Perpetual Wealth Strategy and Real Estate Part 3

About this Episode

This episode discusses the importance of understanding the legal aspects of investments, particularly in real estate. Patrick Donohoe emphasizes the need to comprehend leases, asset protection, and the separation of liabilities associated with investments from other assets. He also highlights the inevitability of mistakes when others are involved and the importance of minimizing these mistakes by understanding the obligations and risks involved. Gary Pinkerton, on the other hand, advises against making emotional decisions when investing in real estate. He warns that many people mistakenly base their investment decisions on personal experiences with their own properties. Instead, he suggests that investments, even those involving a former primary residence, should be viewed from a purely unemotional, financial perspective.

Key Takeaway Timeline

  • 01:07 Quick recap of episode 6 and what to expect in episode 7
  • 05:56 What are the differences between a primary residence and investment real estate?
  • 09:43 Why is real estate an I.D.E.A.L investment?
  • 11:47 What are the biggest challenges people face when buying their first investment property?
  • 14:46 What are some different types of property and their advantages?
  • 19:10 Where do you commonly see people making bad investment decisions in real estate?
  • 25:25 How does the Hierarchy Of Wealth help you mitigate investment risk?
  • 31:49 Does high risk equal high returns?
  • 35:55 Round up of this mini-series on real estate investing

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01:08 Quick recap of episode 6 and what to expect in episode 7

Patrick Donohoe: Hey everyone. Welcome back to the final segment of our three-part series on real estate. This time, we’ll be discussing real estate investment. The episode title is “Investment on Earth: Unlocking the Potential of Real Estate.” You like the pun.

Gary Pinkerton: I do.

Patrick Donohoe: All right, so let’s get into it. We met at an investment conference, and we’ve been around real estate investment for quite some time. I was involved in real estate and had some enlightening experiences during 2009. Right now, we’re in a period of correction, and things are happening that most people weren’t anticipating. These cycles of real estate investment have seen you invest a lot in real estate, with great successes and valuable lessons. So, let’s first recap episodes one and two.

Stacking the principles of those episodes so we can hit the ground running with this one.

Gary Pinkerton: Yeah, real estate is a significant and illiquid decision. You can’t exit quickly, and transitioning into and out of real estate can be expensive due to broker fees, sales charges, and potential tax impacts. You don’t want to make this decision with too little knowledge. Gaining experience the hard way often means losing money, but it’s a valuable lesson that can help you make money in the future.

I love the investment side of real estate, which shares similarities with primary residence real estate. It’s fundamentally important for freedom and capitalism, giving you the agency to do what you want with your family. Ownership of real property is key to living your best life. The investment side of real estate accelerates this.

Patrick Donohoe: We live in a country with strong property laws, providing certainty in real estate ownership despite some fallibility. Property can be taken away in other nations with muddy property and title laws. Ultimately, real estate success or failure comes down to the individual investor.

We’ve found that education is crucial, offering more control, influence, and reduced risk. However, lifestyle happens, and you must protect against anomalies and economic downturns. In the first episode, we highlighted the demand for different real estate types. You can own and supply real estate, and there’s a margin in it.

It’s not just residential real estate for being a landlord; consider Airbnb, which changed the game for residential property income. But COVID had an impact, affecting those who relied on nightly rentals when people stopped traveling.

The idea is that there’s always high demand for real estate, and you can be the supplier. If done correctly, there’s always a margin. In residential real estate, how you analyze and treat the acquisition differs based on property use.

So maybe we can start with that.

05:56 What are the differences between a primary residence and investment real estate?

Gary Pinkerton: To start, it’s crucial to recognize the differences between a primary residence and an investment in real estate. While commonalities make it a good investment, the key is understanding that real estate fulfills a universal need. People will pay to rent a place to live, as shelter is one of their top priorities. This reliability makes real estate a dependable investment. There’s more certainty that a rental property will continue to generate income compared to other investments.

However, what differentiates real estate is that it should not be an emotional decision. Many people make the mistake of letting their positive experiences with their own homes guide their investment decisions. They may choose a rental property based on its appearance or emotional appeal. But it’s essential to approach real estate as a purely mathematical, unemotional investment decision.

Patrick Donohoe: Part of our tutorials will expand on this concept. Humans tend to apply lessons from one context to another due to their habitual nature. If you’ve purchased a primary residence, you might carry over preferences like specific toilet features, wall colors, yard landscaping, or window types when investing in a rental property. However, applying these same decisions to a rental property can negatively affect its success.

