Many physicians I know are struggling to make ends meet while making several hundred thousand dollars per year. Despite growing incomes, their savings rates remain extremely low due to ever increasing expenses. What they do manage to save, they turn over to “professional” money managers. How does this happen? Why are some of the smartest, hardest-working and most responsible members of our society unable to create real wealth? The answer is two words – “financial illiteracy”. Doctors spend so much time in school memorizing facts but receive little education in basic financial skills that can provide a real and lasting positive impact on their professional and personal lives.
I was one of those less than financially literate doctors. After finishing residency, I was on the typical path of most young doctors. I was excited about my new private practice job and the dramatic increase in income it brought. I bought a fancy luxury car, sold our lovely two bedroom house in the city, and moved to a five bedroom house in a nice suburban school district. I set up investment accounts at a local wealth management company and, taking the advice of a local insurance agent working with young physicians, I also purchased disability insurance and began “investing” in both variable and term life insurance. To everyone around me, I was doing great. Unfortunately, I knew better. My expenses were steadily increasing without the commensurate increase in happiness and I had very little control over the performance of my investments. In order to gain some of the financial literacy that I lacked, I started reading books on finance and investing. This is when I luckily came across the writings of Robert Kiyosaki, and my life has never been the same.
Robert Kiyosaki is the author of many best-selling books, including Rich Dad Poor Dad, arguably his most popular book. Since first discovering his books, I have read everything that he has written. One of the major concepts of his books is anything that does not put money into your pocket is a liability, not an asset. This is a huge shift from the way net worth is usually calculated. Vacation houses, expensive cars, boats and other high priced toys are typically considered assets by bankers and accountants – things of “value” that boost net worth. Accordingly, many physicians look at their large house as an investment that boosts their net worth and feel they are doing well. The problem with this type of calculation is that all of these items require active earned (ordinary) income to purchase and maintain, but do not provide any positive cash flow. They only leave you with less money in your wallet.
So, how does one gain true wealth and net worth? The following statement is instructive:
“Rich people acquire assets. The poor and the middle class acquire liabilities that they think are assets”. – Robert Kiyosaki Rich Dad Poor Dad
A great definition of wealth is the number of days you can survive at your current standard of living without physically working. As Robert Kiyosaki writes, “wealth is measured in time, not dollars”. This definition will change the way you feel about your financial picture and that of others around you. We all know people driving expensive cars, living in big houses and taking lavish vacations. Are they really wealthy? How many days could they survive without actively working? The real measure of wealth is not how much money you make per hour of services performed, but how much you make without performing any service. We can begin to create real wealth by first understanding key differences between active/passive income and between assets/liabilities. Active income requires your daily effort to earn and is taxed at the highest rates possible. This is the type of income that most of us earn in our daily jobs – whether you are a teacher, policeman or physician. Passive income, on the other hand, is income that flows to you without your direct active participation, is often taxed at significantly lower rates, and has many more allowable expense deductions. This is the type of income that you receive from selling stock that has appreciated, from yearly profits from any business that you own, or from rental real estate. What the wealthy do is reliably and regularly turn active income into passive income or positive cash flow. By working extremely hard to gain active income, and spending this income on items such as homes and fancy cars, physicians are dooming themselves into a vicious cycle of active work. The purchases they make are not assets, but in fact liabilities according to Mr. Kiyosaki’s tenets. They produce negative cash flow and thereby require more and more active work.
A favorite story of mine described in Rich Dad Poor Dad is when the founder of McDonalds, Ray Croc, speaking at an MBA class in the 1970’s, asked the audience what business he was in. After they all quickly responded “the hamburger business”, Kroc replied, “Ladies and Gentleman, I’m not in the hamburger business. My business is real estate.” The land under the McDonalds is more valuable than the business itself. According to recent report from 2013, the net operating income of McDonalds is around $5.5 billion while the total asset value of their real estate holdings is around $55 billion. Selling hamburgers provides liquidity (cash) but it is the real estate that creates real wealth.
So what can you do and where do you start? First, we all need to have a basic understanding of how the economy works and the various investment forms (stocks, bonds, commodities, and real estate) available. We need to learn the fundamentals of entrepreneurship and what it means to transform an idea or service into real value through the creation of a company. We need to learn fundamental accounting principles to be able to read and understand basic financial reports. It is beyond the scope of this book to provide this type of detail but given the resources available, it is fairly easy to learn these principles at any age.
