So the question becomes, what is the most effective way to spend your time and mental energy?

Think for a minute about a person carrying buckets of water for their crops. There is a direct correlation between how much they work and how much water they get. If they want more water, they have to carry more buckets.

Now compare this to someone who uses their time and energy to build a machine instead. This machine is “passive” in that it works whether it’s owner is there or not.

Obviously there is great leverage in having a machine such as this. It can work day and night while your time is preserved to build new machines or relax.

In the modern day of the knowledge worker, we no longer need to carry buckets of water with manual labor. But there is certainly the mental manual labor of a 9-to-5 job, copying and pasting in Excel, or whatever it is that you do. It really is no different in the sense that there is a direct correlation between your time and how much your earn. If you want to earn more, you need to put in more hours and continue working each week.

Now, if you are surrounded by people who carry mental buckets for a living, the idea of building a machine might sound pretty silly to them. I’m sure the first person who built a water wheel felt the same way. It is more difficult to build, costs money for wood and nails, and might not even work.

While you are messing around trying to get your machine working, your bucket carrying counterparts will probably get a lot more water carried in the short term. They might think you are pretty silly spending all your time and money on a machine that might not even work while they are getting consistent progress each and every day carrying buckets.

But at some point you’ll get your machine working, and it will start to match the output you were able to accomplish manually. Even if your machine is only producing the equivalent of what you could do manually, you still have a very significant advantage: your time and mental energy are still available.

Because they have been preserved, you can now go on to build a second machine, and another, and another. When you have 15 machines running simultaneously your output will be far greater than any one person could produce (or earn in a job).

This is the real key: preserve your most precious resource (your time and mental energy). Build systems and machines that work when you aren’t there. Avoid mental manual labor that require your time for output.

What are the best modern examples of these machines? Owning and investing in businesses, income generating real estate, some web businesses, etc. With these machines in place you can produce far more than any one individual could with manual labor, and get rich in the process.

Hi Brian,

I have been a long time RSS subscriber to your blog (since the 30 day marketing series – I guess it worked) and I would really appreciate your input on something. A little bit of background first: I am 24 year old software developer in New York City making $120k/year. I paid off all my school loans and do not have any debt. Professionally, I like what I do. It’s interesting work, and it pays damn good money. But, I also want to “break free”.

I have been reading your articles for some time, and the way that I see it, they mainly focus on how to convert time into passive income while using a nominal amount of capital. I’m coming from the other side of the spectrum. I have plenty of capital (I should have around $50k in the bank or in minor investments by the end of the year), but very little time. There are plenty of books and articles which talk about finding good real estate deals or starting businesses, but all those things require time. I have not been able to find anything really useful that investigates the possibilities from the other side of the fence. There is always the stock market, but with the current economic conditions, I am not quite sure that is the best option. Real estate is the other option, but that has also come to a standstill in this economy.

What do you think I should do? I feel that for me, personally, trying to convert my earned income into passive income is the way to go. I am perfectly content to save and invest $50k a year at a good return rate for several years. The question is, what is the best starting point?

Thanks,
A

Hi A,

I think you’re right, if you have lots of capital then no need to start your own business if you don’t want to. You can invest this wisely! Real estate is by far my favorite here because it generates cash flow (money you can actually spend each month) instead of just capital gains. I hate stocks. Plus income from real estate is largely tax free. Also, you are right that the real estate market has slowed – but this does not mean it’s a bad time to invest. When home prices are depreciated its a great time to buy (and not to sell). So there are two sides to this, no matter which way the market swings it’s not a bad time for real estate necessarily, it’s either a bad time to buy or a bad time to sell but not both.

Also, when people are unable to purchase houses they have to rent, so home prices and rents are inversely correlated. You can ride out any recession in real estate if you keep your properties rented out and they cash flow each month…you might have huge capital gain shifts during this time but it doesn’t matter because they are generating income you can spend every month. Then when the market shifts the other way and prices are inflated, you can sell at the perfect moment.

