Many investors are plagued by contradictory behavior where they adopt a pro-risk attitude with their investments, but when it comes to the strategies we are about to discuss, they take on more of a scarcity mindset.
It is well known that entrepreneurs and real estate investors create the most wealth in the world. I am going to explain how you too can benefit from the same strategies the wealthy use to create wealth.
But first, we need to identify what makes these two categories of people better positioned for wealth creation than others. I believe there are three things that set them apart:
- They leverage other people’s money to grow their wealth.
- They continue to benefit when the assets they own appreciate over time.
- They enjoy exponentially greater cash flow from the leverage and operation of their assets.
No. 1: They leverage other people’s money
Most often when a real estate investor purchases a property or constructs a building, they acquire a loan from a bank to fund the project. Seldom do they pay for properties in cash. The more resources they tie up in one property, the less cash they have available to acquire other properties. By using the bank’s money to leverage their purchases, they can use the same amount of money to acquire multiple properties. You’ll see why this is important in a moment.
The investor collateralizes the property in exchange for the capital to acquire the property. Say an investor buys a property valued at $100,000. The bank funds 75% of the purchase price and the investor funds 25%. By doing this, the investor now has a property valued at $100,000 that they paid $25,000 out of pocket to acquire.
From a retail perspective, you may point out the fact that there is a loan and the equity position is only 25%. That is true, but there is more to understanding why this is a huge advantage for the investor. Which leads me to the next point.
No. 2: Their assets’ growth comes with a built-in advantage
What many people fail to understand about real estate is that the property is worth the same whether or not it has a mortgage. In our example, even though the investor has a loan of $75,000, the property is still worth $100,000.
This is important as the investor – not the bank – benefits when the property appreciates. The investor gets the benefit of a $100,000 property appreciating with only $25,000 invested. In other words, if the property appreciates by 5%, or $5,000 on the $100,000 property, this is effectively a 20% yield for the investor’s $25,000 investment. This is what is known as an internal return.
No. 3: Their cash flow grows exponentially due to the leverage and operations
Of course, no investment property is acquired without the potential for creating cash flow from the operations. Whether it is a business operating within the property or a rental agreement, the investor has a plan for creating cash flow from the property’s use.
Now, this is where the multiplication occurs, and the idea of internal and external returns is revealed … explaining how this strategy grows wealth.
Continuing with the example of the $100,000 property, let’s assume the property is rented out. Let’s assume the rent collected is $1,200 per month, or $14,400 per year. Using the same math as before, $14,400 would equate to 14% of the value of the property and a whopping 57% on the investor’s $25,000 investment. This is an external return.
After backing out the mortgage payment on the $75,000 of around $6,000 per year, or 6%, the investor’s returns are still above 30%. And when you combine this cash flow with the building’s appreciation, you have a year-over-year return above 50%, all things considered.
This is why an investor often favors using the bank’s money. The returns are higher. And if you multiply this example four times, you can see why using $100,000 to acquire $400,000 worth of properties can be better than using $100,000 on a single property.
Of course, there are risks involved with this, the same as with any investment, and the actual returns on investing in real estate will vary from deal to deal.
The benefits of this concept if you aren’t an entrepreneur or real estate investor
This concept of internal and external returns can be applied to anyone who owns real estate, but they also can apply to anyone with a cash value life insurance policy. But before we can discuss how these two assets could help you grow your wealth, it is worth taking a moment to dispel some common myths.
The Mortgage Myth
The challenge many people face as it relates to a home mortgage is the misconception of what constitutes sound financial advice. On one hand, an investor believes they can invest in the stock market and earn 8% to 10% over time, while simultaneously holding a conflicting view that having a 3% to 4% mortgage is a bad idea. If this is you, I am sorry to say it, but this mindset fails to support its own logic.
If you believe the potential is there to earn a higher return than what is otherwise being paid to a bank for the mortgage, then there isn’t any mathematical evidence to support accelerating the payoff of a mortgage.
Of course, there are those who simply do not want to have a mortgage — and that is a personal preference, not an economic decision.
