Chapter 8 / Part 2 / The Formula for Riches / The Difference Between Rich and Poor / by Dr. Hannes Dreyer.

Chapter 8 / Part 2

Previously we discussed measuring growth, the limitations of the compound interest calculation, and how to measure growth with multiple inputs – which is the kind that relates to property - by means of the Internal Rate of Return (IRR). What follows in this section is a partial recap of this information as it relates directly to the property.

To recap on the important aspects of measuring growth when it comes to property, remember:

Property has at least twenty-seven different variables with hundreds of thousands of different permutations.

To calculate the growth you must determine the IRR using a system that takes all the different variables into account.

Once you have determined the cash flow on a property it is possible (with the assistance of a program like Property Pro) to calculate the IRR within minutes.

Remember that, because a property investment can consist of either income streams or capital growth, or both, your method must be able to take both these criteria into account.

In property the IRR is directly influenced by the cash flow and equity in the property at a specific moment in time, as well as the following:

• purchase price
• market value
• deposit
• assessment fees
• initiation fee
• house owner's comprehensive insurance stamp duties
• depreciation
• transfer duties
• deed office levies
• rental income
• inflation-linked or not
• vacancy rate
• projected capital growth rate
• projected inflation rate
• bond interest rate
• term of the bond
• interest only or interest and capital repayments property management fee
• monthly expenses like rates and taxes
• special expenses
• repair and maintenance
• renovation costs
• tax rate
• type of entity that owns the property,

The Importance of Time when Measuring the Risk in a Property Investment。

Property is normally a long-term investment, one exception being if you’re a speculator, in which case you are taking big risks.

I make my money when I buy, and I do not plan to sell, ever, although there are exceptions. However, if I do sell, it is out of choice, not a necessity.

I never sell because I am forced to by the market. I am never forced to because I do my calculations, taking into account the worst-case scenario, the highest interest rates, etc. and I only proceed if the deal still makes sense.

People do make money speculating, but they take big risks and if they get it wrong, they can and do go under. The property does not and cannot turn over as fast as shares on the stock market.

For all of these reasons, property investors need to consider time and change with great care. No one can predict what will happen in the future. What an investor can do is to determine what has happened in the past. By working on the moving averages over the last ten years, you can measure the probability based on what would have happened if you had followed the system for the previous ten years.

Why ten years?

During the past ten years, we have seen a severe property slump as well as a massive property boom. We’ve seen a big range of interest rates, and inflation rates. In other words, a ten-year period reflects the good and the bad times and this is true in all different investment classes, not just property.

All the risk is reflected in the cash flow. Whether an investor can afford to make an investment or not. The affordability is determined by the surplus.

In The Formula For Riches the S = Surplus。

The surplus can be capital or income.

Negative cash flow means that the investor must have a surplus income otherwise he will not be able to afford the monthly negative cash outflow.

Unless an investor can determine all the variables which will have an effect on the cash flow of an investment, it is impossible to determine the risk for that particular investment. You are in danger of leaving important factors out.

A capital surplus's function is therefore to offset the majority of the risk.

By working on the moving averages the investor eliminates 50% of the risk over a period of time.

Worst Case Scenario。

Another technique I never neglect to use is the worst-case scenario. This is a calculation during which I take the highest inflation rates and the highest interest rates in the past 10 years so that I can see how these would affect my results. What does this do to my IRR and my cash flow?

If I do this and I determine that I will be able to survive and thrive should the worst-case scenario come to pass, the risk of losing my capital becomes very small.

If you cannot live with the worst-case scenario, you really must think twice about investing in the property. The same principle applies to any investment.

If you cannot afford to lose capital, do not invest in anything where you cannot determine the risk or cannot live with it.

As I have said before “Ignorance is the biggest risk there is”. This is very true of real estate investments. The biggest financial risk is the loss of capital.

The only way to determine the risk in a property or business investment is to use a system that will show you the cash flow and the probability of losing your investment. At the same time, the system must be able to identify the growth potential in the class of investment.

When you have a system that does this, by applying a particular strategy it is possible to determine what will happen with the risk and the growth once that strategy is applied.