Real estate is by no means risk free and there are probably 100 ways to lose money doing it (like buying speculative investments – high end town homes, new construction/development, flipping, etc) and I have lost money on some deals. But there is also a safer way to do it and it takes some learning just like anything else. Buying foreclosed 3/2/2 starter homes at a steep discount and renting them, for example, and possibly eventually doing bigger deals with apartments that are more hands off, etc. If you want to go this route, my suggestion is to read some of those books (Rich Dad Poor Dad, The Automatic Millionaire Homeowner, etc), join some local real estate investment clubs to get around the right people, and find a good mentor (someone who has already done this and is RICH, not someone who is still learning).

Btw, not sure I answered your question about real estate taking time. Yes, investing in single family homes will take time both to find the deals and keep them rented. But maybe not as much as you’d think, lots of people do this with a full time job for example. I spend about 3-4 hours per month dealing with my 3 houses although they took a lot of time up front to get going. Once you get into bigger real estate deals, for example being a passive investor in a multi-family deal, you can be completely hands off but this can require larger sums of money (around $100k or so) and I don’t have much experience there.

Millionaires own lots of real estate and they are a great source of passive income!

Hope that helps,
Brian Armstrong

Hey Brian,

I know you’ve thought a lot about investment / passive income, etc. so I wanted to get your thoughts…

I can see how real estate is a great investment if you can get someone else (a renter) to pay the entire mortgage for N years, and then you sell for a profit and you make money. Maybe you can even rent it for more than that and make money every month.

But what about when you can’t rent it for that much? In a few years I will probably move out of my condo, so I need to think about whether to keep it as a rental. Total cost per month that we’d still owe with a renter (mortgage, property tax, and condo fee) is about $2200/month. And I honestly don’t think we’d be able to rent it for more than $1900/month. Maybe rents would go up in 10 years. But the condo fee would also go up over time.

To make money, the value would have to increase faster than inflation. Anyway I’m just curious what you think!
K

Hi K,

Good thoughts all around. Negative cash flow properties can still make sense.

On the plus side…

• Don’t forget a small part of your mortgage payment is going to pay off the principal (maybe $100 on yours per month?) and that is really your money, it’s no different than putting $100 in a savings account each month except it’s equity in the house which you will eventually get back in a refinance or sale, so while I wouldn’t count it as cash flow, it’s also not money spent in your -$300, it’s money saved.
• Real estate gives you tax benefits…all the interest payments, improvements to the house, and property taxes are deductible, some other stuff too like people calculate travel mileage. It adds up quick, I ended up taking a huge deduction in taxes from real estate last year. People who own lots of real estate get away with murder regarding the tax system in this country. Some of them are millionaires and qualify for wellfare because they show such low income, and it’s perfectly legal. So that’s one other side benefit.
• I wouldn’t worry about the inflation part of it, real estate automatically adjusts for it (both rents and values). When people talk about appreciating values or rent going up they mean above and beyond inflation, so yeah I don’t think real estate ever loses value to inflation the way cash would since rents and home values are liquid markets just like any other good. Most leases I’ve seen have an automatic price bump built in each year for inflation, as an example.

On the negative side…

• Don’t forget to include cost of insurance in your cash flow (although that may be part of the condo fee?)
• You’re right condos aren’t ideal because they can assess greater fees whenever they want
• It’s a pain just in answering phone calls from tenants and repairs once in a while, and when someone moves out you have to use their deposit to get it ready again, etc. Your time is certainly worth something. What works out best I think is pricing the rent slightly below market so you get lots of rental applicants, then you can run credit checks (and criminal) on every applicant (costs about $15 each) to make sure you really find a good tenant who will stay in there forever and treat it well. I also have a home warranty policy which covers most repairs so they can just call that number instead of me, costs about $350 per year in Houston, but of course there are always little unexpected surprises so owning real estate is never stress free.

Anyway, it’s not an easy decision, but if it were me I would probably keep it unless you have an immediate need for the cash. In the long term real estate is always a good investment. Many people inadvertently wind up millionaires just because every time they move they don’t sell their old house, they rent it. And for sure that thing will be worth millions some day, hard to say when, but your mortgage isn’t getting any bigger so you know that. Rich people all own loads of real estate, so I say the more of it you can get your hands on the better.

