For years, Ok decades now I have believe that net worth is the most important financial factor. I’ve been tracking my net worth since 2004 when it was only 3 digits. I even have a spreadsheet from back then when I included pop cans and the cash in wallet in my net worth calculations. The over arching long term goal has always been to build my net worth so that in retirement I can withdrawal 5% a year, forever. Want to live off of $50,000 a year? Then build a net worth of $1 million. Although net worth is important I have come to learn that it is not the most important factor for financial freedom.
What’s the goal of $1 million is savings? It’s the cash flow it generates. It’s the $50,000. Cash flow, not net worth should be the primary measure of monetary success. Your ability to position assets to generate cash flow is an extremely important part of the puzzle towards financial independence and long lasting wealth.
It’s Not How Big Your Net Worth Is, It’s How You Use It:
I want to start out with an example of a rental house and that will give the framework for the rest of this article. Here’s the example of my first BRRR rental house. I paid $24,000 for this 2 bedroom house with a finished basement, a finished basement with substantial mold damage. I rebuilt the basement and made an official 3rd bedroom by adding an egress window. I had spent $8,000 on the rehab for $32,000 total. I then had the property appraised after 6 months. This appraisal came in at $64,000 and the bank was willing to lend me 75% of this amount, $48,000. I paid back myself for my $32,000 in expenses and put $13,000 in my pocket after paying closing costs. This gave me a total of $16,000 of equity in this house. I added $16,000 to my net worth. Here’s where the fun comes in. I rent the house out for $900 a month and it cash flows $500 per month every month. I added $16,000 to my net worth, but increased my cash flow by $6,000 per year.
To generate $6,000 in cash flow using just net worth in a stock retirement account with a 5% withdrawal would require $120,000. I generated this cash flow off of $0 in cash and $16,000 in net worth. You can’t eat net worth, you can eat cash flow.
It would take 62 houses with the same numbers to have $1 million in equity, and it would generate $372,000 a year in income.
Examples of Net Worth:
Let’s walk through a few examples of how people with the same net worth can be in vastly different financial positions:
James is a high income upper management worker. He earns $200,000 per year and spends $130,000 per year. He is excited because he finally broke the $1 million net worth value. His house is worth $600,000 and its paid off. The rest of his money is in his employers 401K plan.
What value does James’ net worth provide? Well he has a paid off house, although he probably has to pay around $10,000 a year in property taxes and insurance on it. His $400,000 in retirement can provide him with $20,000 per year in income using a 5% withdrawal rate. Total cash flow: $1,667 a month. For a guy who earns 10 times this amount, he has a long way to go before being financially independent.
In addition to his $1 million net worth only bringing in $1,667 a month, and likely only $833 a month after paying his property taxes, James can’t access any of that money until he is 55 without a penalty, unless he ties his hands and signs up to take equal monthly payments over a term of 5 years or greater using the SEPP method. An SEPP is highly conservative and will only allow him to withdrawal around 2% of his balance.
Tiara: Tiara is 60 year old and earns $50,000 a year and has been saving 20% of her pay for decades. She lives off of $35,000 a year. She has a paid off $50,000 house, 1 paid off rental house worth $100,000 that bring in $10,000 a year in net income, and $800,000 in a retirement account.
Her $1 million provides her with a place to live that comes with a $833 a year tax bill. $10,000 a year in rental income, and $40,000 a year from her retirement accounts.
Her rental property covers a third of her yearly spending. With $50,000 of total income coming in she is financially independent with a $1 million net worth and a 30% buffer!
Steve has a net worth of $200,000 and he spends $35,000 a year. Steve uses the BRRRR method to invest in $40,000 – $50,000 rental houses that provide him with $6,000 per year in income each. Using the BRRRR method Steve leaves no cash in each deal, but builds up 25% equity by adding value to the houses he buys. With each house being worth $60,000 and him getting loans of $45,000 that completely pay him back for the investments, he ends up with $15,000 equity in each house. Steve owns 10 houses like this and he owns a $50,000 home that he lives in that is paid off.
Steve’s $200,000 net worth is composed of $50,000 in his primary residence which comes with a $833 yearly tax bill and $150,000 across 10 rental houses that bring in $60,000 per year in revenue.
What Does This Show?:
Home Equity net worth is trapped equity. The only cash flow it produces is when the loan is fully paid off and the expense is gone. For a $150,000 home with a $500 a month mortgage payment, when the house is paid off the $150,000 is generating $6,000 in income.
Stock Investments are highly volatile. People talk about how real estate is risky, but its no where near as risky as stocks. Stock investments as a whole tend to suffer from strange market forces. The value of stocks gets ran up all the time without a subsequent increase in the cash flow or net income of the company. Apple is a great example. Over the past 5 years Apple’s PE ratio has climbed from 10 to 40. As fast as this climb has happened it can fall much faster. When other people are not willing to pay X multiple of earnings the stocks can fall drastically, as happened in 2000 and in 2008. This is something that is out of control of an individual investor.
For real estate, you have full control and the value of the home is irrelevant, except for placing the first loan 6 months in. Beyond that it doesn’t matter what someone else will pay for the house, what matters is what income the house can bring in.
Measuring cash flow:
Cash flow is relative to your expenses. If you spend $200,000 a year $25,000 in cash flow is not as significant as it is if you spend $30,000 a year. Your Cash flow freedom quotient is your passive cash flow divided by your annual spending.
Any number over 1 is fully financially independent. Any number over 1.25% is upwardly financially independent. It’s not all or nothing, every bit closer makes a difference in the lifestyle you can live.
Is There Something That Matters More Than Cash Flow?
I think I’ve made a pretty good argument for cash flow over net worth, but this is only half of the story. The financial side of financial freedom is cash flow, but the freedom part is about measuring your time. A typical American works 40 hours a week for 50 weeks a year, this is 2,000 hours. The typical married couple is working 4,000 hours per year. Some people average more, some average less. We will use 4,000 hours as our baseline. Your time freedom quotient is calculated by subtracting the hours you work from 4,000 (2,000 if single) and dividing by 4,000.
My Example: In 2020 I worked 867 hours and Mrs. C. didn’t have a job. by this standard we are 78.3% free.
4,000 – 867 = 3,133 / 4000 = 78.3% Free
Opposite End of the Spectrum Example: They could each work 60 hours a week for 6,000 total hours. They are -50% free.
4,000 – 6,000 = -2,000/400 = -50% Free
Days of Freedom:
Another way to look at this is through days of freedom. For example I worked 867 hours last year. If I worked 4 hours a day for 217 days I had less freedom than if I worked 12 hour days for 72 days. Once again the average person works 5 days a week for 50 weeks a year for 250 days total. Your daily freedom quotient is found by taking the total days normal people work, subtracting the total days you worked, then dividing by the total days normal people work. In my example, between Mrs. C. and myself I worked 70 days last year. A normal couple would have worked 500 days.
Same as above 500 – 70 = 430 430/500 = 86% Free.
Financial Independence isn’t all or nothing. The internet retirement police may disagree, but freedom is measurable, both from a monetary standpoint and a time standpoint. Without being financially independent or fully retired, I’ve been able to build a lifestyle that provides 78% – 86% for the time that fully retired people have. It isn’t all, but it’s a whole heck of a lot better than nothing.
Don’t just focus on net worth. Net worth is important, but we also need to be looking at cash flow and our time flow. What steps are you taking to increase your cash flow and decrease your hours/days worked?