Over the last 12+ years, I have provided accounting and tax services to self-employed individuals and their companies. These experiences have provided me with unique insight into the inner-workings of small businesses across a variety of industries.
During this time, I learned that a “one-size-fits-all” approach doesn’t exist for building a successful business and creating long-term wealth. However, I noticed glaring similarities between the most successful individuals that have been able to accomplish these feats, including:
- They are self-employed professionals and business owners that created their own firms,
- They have established numerous profit centers that generate cash flow at regular intervals, and
- At least one (1) profit center consists of real estate generating cash flow from rents &/or royalties.
Upon identifying these traits, I interviewed several clients to inquire about how they built their businesses. In addition, I read everything I could find on other entrepreneurs fitting this mold. Based on my research, I discovered that these individuals followed a methodical approach to building their businesses. Their successes in creating long-term wealth were significant, and I noticed a pattern constituting a blueprint for building a successful business that creates long-term value as follows:
Investment of Earnings in a Secondary Business
The objective of investing in a secondary business is straightforward: To generate a stream of cash flow without having to be actively involved in operating the business. In short, you are putting your money to work (as opposed to your labor) for the purpose of generating passive income in the form of a steady stream of cash flow.
This phase of the blueprint is essential to small business success and long-term wealth creation for the following reasons:
- It generates additional cash flow stream(s), and
- It serves as a “savings account” to preserve and grow the earnings from your primary business.
Investments generating passive income come in many variations, but rental real estate is by far the most common asset class owned by business owners that I have worked with. In fact, the overwhelming majority of these individuals receive some form of rent and/or royalty income from real estate. The correlation between self-employment success and real estate investment is so tight, that it begs the following questions:
The answer to these questions are condensed into the following three topics (and explained in further detail below):
- Generating Passive Income without Sacrificing Managerial Control,
- Access to Credit using Financial Leverage, and
- Four “Wealth Generators” of Rental Real Estate.
Generating Passive Income without Sacrificing Managerial Control
While passive investments in assets such as publicly-traded securities and privately-held joint ventures can generate the passive income vital to small business success and long-term wealth, these investments generally do not offer investors managerial or operational control.
Real estate investments, on the other hand, provide business owners with the option to participate in managerial responsibilities such as screening tenants, negotiating lease terms, maintaining leased premises, and so forth. Alternatively, these responsibilities can be contracted out to a property manager.
Access to Credit using Financial Leverage
Real estate is also an attractive investment because of the access to credit availabile for acquiring property. Business owners can purchase real estate with only a fraction of the purchase price required to be paid in cash. Using leverage, the remainder of the purchase price can be paid with funds borrowed from a bank or another financial institution.
Four Wealth Generators of Rental Real Estate
Rental real estate provides four (4) different sources of wealth generating potential, including (i) cash flow, (ii) loan paydown, (iii) tax savings, and (iv) appreciation. A brief explanation of each of these items is provided below.
Cash Flow – the most important wealth generator for business owners and self-employed professionals, as cash flow is essential to building a successful business and creating long-term wealth. In the context of the rental real estate industry, cash flow is defined as the remaining income after paying rental expenses affecting the property (i.e., mortgage, taxes, insurance, vacancies, repairs, capital expenditures, utilities, etc.). For a detailed discussion of cash flow management, see my earlier post.
Loan Paydown – using leverage (i.e., debt) to finance a real estate purchase, you can generate wealth from the property by paying your mortgage from tenant income each month. The portion of your monthly note payment that is applied to principal reduces debt and increases equity.
Tax savings – the federal government encourages real estate investment through favorable tax treatment, including depreciation deductions and the ability to deduct real estate losses from select sources of income. In short, rental real estate frequently provides tax-advantageous cash flow as a result of annual depreciation deductions. Furthermore, it provides the potential for tax-deferred gains upon sale (as long as the sales proceeds are invested in real estate of a like-kind). For a detailed discussion of rental real estate taxation, see my earlier post here.
Appreciation – defined as an increase in the value of your real estate over time. Real estate investments offer the unique (and lucrative) components of tax deductions on property that generally appreciates over time. There are actually two kinds of appreciation in real estate, as follows:
- Natural appreciation. The natural tendency for prices to rise over time, tied to factors such as inflation, supply and demand, and marketplace greed.
- Forced appreciation. Refers to the concept of improving a piece of real estate so that it’s value increases. For example, turning a two-bedroom home into a three-bedroom or adding a second bathroom can immediately increase its value. Likewise, increasing the amount of profit that a multifamily property can earn will increase its market value.