Here is an example:
Imagine that you receive a bonus check for $40,000 and are wondering what to do with that money? This is where an understanding of the difference between good debt and bad debt is very helpful. Good debt is buying something with a loan that will eventually put more money into your pocket. A great example of this is purchasing an apartment house. Let’s say the apartment house costs $200,000 and has 4 units. You can go to the bank and get a loan for 80% of the purchase price or $160,000. You need to put a down payment (from your active income savings) of $40,000. After paying all expenses including mortgage, insurance, taxes, repairs, maintenance, and property management, let’s assume that there is a positive net cash flow (profit) of $4,000 at the end of the first year. This $4,000 represents a 10% rate of return on your initial $40,000. This return will improve as rents increase over the term of the loan. After the loan has been repaid, the yearly cash flow will now also include the amount that was previously allocated to the mortgage payment. You are then left with an asset worth much more than the initial $200,000 purchase price and significant monthly passive income. You will receive this monthly income without your direct active effort (time) and will have taken the first step to true wealth. You can use this positive cash flow to spend less time working for active income (accelerate retirement) or perhaps to buy another investment property. While this may seem like an oversimplified example of real estate investing, it contains all of the pertinent aspects of generating cash flow and was, in fact, my first real estate investment. When I discuss real estate with others, many feel that the subject is too complex for them. They can’t imagine dealing with tenants and fixing plumbing issues in the middle of the night. I also felt that way at the beginning and am happy to report that I have never dealt directly with any tenant issue (especially at night). As with any new area of personal growth, the initial period is often filled with tremendous doubt and uncertainty. What is helpful to remember is that every expert was once a beginner. No one is born with the knowledge of capitalization rates, profit/loss statements, and property management. It is all within reach – none of it is complex – but it does require work. The learning process is similar to any other subject; learn the fundamentals (80%) through books, podcasts, and lectures while engaging a mentor to learn the additional 20% that is comprised of practical application of fundamentals, transfer of experience and effective shortcuts to accelerate the process. A radiology mentor of mine told our first year class that we should be learning up to 90% of radiology through books and the final 10% during read-out sessions with experienced radiologists (mentors). In radiology, you don’t want your mentor to teach you basic anatomy on a CT scan but you do want them to show you how to interpret a CT to find the specific cause of the patient’s symptoms. Similarly in real estate, you don’t want your mentor teaching you the definition of net operating income (NOI) but you do want them to show you how to translate NOI to a good purchase price offer on a property.
Good debt allows us to purchase an asset (real estate, business venture) that will put money into our pockets. In good investments, the debt is paid for by the asset and not from active earned income. What does bad debt look like? An example of bad debt would be to spend the initial $40,000 bonus check to upgrade your lifestyle with a more expensive car, larger house, or additional expenditures that simply drain money. There is no significant appreciation or positive cash flow. In most cases, the “asset” immediately begins to depreciate. Unfortunately, this is the path that many physicians (and others) follow. They reach for happiness with their spending patterns but end up only creating more anxiety, which requires more active work, which then leads to more spending. It is not a fun treadmill to be on.
There are other methods to acquire significant passive income. Many wealthy people have started companies, opened franchises, created online network marketing businesses etc. The common thread in all of these options is the creation of a value/money generating system that does not require their active daily effort for every dollar earned. As I read more books, listened to podcasts, and met with mentors, I became convinced that real estate investing was the correct path forward for me. It provided everything that investments in the stock market lacked – individual control of a tangible asset that I can see and work to improve, positive cash flow, and a reliably appreciating asset insulated from the majority of external forces. Plus it is fun – like a game of monopoly. I often wonder what would have happened if I started playing this game earlier. Had I known about real estate investing during college, my early years would have looked very different. During college, I would have used the money that I paid in rent to purchase a small house near campus. During medical school and residency, I would have rented this house to pay for the mortgage and to provide some positive cash flow. As my income increased as an attending physician, I would have sold this house (at a profit) and purchased a larger multi-family apartment building. The cycle would continue as I used the cash flow from this investment along with my active income to buy other properties. My asset appreciation and monthly cash flow would have had a 20 year head start. I don’t do this exercise to express regret (well, maybe a little) but to empower my kids and others with this type of knowledge earlier in their careers. Real estate investing done correctly, as well as other methods to create passive income, can provide financial freedom that allows all of us to pursue our passions, fulfill our unique potential, serve our communities and ultimately live better lives. What more can you want for yourself and your children?