Good luck, and until next time, keep breaking free!
Brian Armstrong

P.S. Also, one more thing…to get your cash out of it, you don’t necessarily have to sell it. You can refinance it out and still have the asset plus rent coming in. Some people say never sell a piece of real estate since you can refinance the money out and it will keep paying you both in rent and equity build up.

If it had been an honest mistake with this guy, I’d say it’s water under the bridge. But this particular contractor was just thoroughly unethical and I decided to go after his ass Donald Trump style and make him pay.

I always wanted to try being a lawyer. Mostly just because you get to wear $2,000 suits, act like a bad-ass, and take down mob bosses (of course when I found out this didn’t happen in real life, I quickly moved on to secret agent as my next profession of choice). It was finally my day in court. I put on my best suit (more like $200, but still) and woke up at the ungodly hour of 8:45AM to head to court. At first I thought he wouldn’t even show, but he did and the anticipation was heavy in the air as I furrowed my brow and starred him down (I was watching some discovery channel recently, and this alpha male sure as hell wasn’t going to break eye contact first).

I recognized the feeling coming over me. It was the same feeling I get before doing public speaking, acting, or that one time I tried stand up comedy (no one laughed). It’s nervous energy but it’s also a rush. One of my life philosophies is that you should continually try doing things that sound a little scary to expand your comfort zone. This is how you build confidence. Try to have that scary – pit in the bottom of your stomach – feeling at least once a week if you can. I had never gotten to prosecute a crook in court so I figured even if I lost it would still be worthwhile as an educational exercise.

I had practiced my opening arguments and was all set to launch into a dazzling diatribe complete with photos and earth shattering proof the likes of which Jack McCoy has never seen. I could even picture the standing ovation from the rag-tag audience that populates a small claims court house and the press waiting outside to snap my photo as the defendant was escorted in silver bracelets. Unfortunately, my daydreaming was cut short as the judge called us up and announced he was sending us to mediation.

Mediation is apparently standard practice in small claims court where they sit you in a room with a neutral third party and see if you can work it out. I still got to do my diatribe though.

It started out predictable, I laid out the facts of my case clearly and simply. I had also sued him for an absurdly large figure in the hopes this would be a starting point for negotiations (which it was). It was then his chance to respond, and boy was he a weasel. I got the feeling this man had been practicing the art of bullshitting since he was in the womb. I couldn’t tell if he really believed some of the stuff he saying (delusional) or if he was was just good at faking it. Probably a bit of both.

He had perfected the art of saying a bunch of totally unrelated things in rapid succession during an argument to the point where you forget what the main point was (a tactic I first saw employed successfully by my old college roommate when picking up women).

It would have been a pretty open and shut case in my favor, except he did pull one pretty neat trick. It turns out when he bid the job, his first bid included an itemized list of stuff to be completed and a bid for labor only. I didn’t want that so he submitted a second bid later for labor and materials which is the one we actually signed. Problem is, the second bid referenced the list of items in the first bid and didn’t duplicate it in one complete contract.

Therefore, we were left with a somewhat unfortunate situation where the contract and the list of items document had a contradiction. One said he was bidding for labor only, and the other said he was bidding for labor and materials both.

The one with the signatures on it stated what we actually agreed (labor and materials) but he stapled the original list of items to the back of the contract so it looked like all one document. Bad weasel!

Sure, it had no initials on it or anything (a thinly veiled ploy of a desperate man), but I still needed the list of items document to show what he had not completed so I couldn’t discount it completely. At the very least, the judge would have had to admit there was some contradiction between the two pieces of paper and this opened up a window (however slight) of doubt.

I have to say, the 150 year old man who was mediating was very impressive. We verbally sparred and battled on, both concluding the man across from us was a complete idiot, and eventually gave up communicating and decided to go before the judge. But the mediator wasn’t done yet. He asked to speak to each of us individually.

After lecturing me on how to get a better contract next time when dealing with the criminal under-world of contractors, he looked me straight in the eye and said: “Brian, what will make you happy?”