The ideal situation is to use a number of different strategies in order to minimize the risk and optimize the growth potential of your investment.

I have developed such a system and I have been using it since 1987. I explained this in my thesis for my M.Sc. degree.

The best thing about this system is that it eliminates ignorance and emotion in any investment. Emotional decisions are seldom good ones when it comes to investments or money in any form. This is the reason why marketers employ emotion as the dominant method for getting you to choose their products or deals.

Conservative is the Key Word when it comes to Property Investments。

I am a conservative investor and I do not want to make emotional decisions when it comes to investments, therefore I always use a proven system.

However, any system is only as good as your inputs. It is easy to manipulate the inputs in order to try and “twist” the results. If you do this, you are allowing your emotions to rule your decision and in my experience, this is a very dangerous thing to do.

You have to be honest with yourself because, in the end, you do yourself no favors if you do not follow the system properly.

Here are some special rules and considerations regarding property investment:

General Wisdom regarding Real Estate Investments。

Property investment is a long-term decision and the factors which influence it, such as inflation and interest rates, constantly change. For this reason, I always consider the worst-case scenario when I evaluate a property. If it is still a good deal even in the worst of circumstances, I proceed with the transaction. If not I will stay out of it and wait for the next one.

This is because I am a conservative investor, as I mentioned before, I do not take risks. I take the rules seriously, and one of the rules of a Wealth Creator is: “If there is nothing to do – then do nothing”. This simply means if you do not find the right investment which adheres to your investment criteria, then do not invest. Wait and look for the right opportunities.

Don’t allow anyone to rush or panic you into buying with loose talk about “bargains” and “last chance” and “don’t miss out”.

This is classic sales talk, it appeals to your emotions, fear, and greed, and it short circuits the logical side of your mind which needs time to analyze and decide without pressure. Don’t fall for it.

For these reasons, I always consider 10-year moving averages. 

If I want to evaluate a property in new development and the only history available is for the past three years; and according to the history available, the area had an average growth rate of 50% over the last three years, I will still use the 10-year average moving rate.

The way I see it, no development is so special that the rules do not apply – if it lacks a history, it doesn’t mean history does not apply in this case.

Rules to Apply when Investing in Real Estate。

There are a couple of rules to remember before you enter into any real estate transaction.

It is my opinion that these rules will benefit any real estate investor:

1. Don’t make it personal。

If for example, you make an offer to purchase and the seller declines the offer, it is nothing personal, it’s not you he refuses, it is the offer. There’s a huge difference between you and the offer. Please keep that in mind when dealing with anyone.

I find a lot of times that if people do not get their way, they feel threatened or offended. This is a business transaction, no matter if you’re dealing with an auditor, an attorney, the seller, the estate agent, or the bank.

You will often find that things do not work out as you’ve expected. There may be obstacles like the bank does not approve your loan. If this happens, don’t be offended, and don’t give up. Just try another bank.

2. Cut out the emotion。

Most real estate investments are emotional decisions. Marketing relies heavily on appealing to the emotions and at the same time not giving the logical side of your brain a chance to think. So it is not surprising that the property market works this way too.

Plus, buying property is an emotional thing to do for most people who think in terms of providing “stability” for their family. (Why the quotation marks around stability?

Because the way most people buy a house gives less stability, not more. We won’t get into this subject at this point!)

To avoid these pitfalls, you will need a system to enable you to calculate the growth and to determine the risk of the investment.

I’ve talked to more than 120 000 people over the last five years about real estate investments and I have found that less than 1% can determine the growth of their real estate investments.

Be careful! Sometimes there is a lot of hype involved in the process and you must be able to determine what is real and what sales talk is.

In South Africa, over the last six years, the property has been an incredibly good investment. But that is only for six years. Have you considered what will happen should the interest rate increase again, maybe as high as 24%?

This is not so unlikely and it has happened more than once before, not that long ago. Do we have any control over the petrol price? It is the same with interest rates.

This is why you should not base your decision on emotion, instead, you must do the financial calculations.

If you can’t do the calculation, then wait until you have learned how to do that calculation. In the long run, your emotions will let you down. I can prove it to you. It’s a fact. Let me give you an example.

