession that hurts your business or affects your rental income. Now, I love real estate. We own over $150 million of investment property, but it’s not a passive investment. When you have a management company, you have to manage the management company and make decisions on the direction of the property. With the right investment portfolio allocation and proper advice, you can know with a high degree of certainty that those checks will keep coming in, regardless of what’s happening in the world. The reason we like portfolio assets isn’t because of the huge growth we can get. It’s because of the truly passive nature of the income. We think a good rule of thumb to strive for is to build liquid assets in portfolio wealth equal to one year of income Before you start putting money into illiquid assets like real estate and other business opportunities. Now, this does not include our cash liquidity that we have as a margin of safety. We have an entire episode that will talk about the value of protecting liquidity. So if you have an income of $500,000, you want to have $500,000 liquid in an investment portfolio before you start investing in assets like real estate. That leads us to our next asset class, and I am biased on the benefits of owning real estate.

11:11
I started my life as an entrepreneur by starting a real estate investment business. I had a full ride to law school. I was late for my very first class, buying a piece of real estate. Needless to say, my law career was short-lived. At the encouragement of my wife, I went to the admissions office and let them know that I was pursuing a career in real estate investment. They let me know that if it didn’t work out I could come back next year with my scholarship still in place. That was a nice safety net, but I never became a lawyer.

11:35
We were fortunate because the real estate market was really hot in the Twin Cities and we were able to make money buying property with owner financing, flipping some deals and put a little bit of cash in our pocket through that process. It started with single-family homes and then, after about 20 houses, we started moving into small multi-family properties. Now we sold a lot of those properties and tied up some large multi-family projects in Texas. In the meantime I recruited my wife, julie, into the business. This is when things really took off. She has a master’s degree in hospital administration, had run an oncology unit, was currently working for a medical device company. When I convinced her we would make a great team, we had figured out that she had been home about 40 days in six months. Her travel schedule for work was crazy. Julie had operational skills and I was good at finding the deal, analyzing it and raising the money.

12:22
We had a 300-unit multi-family project in Texas under contract. We had the financing, the management skills to manage it and the willingness to grind. We just needed someone with a down payment. We found a partner to help us finance the deals. He had a large real estate operation and didn’t have any multi-family in the portfolio. This was in the late 2000s, when financing on residential property was like the Wild West. It wasn’t that much different with large commercial projects either. We had 92 to 95% financing available and quickly grew the multi-family portfolio to 1,500 apartment units. The debt was non-recourse and we were making a ton of money.

12:57
Texas was, in the late 2000s, doing really well. I remember buying gas at $4 a gallon and oil prices were booming when the rest of the economy was struggling. The problem was our partner owned a bunch of commercial and industrial properties across the United States and it was all cross-collateralized with our multi-family projects. When his projects began to fail, the bank looked at these performing assets and these non-performing assets and we got a call one day that the lender was taking over all of our property. After the initial shock wore off, the good news was we had enough money to survive for a while. We had to completely reinvent ourselves. Our partner had a mutual partner that owned some senior housing projects that were on the brink of foreclosure and they were on the third management company, julie and the new partner decided, with her experience in healthcare and multi-family, she’d be a great fit to start a management company for senior housing projects. And it worked. She got the projects turned around and that portfolio has grown dramatically in the last 14 years.

13:54
Real estate offers tremendous leverage. The first leverage is financing. I can buy a million-dollar property with 20% down, which is $200,000. If it appreciates a 5% a year, that’s $50,000 in year one return a 25% return on my investment. We also leverage the fact that the tenants in the property are covering all of the expenses mortgage payment and taxes while creating positive cash flow. While the tenant covers the payment, my loan is being paid down. In the first year of a 20-year amortization on an $800,000 loan on the above property with a 7% interest rate, I would get an additional $19,000 in equity. So when I add the appreciation plus the amortization, I have $69,000 of additional wealth added to the balance sheet after year one with my $200,000 investment. That is a 34.5% return on equity in year one.

14:47
The wealth building that occurs with amortization is underappreciated. We also get a factor in depreciation where the government says the asset loses value for tax purposes and I get a write-off of a portion of the purchase price against my income every year. If the structure of that property is valued at $750,000 and $250,000 for the land, I get to use straight-line depreciation and write-off the $750,000 over 27.5 years for a residential property, we get an offset of over $27,000 of income with a phantom loss. Now there is nuance to this write-off, but it is a powerful tool when used to its full extent. We’re going to do an entire series looking at the tax benefits of real estate, so tune in to future episodes to understand the value that real estate can have to reduce your tax bill. When we factor in these three things together the appreciation, the amortization and the depreciation real estate may be the single best place to hold and build wealth.

15:47
When we factor all this in, it’s an imperfect market and you can buy an asset and instantly increase the value by making some operational changes. Real estate is my favorite asset class. The downside to owning real estate is it’s an illiquid investment. If you need your money quickly, this is not the place to hold it. Also, no matter how you structure your portfolio, if you own real estate, it will take some of your time and attention. It is like owning another small business.

16:13
I just agree with the statement that real estate is passive income. There are ways to create passive income through real estate, but it isn’t you owning and hiring a management company to manage the property. Now we’ve covered the three areas that we think make the most sense to build wealth. So owning a cash flowing business, creating a portfolio that really produces passive income, and then real estate to hold your wealth through the appreciation, amortization and depreciation is the key to building tremendous wealth. We think those three pieces are necessary to really accelerate your wealth.

16:49
Now, if you’re looking to build a team to help you navigate the challenges of business, paying less tax and building more wealth, go to vitalstrategiescom forward slash client to fill out a short survey, see if it makes sense for us to work together. We weren’t taking on any new clients at the year end, but now we’ve got some openings in February and March and we’d love to talk to you see if it makes sense for us to work together. We’d love to help you pay less tax, build more wealth so you can live a great life. Thank you for listening to the Vital Strategies Podcast. This conversation today is for informational purposes only and we recommend you talk to your investment professionals before making any investment decisions. Follow the Vital Strategies Podcast wherever you listen to podcasts and if you’re enjoying the content and have a few minutes, we would appreciate it if you would rate and review the show. We look forward to having you back next week where we will help you pay less tax so you can build more wealth and live a great life.