In the investment world, choices have consequences. When you invest in one thing, you give up the ability to invest in an alternative. Let’s consider a comparison between real estate and the stock market. While both have their merits, expertise plays a significant role in achieving gains. Real estate offers opportunities for returns with less education required to navigate the market effectively.

If you’re buying expensive fixtures and amenities in a neighborhood that doesn’t warrant them, you’re not making a wise investment. Your goal is to provide an efficient living space that meets the demands of your target market. To maximize returns, you must efficiently supply what tenants demand in the most cost-effective manner possible. This approach leads to optimal returns on your real estate investment. Does that clarify things, or would you like to add to it?

09:43 Why is real estate an I.D.E.A.L investment?

Gary Pinkerton: I completely agree with your points. In the real estate world, there’s a saying that “time turns every horrible deal into a genius.” This means that with real estate, appreciation and the universal need for the asset can ultimately make even a bad decision look good. Real estate allows you to work your way out of a bad decision over time, even if you bought above market value. It may take a while, but real estate appreciates.

Unlike assets in which transactions happen instantly, real estate is an inefficient market. This inefficiency can work to your advantage. Real estate offers multiple ways to make money, making it a multi-dimensional asset. I like to use the acronym “IDEAL” to remember the different aspects of real estate as an ideal investment.

“I” stands for income or cash flow. “D” represents deductions, including depreciation, which allows you to claim a tax deduction as the property’s value decreases over time. “E” is for equity, as tenants pay off your mortgage, and the “A” is for property appreciation.

Patrick Donohoe: And don’t forget about “L” for leverage. You can use a mortgage to acquire the asset, meaning your acquisition costs are much less than if you were buying an asset without leverage.

Gary Pinkerton: Right. So, when you add up all these different features, real estate can often outperform what someone with the same education level could achieve in a more efficient market like the stock market.

11:47 What are the biggest challenges people face when buying their first investment Property?

Patrick Donohoe: Let’s explore people’s challenges when starting their first investment property. One significant challenge is the emotional aspect of buying. People often base their decisions on whether they would live in the property themselves, which is not the right approach. Additionally, for many first-time investors, it can feel isolating because they might be the only ones in their social circle venturing into real estate. Most people may perceive rental property ownership as unusual or even crazy.

Another challenge is understanding what kind of real estate aligns with your financial goals. For instance, there are various real estate types, and you need to determine what fits your objectives. Let’s briefly touch on a few of them.

First, there’s residential real estate, which includes houses you may have previously lived in. This is often where many people begin. It’s the area with the highest demand for housing, making it a relatively low-risk option, as there’s a constant demand for rental properties.

Then, we move up to multi-unit properties, such as fourplexes, which are still considered residential. Beyond that, you have multi-family units, which fall into the commercial category. This could include large apartment complexes. There are even more specialized categories like industrial, retail, mixed-use, land, and farmland.

Regardless of the type of real estate, the same fundamental principles apply. You need to assess if there is a demand and, if so, determine if you can supply it with a reasonable margin. These considerations are essential for any real estate investment, regardless of the category.

14:46 What are some different types of property and their advantages?

Gary Pinkerton: Each type of real estate investment has its advantages. Single-family homes are often a starting point for many because they are familiar and offer accessible loans. However, there’s a middle ground, typically after a four-unit property, where financing can become more challenging. Banks often follow demand, so it’s essential to consider where the demand is and invest accordingly.

Single-family homes offer numerous exit strategies. You can rent them long-term, sell them to the renter, convert them into short-term rentals, or sell them on the open market to anyone interested. This flexibility is an advantage. On the other end of the spectrum, large apartment buildings offer economies of scale and professional property management, reducing the challenges for the owner.

Industrial or retail properties often involve triple net leases, where tenants handle most of the expenses, taxes, insurance, and repairs, relieving the owner of many responsibilities. Investors sometimes transition through seasons in their real estate journey, adapting their investments to their changing preferences.

Additionally, real estate investment can extend beyond property ownership. It can involve being a hard money lender, working as a remodeler, or running an active business associated with real estate.

Patrick Donohoe: People often start with single-family homes due to accessible financing, but as they accumulate properties, they might unintentionally apply residential property theories to other asset classes, increasing the risk. As you move into different property types, the risk rises unless you gain more control through education and experience.

Education and experience are crucial for mitigating risk in real estate investing, and this is especially important as investors graduate into various property types. We work with many clients who are real estate investors, and it’s evident that understanding the unique challenges and strategies for different asset classes is key to success.