The Life Insurance Myth
There are few subjects more misunderstood than life insurance. With all the uses and applications and multiple types of policies, it is easy to see why the opinions and views of life insurance are all tangled up in a web of confusion.
But let me be clear: When a dividend-paying whole life insurance policy is designed and funded correctly, its benefits mirror those of most real estate. Both are similar in that, they build equity, grow tax deferred, allow for tax-free access to cash, and can be owned free and clear.
With the overlapping characteristics of life insurance and real estate, I see both being used as a conduit for receiving both an internal and external rate of return.
So here is what we know to be true:
- Real estate will appreciate the same whether or not it is mortgaged – Internal Return.
- Accessing cash through refinancing real estate is a tax-free transaction.
- Hanging on to cash while leveraging capital can improve cash flow – External Return.
The same can be said about a specially designed life insurance policy:
- Cash values will appreciate the same whether or not there is a loan – Internal Return.
- Accessing cash through a loan is a tax-free transaction.
- Hanging on to cash while leveraging capital can improve cash flow – External Return.
One advantage to a life insurance policy loan over a bank loan is that there are no requirements to pay the loan back. This is a cash flow advantage because you have the ability to set the terms.
Here are a couple of quick examples
Let’s say you have investments and need to make some home improvements. Consider using home equity to make those improvements as opposed to using your investments. There are three benefits to this:
- You keep your money invested and growing.
- You are using equity in your home that is earning nothing to increase the value of the home.
- You could possibly increase you cash flow depending on the investment yield and current mortgage balance.
Another example would be using the specially designed life insurance:
- The insurance company lends you the money while your money remains in the policy growing.
- You receive an internal rate of return on the money in your policy while using the money taken as a loan to create a new asset that appreciates, providing you with both an internal and external return.
- You could possibly increase you cash flow depending on the new assets and current bank payments. In other words, the policy functions as your bank.
Properly utilizing these strategies can be a catalyst for building wealth and increasing cash flow efficiency within your personal economy. To learn more about how to develop this system for yourself, visit BUILDBanking.com.
Benefits and guarantees are based on the claims paying ability of the insurance company. Results may vary. Any descriptions involving life insurance policies and its use as an alternative form of financing or risk management techniques are provided for illustration purposes only, will not apply in all situations, may not be fully indicative of any present or future investments, and may be changed at the discretion of the insurance carrier, General Partner and/or Manager and are not intended to reflect guarantees on securities performance. The terms BUILD Banking™, private banking alternatives or specially designed life insurance contracts (SDLIC) are not meant to insinuate that the issuer is creating a real bank for its clients or communicating that life insurance companies are the same as traditional banking institutions. This material is educational in nature and should not be deemed as a solicitation of any specific product or service. BUILD Banking™ is offered by Skrobonja Insurance Services, LLC only and is not offered by Kalos Capital, Inc. nor Kalos Management. Skrobonja Insurance Services, LLC does not provide tax or legal advice. The opinions and views expressed here are for informational purposes only. Please consult with your tax and/or legal adviser for such guidance.
Securities offered only by duly registered individuals through Madison Avenue Securities, LLC. (MAS), Member FINRA & SIPC. Advisory services offered only by duly registered individuals through AE Wealth Management (“AEWM”), a registered investment adviser. Skrobonja Financial Group, LLC, Skrobonja Insurance Services, LLC, AEWM and MAS are not affiliated entities. The article and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you consult your accountant, tax or legal adviser with regard to your individual situation.
Brian Skrobonja is an author, blogger, podcaster and speaker. He is the founder and president of a St. Louis, Mo.-based wealth management firm. His goal is to help his audience discover the root of their beliefs about money and challenge them to think differently to reach their goals. Brian is the author of three books, and his Common Sense podcast (opens in new tab) was named one of the Top 10 podcasts by Forbes. In 2017, 2019, 2020, 2021 and 2022, Brian was awarded Best Wealth Manager, in 2021 received Best in Business and the Future 50 in 2018 from St. Louis Small Business.