That was a good question I had to think about. Money? Yes. Punishing evil? Yes. Getting him to admit he was wrong? I’d given up on that…you can’t change people who are a detriment to society unless they want to change themselves. He wasn’t ready for that yet. Still needed a few more lawsuits against him. I eventually came up with a figure that would make him think twice before screwing over other citizens, and it was his turn with the mediator.

Anyway…long story short, I eventually walked outta there with $2 grand. I would have been a lot happier with $5 or $6, but oh well. As they say, a negotiation isn’t successful unless both people leave feeling like they gave something up. And hopefully he’ll at least think twice before taking advantage of someone next time.

Chalk one up for the good guys.

Lessons learned:

• Do scary things in life, they help you grow.
• Lawsuits are emotionally draining and bring a lot of negative energy into your life. Next time I would love to be able to afford some swanky (real) lawyer to take care of it for me. This way I’d still be able to punish crooks without it taking up my personal time or energy (I have far more fun things to be doing).
• Next time I’ll work harder on getting an unambiguous contract. It’s worth a few awkward moments and being stickler up front for paperwork to save this headache down the road. Itemize every item that needs to be done and have them initial each NUMBERED page so there are no “paper-rearranging-stapler-weasel” tricks.
• My biggest lesson (which seems obvious and everyone told me but I still didn’t do): DO NOT pay a contractor a dime until the work is done, period. Don’t ever give them money for materials up front, even if they say they can’t afford it. Inspect the hell out of their work before paying, and don’t ever let a contractor talk you into giving them money up front. Walk away from the deal if you have to. The day you write the last check is the last day you will ever see them (unless you are in court).

At the end of the day I have to remind myself that this was an incredibly valuable (and inexpensive) lesson to learn so early in life. Many people don’t get taken advantage of so early in their business careers, and I’m almost glad it happened now instead of when there was a really big deal on the table. You just can’t learn this stuff in business school. Thank you, Mr. Weasel contractor, for teaching me about the world.

Until next time, keep breaking free!
Brian

A few weeks ago I told you about a real estate deal I did that gave a 113% return in one month. Well, I am quite human and make mistakes just like anyone, so today I’m going to tell you about a real estate deal I did that DIDN’T go quite so well, and the lessons I’ve learned from it.

This was another foreclosure that I worked on rehabbing. As more and more money was sunk into it, it no longer made sense as a rental, so I will have to sell this property now to probably break even. At least I live to fight another day.

Here are a few before and after pics:

Some mistakes…and lessons learned (which seem obvious, but somehow weren’t):

• Put More Detail In The Contract
  Perhaps the biggest mistake I made on this property had to do with the contractor who I hired to fix it. I correctly got a signed contract with him, but didn’t make it detailed enough. It was not specific and I let him convince me that a number of items would be included that were not specifically written. Bottom line, what someone says doesn’t mean anything, only whats written counts.
• Withhold Final Payment Until You Are 100% Happy With The Work
  I knew that I should always withhold the final payment until I was 100% satisfied with the rehab job. I knew this, yet I didn’t follow it. When I inspected the work, I was in a hurry, it was getting dark, and I wasn’t thorough. Upon closer inspection it wasn’t done. And of course, being already paid, the contractor had zero incentive to come back. Never pay a contractor until you are 100% happy.

  I realized that I need to build my confidence in dealing with and negotiating with these contractors. For an great book on this subject, check out When I Say No I Feel Guilty.

• Bring As Little Money To Closing As Possible
  I brought too much money to closing. When I didn’t like the lenders numbers, I was afraid to back out (risking losing the earnest money and the deal entirely) so I convinced myself to go ahead with a deal I didn’t quite like.
• Lock In Financing Before Entering The Deal
  The lender rules changed mid deal. I thought I’d be able to do an 80% cash of refinance. I was told part way through construction that the rules had changed and I could only go up to 75%. Locking in the financing before starting he deal would have prevented this.

Of course the irony, looking back on this, is that I KNEW all of these things before I did this deal. At least I knew them intellectually, but somehow I got myself in a situation where I didn’t do what I knew was right.