19:10 Where do you commonly see people making bad investment decisions in real estate?

Patrick Donohoe: One common breakdown in real estate investment is a lack of understanding of the asset class they’re in. Many investors lack the education and mentorship needed to make informed decisions. This often leads to learning through the “school of hard knocks” and inadequate preparation and protection for their assets.

Gary Pinkerton: An example illustrating this is a client in retail real estate. When times are good, it looks like a great investment with ten-year leases. However, during a recession, vacancies can last for months, turning positive cash flow into negative. Investors need sufficient cash reserves to weather such periods.

Transitioning to a new kind of real estate investment requires careful preparation. Investors need to ensure they are ready for the challenges specific to that type of property. The goal is to understand the asset class deeply and ensure their financial life aligns with their chosen investment.

Patrick Donohoe: Adding to this, when dealing with residential real estate, control is more straightforward as you often manage it yourself or through a property manager. In contrast, multifamily, industrial, land development, or hard money lending typically involve more people. More people mean more potential for mistakes and increased risk.

Understanding the legal aspects, like recourse laws, becomes critical. You need to be aware of your obligations and potential risks. Also, asset protection is crucial. Separating liability associated with your investment from other assets is a vital aspect of risk management.

The presence of other people in your investments will invariably lead to mistakes. The goal is to minimize these mistakes as much as possible by understanding your obligations and risks and protecting your other assets. Many valuable lessons come from experiences, both personal and from clients.

Gary Pinkerton: Adding to this, the Hierarchy Of Wealth plays a significant role. Land development, for instance, is entirely different from other forms of real estate investment. It involves learning about city government relations, permitting, and the extended time it takes. Extending loans and overcoming political obstacles are just some of the challenges that land development presents.

Sometimes, people dive into land development or other complex real estate without realizing the complexity involved. It’s not merely a unique twist, and you need to approach it with caution. Building on raw land is not as simple as putting down sticks; it has many intricacies.

25:25 How does the Hierarchy Of Wealth help you mitigate investment risk?

Patrick Donohoe: Let’s delve into the Hierarchy Of Wealth, as it’s an important aspect. We want to clarify that there’s no perfect investment that guarantees your money will perform exactly as anticipated. Different investments have varying degrees of certainty, and life changes can affect investment circumstances. Therefore, every investment carries inherent risks.

To manage these risks effectively, we’ve developed a way to allocate assets based on control and inherent risk. This system categorizes assets into different tiers, each with specific characteristics. These tiers help investors determine their risk appetite and asset allocation.

Here’s the key idea – the same asset can be less risky for one person than for another. The Hierarchy Of Wealth categorizes assets into four tiers. Tier one has the highest degree of certainty, but it may offer lower returns. Its goal is to provide higher returns with high certainty.

In contrast, tier-two investments carry higher risk and the potential for higher returns. Tier three and tier four investments are more speculative and come with the potential for significant losses.

Your asset allocation across these tiers can help you manage your risk and determine your risk appetite. By having a diversified allocation, you can better handle changes in your investments and avoid the risk of bankruptcy. It’s about balance.

Many investors, however, begin with investments they don’t understand, lack control, and carry higher risks. They often start with tier three or four investments, which have more significant potential returns but come with higher risk and the probability of loss.

Gary Pinkerton: Risk increases as you move up the Hierarchy Of Wealth. Higher tiers involve relinquishing control and having less insight into your investments. The risks come from the human element, as more people get involved, there’s a greater chance of encountering crooks, incompetence, or poor communication.

The asset location also plays a crucial role. For instance, investing directly in an apartment building under your control differs from investing in a syndication or a real estate investment trust (REIT). The further you are from direct control, the more potential risks you face.

Your experience with investments in higher tiers is often more about luck than intentional actions you’ve taken. The risk can pay off, but it’s not the result of calculated steps.

Patrick Donohoe: The Hierarchy Of Wealth helps you analyze the practical mathematical side of your investments, as emotional factors often drive investment decisions. Balancing the emotional and mathematical aspects can lead to better decision-making and more effective wealth management.

31:40 Does high risk equal high returns?

Gary Pinkerton: I’d like to push back on the notion that higher risk guarantees higher returns. While it might enable higher returns, it’s not a certainty. I often ask people if they know anyone who’s never left tier two after explaining the hierarchy. Elon Musk and Warren Buffett, for instance, have remained in tier two and enjoyed good returns.

There’s no requirement to move beyond tier two. You don’t have to take on more risk to get higher returns. Some individuals are satisfied with their tier-two investments and the stability they offer.

