In the previous issue, Bill Zheng, CEO of Investor's Direct outlined 15 different investment strategies highlighting their own unique characteristics and none being necessarily any better than the other when it comes to making money. In this second installment, he takes you one step further by tackling the Money System
To be a successful property investor I believe there are 3 different types of systems you need to master:
1. Property Systems
2. Money Systems - your capital plan, cash flow plan and finance plan
3. People Systems - your team and self management
However, it is the second system, your Money System, which determines whether you will achieve your property investing goals. Let's face it, property investors are in the business of making money. Property is the vehicle or asset class you as an investor have chosen to focus your efforts on.
Having a thorough understanding of money, how it works and understanding your own Money System is crucial in achieving financial independence through property investing, or for that matter, any type of business venture.
Why is having a system important? A good system allows you to stay away from unnecessary distraction while you are investing, most people know how to make some money every now and then, but very few can stick to a system long enough to reap the real benefit.
Contrary to the widespread diversification theory, most wealthy individuals become wealthy by doing one thing really well first before getting into diversification, especially when they have very little to diversify at the beginning.
Before I jump into the discussion of Money Systems, it is worth mentioning that the best system can still be useless if one does not have the control to follow it. So being accountable for our own actions goes hand in hand with a well defined system.
Do you treat your property investment as a business?
We believe that investors should treat their property investment as a business, right from the time they purchase their first property, i.e. they should start with a business owner's mindset.
Why is this critical?
We have spent the last few years observing those people who have achieved financial independence. We wanted to figure out how they did it. We wanted to know what it is about those individuals that led them to achieve their goal of financial independence. Most importantly, we wanted to discover what every single one of our clients can do to be more like them.
According to our research, 87% of the people who are financially independent are business owners and 13% are employees with strong financial discipline or people with exceptional talents with loyalty income. We found that the:
• Majority of the business owners never make it to financial independence;
• Majority of the self-employed people never make it to financial independence;
• Majority of the employees never make it to financial independence;
• Majority of the investors never make it to financial independence;
But for those who have made it to financial independence:
• Majority of them are business owners;
• Minority of them are employees who treat their investment like a business;
So obviously, business owners have some attribute, some characteristic that drives them to reach financial independence.
What we discovered is that achieving financial independence has got very little to do with what you do for a living, i.e. it has got very little to do with whether you're a business owner or an employee. But it has everything to do with your mindset.
In other words, you can be a business owner but still thinking and acting like an employee (I call it business owners with an employee's mindset). On the other hand, you can be an employee but thinking and acting like a true business owner (I call it employees with a business owner's mindset).
There are 3 mindset categories: Business owner, self-employed and employee (remember, they're not what you do for living, but just a mindset). They are defined by how much financial accountability you take and how you build systems.
Mindset Category Financial Accountability System Building
Business Owner Mindset High - do or die High - create profitable systems for others to work in;
Self-Employed Mindset Medium - keeping busy Medium - at best, they're the system;
Employee Mindset Low - my boss's problem Low - working in a system created by others, at best improving them;
All people who achieve financial independence have the Business Owner mindset, regardless of what they do. Why? Because only the Business Owner mindset combines building of profitable systems and taking 100% financial accountability.
It is possible for an employee to think like a business owner when it comes to investments. We have plenty of clients who are employees that love their job and are not inclined to leave it, yet they achieve financial independence. This happens because they treat their investments as a business with full financial accountability and build their own systems.
When we talk about building systems, we're referring to systems that you develop to achieve some financial success, and then replicate it again and again to achieve even more.
Before we can talk about financial accountability and building a money system, we need to learn how to identify the "flow of money" around us. You need to know what you have before you can manage it.
The concept of money flow is not what your will learn from traditional business schools. What we are trying to illustrate is a very complex subject with the simplest possible interpretation, especially for non-accountants.
Let's examine :
Imagine that the money around us is like water, and you have a few containers to hold it in. There are 4 key components:
1. Water coming into a container is called 'money inflow', e.g. 'revenue';
2. Water leaving a container is called 'money outflow', e.g. 'expense';
3. Each container is called a business entity. The concept of a container is to separate your money making activities so that you can see the boundaries and manage the money better. A business entity here can be a PAYG person, a normal business or a property investing business, etc (more explanation on this later);
4. If the Money Inflow is greater than Money Outflow, then there is surplus water in this container, i.e. you are making money and having positive Cash Flow (again, this is not strictly your accountant's definition);
It is not hard to see that if you can maintain positive Cash Flow, i.e. having surplus water in all your containers, you will be sure to make money.
In reality, maintaining positive Cash Flow is not always possible in business, this leads to the next question: how do you manage the risk of having 'Negative Cash Flow' while you are building your business or asset?
There are two basic ways to carry yourself through a negative cash flow situation for any business:
• Inject capital. We call capital our 1st layer of defence. This can be money put aside for rainy days, start up capital, working capital, or investment capital, etc;
• Obtain finance. We call finance our 2nd layer of defence. This can be money borrowed against the Business Entity, such as a business loan, a personal loan or a mortgage. While the money you borrow can keep the business going further, its debt repayment will also reduce your Cash Flow.
What capital and finance really do is to buy you more time for the asset to grow and your cash flow to become positive again.
There is still some 'Money Left' for this Business Entity, i.e. as long as there is still some water in the container, the business can still live to fight another day.