This brings me to another interesting point. I was very upset at this particular contractor for a while, and considered even suing him, but I realized that I have no one to blame but myself.

Sure, he might have taken advantage of the situation, but I gave him the chance to do so. I realized that I have to take responsibility for it, and not put my problems on to someone else. In a way, I am actually grateful to him for teaching me this lesson. It was an invaluable lesson that was worth far more than it cost me.

Finally, it has occasionally been a struggle to stay motivated during a deal like this. I had to keep reminding myself that it is actually great this happened; I’m learning so much. When a deal works out perfectly, you learn nothing. When things go wrong is when you really start to grow as a person.

One of my favorite quotes is by the American industrialist Thomas Watson, who is famous for building IBM. One time a reporter asked him how other companies can match the incredible success of IBM. He replied:

It’s quite simple, really. Double your rate of failure. You’re thinking of failure as the enemy of success. But it isn’t at all.

You can be discouraged by failure or you can learn from it. So go ahead and make mistakes. Make all you can. Because, remember that’s where you’ll find success.

Going out and trying something new, and failing, is probably the best learning tool ever developed. I was talking with a gentleman who owns over 400 houses to get his advice on this deal, and he told me that of the 400 houses he has bought, he has only lost money on 13 of them. But he remembered each one of those 13, and he said he learned more on those than the others combined. They were earlier in his career, and really it was the 13 that allowed him to have the 400.

Ultimately, I’m glad I went out and did it. Even if I make zero dollars, the experience will make the next deal that much better. In fact, the next deal is already looking quite good….like it’s going to have very little money down (nearly zero) and an outrageous rate of return. I’ll keep you posted!

Fixing it up! Before and After Pics

The house got new paint inside and out, carpet, air conditioner, microwave, dishwasher, light fixtures, doors, landscaping, and a few other cosmetic things.

Here you can see the new AC, the old one was rather beat up!

Here you can see the new microwave and dishwasher in the kitchen. Overhead lights have been fixed, cabinets painted, etc.

White paint on the outside and raising the tree line improves the curb appeal.

Keep in mind that I didn’t do any of these repairs myself. I hired contractors so it was zero work on my part. Total cost of the repairs were $14,500 and they took two weeks to complete. I had the contractors lined up and ready to go the day after closing.

Equity Capture

I bought the house for $76,000 and put $14,500 worth of repairs into it. In it’s newly repaired condition the lender appraised the house for $115,000. So I now own a $115,000 house.

115,000
- 76,000
- 14,500
———–
$24,500 Equity Capture

As you may recall from my previous article, I financed this deal with a lender who loaned me 80% of the after repair value. This allowed me to put very little money down.

I was hoping to get it with zero in the deal, but unfortunately that didn’t happen here (maybe on my next one). Still, it worked out quite well….there was no down payment, but including all repairs ($14,500), closing costs, appraisals, finance charges, etc…the total cash out of pocket that I have in this deal is $11,500. (I brought $5,900 to the first closing, repairs went $3,100 over what was escrowed by the lender, and $2,500 to refinance out of the hard money loan into permanent financing.)

(24,500-11,500)/11,500 = 113% return on equity

Note that I didn’t have to wait a couple years for this to appreciate. I raised the value of the property by this much in one month, just by fixing it up!

Of course equity capture is an “unrealized gain”. I can’t go out and spend that $24,500 because it is tied up in the house. But in a year or so I can do a 1031 exchange perhaps to sell some houses and get into an apartment, and I’d be able to get that equity out. The lenders appraisal of $115k is a conservative one, and in a year it may have appreciated as well. But even if it doesn’t (I don’t like to count on appreciation) it has still gone up in value just by rehabbing it.

Cash Flow

Getting a 113% return on equity is a nice way to raise my net worth, but the cool thing about this property is that it is also paying me with money I can actually use today. In other words it “cash flows”.

I listed it for rent at $1,100/month. This is slightly below rents in the area and it was in great condition so it only took about a week to get a lease signed. The mortgage at 7.75% interest is $647/month. Taxes are $270/month. Insurance is $80/month.