Patrick Donohoe: As we wrap up this episode, consider that those in tier three and tier four have balanced their investments well. They view losses as valuable lessons rather than survival challenges. They learn from their experiences, apply the lessons to future investments, and adjust their approach.

However, many investors don’t have the right framework to manage risk and control. When they encounter losses due to poor planning and high risk, they often feel traumatized and exit the game entirely. They put their entire life at risk and are afraid to invest again due to that one bad experience.

Gary Pinkerton: Human elements play a significant role in investing. Tier four assets involve numerous people between you and your money, and the opportunity for failure is high. Many people don’t learn from their losses but accept them as part of the game. You need to take ownership and invest time in learning about the assets you’re investing in.

Understanding more about what you’re investing in, such as real estate, even if you ultimately invest in a tier four real estate investment trust, can help you make more informed decisions. Typically, people invest without conducting due diligence, which can lead to failure, as they haven’t learned or experienced enough beforehand.

35:55 Round up of this mini-series on real estate investing

Patrick Donohoe: It’s been a delightful series, and I’ve gained a lot from our discussions on and off the record. The knowledge, experience, and insights you gain over time will make you a better investor, and that’s crucial. It helps you maximize gains while minimizing risk.

Gary Pinkerton: I appreciate the opportunity to participate in this discussion and share this valuable content with my clients and all Paradigm Life clients, particularly those focused on real estate investing. I’d like to reiterate the multidimensional nature of real estate as an asset. It’s not just about cash flow, equity building, or appreciation. It’s the combination of all these factors that makes it unique. I’ve had years where the cash flow seemed negative, but the overall gain remained positive when considering all elements.

Patrick Donohoe: In the end, life is about experiencing incredible opportunities and living a more fulfilling life daily. Managing your personal finances and investing wisely position you for a better life. We aim to provide the education you need to make informed financial decisions and achieve financial independence.

If you haven’t already, make sure to watch the first series of this new season on cash flow protection and wealth. We have more segments coming up that delve deeper into relevant education to help you make the best financial decisions for a more financially independent life.

Thank you, Gary, for your participation and insights. You’re amazing, and we look forward to the upcoming episodes.

Gary Pinkerton: Thanks, Patrick. Take care.

About Patrick Donohoe

Patrick H. Donohoe IAR, AIF®, RFC®

Over two decades of experience in the financial services industry, Patrick has seen the challenges people face in managing cash flow, risk, and investment performance – especially for business owners, real estate investors, and entrepreneurs. The struggles lead to continuous uncertainty and unease, – negatively impacting the areas of life where they have the most significant impact.

At Paradigm Life, where Patrick serves as CEO, he leads the company mission of helping Clients overcome these challenges through proven, economically sound, and time-tested strategies. Since 2007, Paradigm Life has guided over 8,000 clients nationwide to new levels of financial independence, helping them create and follow a path to thrive personally and professionally.

Patrick’s journey into the financial industry was unique. Growing up in a middle-class area in central Connecticut, the child of two teachers, he wasn’t taught much about money, investing, or business. His interest in finance was sparked by studying Economics & Statistics formally and reading Rich Dad Poor Dad in 2002, which opened his eyes to the financial potential of all human beings.

Patrick’s first real taste of personal finance came during college, where he worked in a call center that provided debt consolidation strategies as an alternative to bankruptcy and, later, in the mortgage industry.

He founded Paradigm Life in 2007 and, like many during the 2008-2009 financial crisis, learned firsthand about the unpredictability of the business environment and economy. That period tested him but also shaped him. Amidst the struggle, he worked tirelessly, providing consultations and webinars to help people navigate the financial storm. In 2011, those efforts started to bear fruit, allowing him to expand his team and build a strong company culture.

This journey compelled Patrick to write “Heads I Win Tails You Lose – A Financial Strategy to Reignite the American Dream” in 2018. The book encapsulates his financial philosophy and the wealth strategies Paradigm Life uses with Clients, rooted in his career experiences. To date, the book has sold over 60,000 copies.

Patrick also co-hosts several podcasts with over 1,000 episodes combined.

As a veteran of the industry, Patrick gets the challenges Clients face. His personal and professional experiences have equipped him to guide others through the complexities of personal finance. While he is passionate about numbers and objective analysis, he strives to prioritize making financial theories accessible and practical for Clients without getting lost in the complexity.

On a personal note, Patrick has been happily married since 2003 and has three children. He’s a Utah Jazz fan, plays Ice Hockey, and loves spending time in the mountains with his friends and family.

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