Once we have a basic understanding of the flow of money for a business entity (container), we can check how many containers we already have. The following table lists 3 different containers: You (PAYG), a Normal Business and a Property Business. You may have one or more of them at the same time; you can use each column to test yourself to see if you can follow the flow of money for each container.
|• Money Inflow
|| • Revenue:
Personal loans, etc;
| • Revenue: Business income;
Working & seed capital;
• Against business value;
Rent, tax benefit;
Current value & future capital gain;
Family livings, etc;
• Debt repayment
Business expenses, taxes, etc;
• Debt repayment
| • Expenses:
Legal & accounting, education, taxes,
• Debt repayment
|| Can be either Positive or Negative
|| Can be either Positive or Negative
|| Can be either Positive or Negative
||Must be positive
||Must be positive
||Must be positive
As a general rule of thumb, you would try to avoid having negative Cash Flow if possible, but you definitely cannot have no 'Money Left' because that means you have exhausted your money option to keep the business entity viable.
You may ask why we should bother to identify the different kinds of container, can't we just have them all in one container? It's all my money any way?
The reason is that it is a lot easier to manage something smaller. The 'divide and conquer' method can help you manage your financial affairs much better. Once you can see which container is leaking, you can fix it accordingly.
How does this relate to residential property investors?
Many property investors have either a job or run a business. It is very important that you treat them as self contained business entity (a container). While you may not always be able to have positive cash flow from your investment property, you must still make sure there is always 'Money Left' in that container, which means you must keep enough cash buffer or make sure you can borrow more money from your property down the track.
A common mistake many property investors make is to use the water from one container to fill another and ignoring the fact that some of the containers are leaking beyond repair.
For example, you may be running a loss making business for too long, but your property is going up in value, it is not uncommon to see an investor keep pulling money out of their property to keep the business afloat while they ignore the critical issues (leakage) of their business.
The same can happen to personal expenditure, many investors can live beyond their means while their properties are doing well, they neglect to see their personal container is full of holes. The moment something happens to their properties, they will find themselves not being able to handle the living expenses.
It is very clear that once you can see your money in different containers, you should get rid of the one that is leaking and won't have any 'Money Left'.
For property investors, how do you ensure that your 'Property Business' container always has some 'Money Left', i.e. be a viable business?
Money Systems for a Property Investor
If you refer back to the above diagram, whether you will have any 'Money Left' for a business entity depends on how you manage your Cash Flow, Capital and Finance.
Hence a Money System comprises 3 key elements:
• Capital Plan
• Cash Flow Plan
• Finance Plan
Without getting into too much technical details here, you can quickly scan through the following few sections to get an idea of what these plans are about. Every person has their own individual situation. To develop a tailored made solution that can evolve with your over time, you should regularly check in with your finance consultant.
It is a known fact that most businesses fail not due to lack of profit, but due to inadequate capital. A Capital plan is part of your risk management plan, it is important that you put some serious planning into this before starting your property investing business.
Your Capital Plan helps you answer the following key questions:
• How much money should you put into your property business now and in the future?
• What other equity do you have available outside of your property business?
• How much contingency buffer do you need for your risk appetite?
• What is your total leverage capacity based on your capital contribution?
Cash Flow Plan
Your Cash Flow Plan is closely related to your Capital Plan. For example, you might want to put in a lot more capital to reduce your borrowing when you buy a property. This will greatly enhance your cash flow position due to less debt repayment. Conversely a better Cash Flow position can reduce the reliance on additional Capital and Finance.
Your Cash Flow Plan is to answer the following questions:
• What is your current annual cash flow from existing properties?
• What adjustment do you need if the existing cash flow is positive or negative?
• What is my new annual cash flow after adjustment?
• What is going to be the cash flow impact of purchasing additional investment properties?
• What could be the worst case scenario and how long can you last before you have to sell the property or sell down your shares?
• What is the potential to turn future capital gains into cash flow from further refinancing?
• What is the realistic amount of property you can purchase safely right now?
The Capital Plan and Cash Flow Plan have helped you to come to a simple conclusion: how much property you can purchase safely right now.
Your Finance Plan is to make sure that you can obtain the finance you need to reach that target; hence the Finance Plan is the final filter of the strategies defined by your Capital Plan & Cash Flow Plan.
Some of the most important points to keep in mind with your Finance Plan are;
• Flexibility - ability to access more money by adding, increasing or changing your loan with ease;
• Risk Management - protect yourself from interest rate movement and lender's aggression during bad times;
• Suitability - there are a few stages of finance an investor would go through over time, and there are suitable finance for each stage;
• Cost - there always costs in running any business and we may not be able to go for the cheapest option to achieve our overall objective, it is always a balance between cost and benefit ;
• Lenders Policy - lenders policy can have a great impact on your finance options, and their policy is heavily influenced by the availability of funds, historical performance and current market condition;
Your Finance Plan will let you answer the key questions:
1. What is the total amount I can borrow right now?
2. How many properties does that equate to and at what price?
Remember your Finance Plan may reduce the original target you set via the Capital Plan and Cash Flow Plan. However, your Finance Plan is an essential enhancement to your Capital Plan and Cash Flow Plan.
It was Sun Tzu (Art of War, 500BC) who said "it is that in war the victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterwards looks for victory".
A well defined Money Systems is the victory you can win before the battle, and this will make contesting the battle merely a formality.
Next month we will focus on strategies to define the final piece of your property investment puzzle...your People Systems.
This article was written by Bill Zheng founder and CEO of Investors Direct™ (with contributions from Vincent Power, Regina Looi, Lee Dittmer, Lynda Heise & Tim Riley). Investors Direct is a property finance company that provides financial solutions exclusively for property investors and understands that your mortgage is an asset, not a liability.
For further details about Investors Direct™, please go to www.investorsdirect.com.au
To subscribe to our FREE monthly e-newsletter on investment property finance visit www.investorsdirect.com.au
Copyright © 2001-2007 Investors Direct™
Related: Home Loan Calculator
Do you have more than $120k in your super fund? You could use your super to buy property - Find out how