99% of the population will not be in a position to retire wealthy at age 65.

In other words, less than 1% of the total population will be rich.

Most people make decisions based on emotion.

Now this tells me something and I can take it back and relate it to the fact that with property, less than 1% can do a financial calculation. 

And it’s not only with the property. They make emotional decisions when they buy policies and when they change their jobs.

They make emotional decisions when they buy a car. But those emotions are going to cost them their carefree, early retirement in the long run.

There’s nothing wrong with emotion. Don’t get me wrong. It has been proven that if you do not have an emotional reason to get out of bed in the morning, you cannot do it.

Emotion plays a powerful role in our lives, and rightly so. The trick is to keep it where it belongs, which is contributing to your passion for your goals; motivating you, and keeping you enthusiastic and driven.

Keep it out of areas where it is not supposed to be, like property investment, and you will be making the right decisions, as well as balancing the two sides of your brain and your life.

For example, I have a passion to teach people how to become rich and how to stay rich. That is nothing but an emotion. But it’s a good emotion and I know how to control it. But when I make financial decisions my emotions play no role in the process.

Even very rich people have lost it all, because of using emotion in the wrong way.

3. Start by investing in a real estate close to where you stay。

Another problem that I see, especially if you are an inexperienced property investor, is distance and control. If you do not have a system in place and you’re buying a thousand kilometers away from where you live, you’re going to find it difficult to manage your investment.

If you are in a city and your investment is in a city 1,400 km away and the tenant acts irresponsibly, you’re going to have to find a way to manage the problem from where you are. Take that into consideration when you first buy property.

Once you’ve got the systems in place and you’ve got people who can manage that property for you, it’s not a problem. To begin with, buy something which is close to you so that you can go through the learning curve. 

Learn how to do it. Learn how to build the systems and get them in place before you start investing in other towns.

4. Start small。

Begin with what you can afford. The moment that people understand that property is a good investment they rush off and they start buying as many properties as they can possibly afford. There’s nothing wrong with it, but make sure you know and understand the implications of what you’re doing, that you know the pros and the cons.

Will you be able to manage your tenant and do you understand the financial side? 

Make sure that you understand the principles relating to property investment. 

Will your financial situation be strong enough to absorb the risks involved? In other words, have you looked at the worst-case scenarios?

If you are not sure then wait a few months or even years, before you invest in the second property.

Lay a solid foundation and work from there. If the foundation is not solid, you are going to experience serious problems later on. 

Create confidence in yourself and in your situation and build up a team of people around you. Get your systems in place and then progress slowly.

With property, it’s possible to buy one single property and make a profit of 80%, 500% or even more. Now if you can, for example, escalate that profit over a period of time, you’re going to find exceptional growth at the end of ten years.

There is a condition and that is that you have to maintain the growth. It’s not a once-off and now suddenly one knows what it’s all about and one can rush forward. Make sure that you understand the risks attached to each and every investment as well as the cumulative effect it will have on your budget.

5. Property is the Written Word。

And don’t believe a word that you hear. 

Make sure that you know and understand the implications of the contract. Make sure that if you make an offer to purchase you understand what you are letting yourself in for.

A lot of people think that an offer to purchase is just an offer and that it is not binding. But the moment that the seller accepts, it becomes a binding contract. If the seller promises all sorts of extras and they are not in writing, they are worth nothing.

The law requires the contract to be in writing. It is really that simple.

6. Try to Avoid Being the First one to Name a Price。

Find out what the seller wants. The moment that you’ve got a price the negotiating process begins. Let me give you an example. Let’s assume that I am selling a property and I want $100,000 for it. The buyer perceives this property to be worth $150,000. He offers me an amount of $130,000, thinking that it is a bargain.

Guess what’s going to happen? I will accept the $130,000 because it is $30,000 more than what I’ve bargained for. I may even ask $140,000 and the buyer will accept, thinking it is still less than the $150,000 that he is willing to pay.

But if the buyer asks me to be the first to name my selling price, I would say $130,000 because I know the negotiating process is beginning and chances are we will settle at the $100,000 which is what I wanted from the beginning.