1,100
- 647
- 270
- 80
———
$103 per month positive cash flow

Right now the taxes are based on a value of the home of $112,000. But since I just purchased it for $76,000, I should be able to get the tax value reduced to $76,000. This would make the tax payment only $200/month instead of $270/month. Paperwork has been filed for this but it will probably take another few weeks.

That would bring the positive cash flow per month to $173/month.

173 times 12 months is $2,076 per year

$2,076 divided by my total cash out of pocket of $11,500 gives an 18% cash on cash return.

Conclusion

Overall I’m happy with how the deal turned out.

In the future I think I can make it work even better by doing a few things differently: First, I’m going to try a different lender to see if I can reduce the finance charges. I think I could do a lot better in terms of the origination fees, broker fees, and closing costs overall. Secondly, I’m going to try and end up with much less money in the deal. If that $11,500 was closer to zero the rate of return would go way up. I’ve seen a couple deals where I could actually get it to zero, or even better, get cash back! So I hope to do that soon.

That being said, the numbers really are quite staggering when you look at it.

113% return on equity
18% cash on cash return

Try getting that in the stock market! And of course, my equity will continue to grow by about $100 each month as the tenant helps me pay off the principal. Oh yeah, and I forgot to mention…the cash flow will be TAX FREE. The $173/month in positive cash flow is really equivalent to $247/month of ordinary taxable income that you’d get from a job or some other source (assuming a tax rate of 30%).

Finally a big point to keep in mind here is that this is passive income. It may be hard for some people to get excited about a couple hundred bucks a month, but the key point is that I will make it without doing any work (or very little). Get 10 houses and now you have something…and income stream you don’t have to work for! Plus of course the equity gain is much larger and will help build net worth quite rapidly.

Here are some common questions I assume people might have, so I will try to answer them. If you have others please post below.

Your cash flow won’t be $173/month because something will break in the house that you will have to fix. And won’t you be getting calls in the middle of the night to fix things? That doesn’t sound like zero work!

I put in the lease that the tenant pays the first $250 of any repairs. So all minor repairs are their responsibility and cost. Larger repairs like the air conditioner are under warranty right now. So hopefully this won’t be an issue. I have to admit that the one expensive item not under warranty is the water heater, so if that breaks I may have an expense (minus $250 from tenant). In the future I may try a home warranty company that I found which would be an easy way to cover all repair costs.

The house really only needs to stay in decent condition for about a year. I plan on selling it in a year or two along with a number of other houses to get into an apartment complex.

What if the tenant doesn’t pay rent or destroys the house?

If they don’t pay I’ll evict (entire process takes about 20 days in Texas) and keep their deposit. I did a criminal and credit check on them (and several other applicants) to try and select the best candidate. I required them to pay double deposit (two months rent, $2,200) because their credit wasn’t perfect, so this provides a buffer. Given that you can evict so quickly and keep two months rent, its possible to actually make MORE money in this type of situation, unless the damage is really quite substantial.

What if it floods, a pipe breaks, a tree falls through the roof, etc?

These type of claims are covered by the insurance.

What about vacancy? You should account for that in your numbers.

I didn’t account for vacancy because it took me 1 week to rent the house initially. It is now one of the nicer houses in the neighborhood and I deliberately charged a rent ($1,100) slightly below market value to attract more people. I feel confident that if I need to evict I can rent it again in a week or two.

You didn’t really make a 113% return because you can’t spend that money.

You are right. Return on equity is an “unrealized gain”. I can’t go out and spend it, but it is real money that belongs to me. It is just tied up in the house. Note this is different than saying “I think it has gone up” or “I think it will go up” like when talking about appreciation. The house is worth that right now, and I was able to raise it’s value by that much in one month by fixing it. This is much more certain than betting on appreciation because you can see what other properties in the area are selling for. The lender (who has an incentive to estimate conservatively) appraised it at $115,000 so I feel confident it’s worth at least that much.

Anyway, I am happy with how it turned out and learned a lot to hopefully make the next one better. If you see any errors or have questions/comments please leave a comment below! Thanks!