Eric is a Real Estate investor, founder of MartelTurnkey, and author of Stop Trading Your Time for Money.
Even if achieving financial independence is your No. 1 goal, how to make that a reality is far from obvious. A critical first step is to understand your expenses. Make sure your revenue is greater than your spending. This is basic advice, but a surprising amount of people spend more than they earn. Next, review your spending habits and itemize them so you know exactly how much you’re spending on things like clothing, restaurants and transportation. Identify areas where you’re overspending or buying things you don’t need. This may sound excessive, but make sure your money’s going toward expenses that are necessary or bring you happiness. To use a personal example, one expense I realized I could cut was cable television. I decreased my bill from $230 to $70 per month for high-speed internet and hardly missed all those channels I wasn’t even watching.
Next, find a passive income revenue source to offset your current expenses. Once your passive income exceeds your living expenses, you’ll have achieved financial freedom. But what kind of passive income investment is right for you? You should invest in something you fully understand and that works with your lifestyle, because ideally, you’ll be collecting passive income from this investment for a long time. Find opportunities with the highest, most consistent returns rather than highly volatile ones. Finally, you’ll want an investment that allows you to use leverage by borrowing money to increase the potential return. If the investment also provides tax benefits, even better. I chose real estate for my first passive income investment because it meets all these criteria.
Once you’ve chosen your investment, calculate how much money you’ll need to achieve financial independence. For example, say you put $20,000 down on a turnkey rental property, and it provides you with $3,000 in annual cash flow. If you need, say, $60,000 a year in net cash flow, you would need to buy 20 properties (i.e., a purchase price of $400,000 for all properties).
Where will you find the money to invest? Examine your bank account, 401k or other retirement accounts. These are not obvious choices to invest from, but certain 401k accounts let you invest directly into a real estate property. Also consider equity in any assets you own, such as your home.
It’s important at this point to really run the numbers. Don’t make investment decisions based on instinct or emotion. For most Americans, the home is their primary form of equity, and they rely on it for retirement. However, factoring in property taxes and repairs, using your home as your main equity isn’t ideal.
Take this scenario: In 2005, let’s say you bought a house on the West Coast for $750,000. You put down 20% or $150,000. In this area, people are having a hard time coming up with the down payment because house prices keep going up and they can’t catch up. You spend $300,000 in renovations over 15 years, paid in cash or perhaps via a line of credit. At some point, you may have to refinance to account for other expenses such as a car.
Let’s say 15 years later, your mortgage balance is now $700,000 and your line of credit is maxed out at $200,000 and you’re ready to generate some passive income and achieve financial freedom. Your home is now worth $2 million. While this seems like a great investment, when you consider the tax payments, repairs and expenses, your actual return on investment is less than 5% per year. Your equity is about $1 million and you are trying to figure out how to leverage that equity. If you refinance, your mortgage payments will jump from $3,000 to $7,500 per month. In order to pay for this increase in expenses, you now need an additional $350,000 worth of rental properties to generate passive revenue to keep pace. Now it feels like you’re going backward financially.
I faced the same conundrum when I ran the numbers on my own financial situation. It didn’t make sense for me to use my home as equity. Every day I was visualizing this equity sitting on the couch watching television while I was working. I needed to figure out a way to have this equity work for me.
It is critical to figure out what you really want. Do you want to own a home? Do you want to be able to travel and not worry about work? For me, my home was a stressor. If the real estate market had a sudden drop, my equity would be jeopardized, along with my retirement. Rather than waiting until retirement, I used that equity in the present by selling my home and investing in my business, MartelTurnkey. Soon my passive income was offsetting living expenses. Many people warned me about the capital gains tax, but I didn’t end up paying tax on capital gains because the accelerated depreciation on the apartment building I purchased offset them.
Some will ask, “Isn’t renting a home more expensive than owning it?” or “Isn’t it difficult to find a nice rental home?” I did the research and found neither of those assumptions to be true in my area. Our monthly expenses for the 4br/2b, 1700 sq. ft. home we owned near San Francisco was $6,000. We soon found and rented a much better, larger 4br/3b, 2,400 sq. ft. house in the area for $6,000. Instead of $6,000 in monthly expenses for a house I own, my investments are paying my rent and living expenses. This is how I manage to live for free, and it’s possible for you, too.
Forbes Real Estate Council is an invitation-only community for executives in the real estate industry. Do I qualify?