So the moment that you mention the amount you’ve given away a crucial piece of information and information in the negotiating process equals power.

7. Seldom Sell。

Keep the property as an investment. Seldom sell. I don’t say sell, I say seldom sell. What do I mean by that? I mean that you are investing, not speculating. Many would-be investors confuse speculating with investing.

Over the past 25 years, I have seen what has happened to “investors” who speculate with the property. If you are lucky you will make a profit, but there is no guarantee that the market will not turn and that you may lose everything.

On the other hand, if you have calculated your growth conservatively and you buy with the intention of keeping the property for a longer period, your investment will grow and you will make a profit.

If the market conditions improve and you can get a far better return if you sell immediately, it is not a problem to sell, but it should not have been your intention from the start. Never get yourself into the deep end and over-extend your financial limits thinking you will make a quick profit.

8. Use Systems。

Another tip that I can give you is to maintain and improve your investment. If you keep it in mind the whole time, you will find that there are many ways to improve your investment. In my Property The Road To Riches DVD Courses, I show my students 24 different techniques for improving the growth of their investment and at the same time lowering the risk.

Start off with what you’ve got, then make the very most of it. This applies to many “investments” – yourself, your properties, your money, your cash flow, and your expenses. I see too many people who do not utilize what they’ve got to the maximum. Always work towards improving your investment.

9. Cut your Losses。

Many times a student will come to me with a property that’s not a good investment, clinging to it, fearing that they’re going to lose something if they sell it.

You know what? You’ve already lost.

If you cannot improve what you have got and it is a bottomless pit absorbing all your resources, cut your losses. Get out of the deal on the condition that you find something more profitable to invest in.

The moment that you understand The Formula For Riches, you will know that the second part of the formula says that you must get the maximum growth.

If, for example, your property investment at the moment is giving you a 30% growth on your investment and you can change that to a property investment that is able to give you an 80% growth on your investment, then you should do that.

It is logical. If you’re going to invest your surplus to receive better growth, then over a period of time, even if you make a loss at the start, you will absorb the loss and the increased growth is going to help you to become rich.

10. You make your Money when you Buy the Property。

I see for many “investors’ it is a strange concept and difficult to understand that you only make your money when you buy the property. You do not make the money when you sell the property.

You have only one chance and that is when you make the offer to purchase that property. So make sure that you know how to do the calculations.

Make sure that you understand the principles and make sure that you lock your profit in, the moment that you make the offer. You have no second chance with the property.

11. The Next Tip is to Fall in Love with the Deal, not the Property。

Do not fall in love with the property! Property investments, unlike some other types of investment, are very prone to emotion. We associate the residential property with homes, with families, with stability and security, and a future. These are all highly emotional thoughts.

The moment that you become emotionally attached to that property you’re going to make mistakes because your emotion is very strong and it’s going to give you thousands of reasons why this may be a good investment and why you can ignore the calculations.

If this starts to happen, take a step backward and get some distance, a step backward means taking some time out, away from the property, the seller, the estate agent etc.

It means time spent doing the financial basics. It means time spent unemotionally considering risk, growth, and your long-term goals.

If the calculations work and if it proves to be a good deal then, and only then, can you fall in love with the property. Make a financial decision and not an emotional one.

12. Always Buy with as Little Money Down as Possible。

If you do the calculations, you will see for yourself that it is better to work with other people’s money instead of your own.

We were raised with the perception that ideally, we should buy property for cash. That is not necessarily the correct way and it can cost you money in the long run. The reason is that if I can get growth of 50% and I have a registered bond on the property, I am working to receive income and not capital. I am paying a monthly installment on the bond and I’m converting my income into growth.

Which is going to give me capital at the end of the day?

Now let’s assume that I take that money and I buy a property in an area that grew at 12% over the past 10 years. My capital is growing at 12%, now 12% is a lot less than 50%, especially over time.

Let’s assume further that the bank is willing to give me a 12% return on my investment if I pay my bond as soon as possible. But the moment that I start paying my bond back, guess what’s going to happen?

The maximum return that I’m going to get is 12% and I know by using the bank’s money, I can get it up to 50% with the right property investment. 

There are huge differences between 50% and 12% and for that reason, I always buy with as little of my own money as possible.

But herein lays the danger for the average real estate investor. The higher the gearing, the higher the risk, if you cannot afford the worst-case scenario, then stay out of the real estate investment market.

13. Be Counter-Cyclical。

If you know the market, be countercyclical. If everyone else is buying, it’s time for you to sell. And if everyone else is selling, then it’s time to buy. That is a golden rule and if you follow it you’ll be surprised to see how well you’re going to do overtime.

14. If you have Two Properties both with the same Risk and both with the same IRR, go for the Property in the Better Area。

Another tip which I can give you is that areas that tend to grow, will most probably keep on growing. 

Why is that? 

Because of perceptions, if enough people believe that an area is good, it will be a good area, and it will stay a good area until such time that people change their opinion.

People can change their opinion overnight, but on the whole, they don’t. Not about areas worth investing in, anyway.

It takes time for changes like this to happen and for this reason, it’s easy to learn the trends when it comes to property in specific areas. 

You can predict what is going to happen with a property in a certain area with great accuracy, based on what has been happening up till now.

15. Use Market Momentum。

Make sure that you understand how to use market momentum. In property, the market builds up momentum as long as there’s positive growth. If there’s enough momentum behind it, the market will violate all known rules and it can change rapidly, mostly because of people’s perceptions.

Luckily even if the change is rapid it still does not change overnight, unlike the stock market. Normally the indicator is the interest rate. So unless the interest rate is changing, the market will keep its momentum.

16. Facts, not Emotion。

The next rule to remember is that you should use the facts and not your emotion. Fall in love with the deal don’t fall in love with the property.

I never, ever buy a property unless I’ve done the calculations. If the calculation does not work, I will not buy the property. There are more than enough bargains out there, despite what you may have been led to think. It is not necessary and it is financially dangerous to buy on emotion.

As an investment medium, I see real estate as a long-term investment. There are many people who buy real estate planning to sell again within six months or a year with the intention of making as much money as possible.

It may work over the short term, but what will happen if the market changes? If you buy real estate and the market turns around, guess what’s going to happen? You can’t sell a property as fast as you can sell shares. So you’re going to be the proud owner of a property that is losing value, costing you money and you won’t be able to sell it at a profit.

17. Invest for the Long Term。

That’s why I don’t speculate. It is better to invest with the long term in mind, then should the market stay in your favor you can sell and make a huge profit. But if the opposite happens and the market changes and you cannot sell, it won’t matter because you have done your homework and you will be able to keep and maintain your investment until the market changes for the better.

This is what I mean when I say you make your money when you buy, not when you sell.

If the sums add up before you buy, making changes and worst-case scenarios into account, then it doesn’t matter what the market does because you are still getting growth over and above your expenses.

If the market goes up and you decide to sell, that’s a bonus. If not, you still have an asset - a real asset not a liability - that puts money in your pocket every month. It’s a win-win situation and it’s one of the key secrets of the Wealth Creator.

18. Income is more Important than Capital。

It is easier to build and maintain your riches by using passive income streams than by trying to build wealth with capital.

19. Be Careful of the “Experts”。

Another rule that I always add is that you should talk to the professionals but be careful of some so-called experts. There’s a huge difference between a professional person and an expert.

Normally an expert will give you advice and tell you what to do and how to do it, while the professional will do his job.

The expert doesn’t aim to help you become independent of him, his advice, or his products. He aims to keep you dependent on his version of the truth because otherwise, you might realize how poorly his products work for you.

The expert has an ulterior motive when he deals with you it is good for him but not good for you. For example, he may wish to sell his own products, earn a commission, or earn fees that are higher the longer he takes and the more “indispensable” he becomes.

On the other hand, a professional is truly qualified, by which I mean more than the fact that he has a framed degree hanging on his office wall – I mean, he follows the same principles that he shares with others, he runs his own affairs on the same lines as his recommendations to clients. He aims to provide real value and information which helps his clients become more independent, more aware, more informed, and more responsible.

A true professional does not give his time away for “free” or hide his fee in the small print. A true professional tells you what it costs upfront and that is often more than you expect, but this is because of your conditioning.

For example, the average financial planning “expert” gives you a free planning session, but he and his employer actually take let’s say $3,000 in fees and commissions on the policy – which would come as a big surprise to the average policyholder in spite of all the so-called transparency rules and procedures the industry is supposed to follow.

On the other hand, a true professional who follows the same advice he gives his clients probably does not even sell or earn commission on a specific product or deal, but he may charge say $300 per hour for his time. 

This, for people conditioned to expect “free” planning, is very high, but the irony is that it is less than 10% of the hidden fee of the “expert”!

This is why I say that the only expert as far as I’m concerned is myself and of course, in your own situation, the only expert is you.

It’s your money and the only person who can lose it is you. This is the best motivator for taking responsibility, and taking responsibility is essential for sticking to the formula.

So seek advice from truly qualified professionals only and let them help you to achieve your goals, but be careful of the so-called “experts”.

20. Invest in Yourself。

Another rule is to learn and understand the business which you’re in. If you’re into long-term investments, understand what long-term investments are all about. Learn about the risks attached to the investment. If you invest in property to make a quick buck, understand what you are doing.

Understand the risks involved and make sure you are prepared for them. If you’re into a renovation, understand the game. Become an expert in that game, before you invest a cent in any specific property or project.

21. Master the Trade。

Don’t learn the tricks of the trade, master the trade.

If you understand property as an investment, it becomes clear what you must do. There are always basic fundamental principles that you follow, and those principles are universal. They apply anywhere in the world.

Another way to master the trade is to do my Property: The Road To Riches DVD Course, along with as many different courses on real estate investment as possible.

There may be a number of different workshops you can attend or books you can read. But however, you plan to do it, make sure that you learn how to become a master of your trade.

Learn the rules I’m giving you right now understand them and then apply them before you enter into any property transaction.

This is not only applicable to property, it’s also applicable to business or to any other kind of investment in which you would like to involve yourself.

So, to summarize:

•  Don’t take it personally
•  Cut out the emotion, and do the calculations. If they do not add up, then get out of the deal
•  Remember the problem with distance and control - if you do not have a reliable system to manage your long-distance tenants, it is better to start with property closer to home so that you can manage them yourself.
• Start small - begin with what you can afford and remember that most people bite off more than they can chew
• Remember that interest rates go up as well as down and they do it quite often – make sure that you plan for them.
• Property is all about the written word - don’t believe a word you hear, the contract is all that matters; if a deal does not work out and you end up in court, then it is the contract that will determine the outcome because promises mean nothing
•  Never be the first to name a figure - this is a valuable tool in negotiations because the first to name the figure (the amount) has given up a major advantage.
• Plan to hold onto the property and seldom sell; know what you are doing and stick to your strategy.
• Improve your investment by utilizing your surplus better ? Never forget that you make the money when you buy the property which means you have only one chance to make the right decision - before you buy the property – so do your homework.
• Fall in love with the deal, not with the property – most people buy a property based on emotion and that’s why most people don’t consistently make money out of a property. Remember that the trick to being a successful investor is to overrule emotion with logic and make wise financial decisions.
• Always buy with as little money down as possible - according to my experience and the application of the Property Pro Program, it is better not to use your own capital if possible, but in this case, make sure that you can afford the deal especially if you want to make use of negative gearing.
• Areas that tend to grow will most probably keep on growing - this law of property has stood the test of time, but it is not infallible, so keep an eye on the growth of the area.
• Use numbers, not emotions.
• See property as a long-term investment and build passive income streams, because it’s a lot easier than trying to build capital the only expert there is when it comes to your money is yourself, so apply the first law of a successful property investor and invest in yourself before you invest a cent in any property investment.
•  Get to know the business which you are in, learn as much as possible, look at different strategies and attend as many seminars as possible.
• Don’t just learn the tricks of the trade, master the trade.
• Before you buy a property make sure that you have done due diligence on the property.

For more information on the Formula for Riches;