Why Interest Rates Matter Less Than Income Growth in Real Estate Investing | Ep 148

Given all of the economic it's not really turmoil, but just uncertainty, I thought it would be cool to review a video that has been seen millions of times that talks about how the economy works. And that's what we're gonna do on the Furlo Capital Real Estate Podcast, where we dive into the intricacies of passive real estate investing. And our mission is to equip people to understand the economy so that they can invest wisely and improve housing. I'm James and this is another solo episode. Trying it out. And um yeah, gonna see how it goes.

So if you're watching on YouTube, awesome. I got some slides that'll go with what I'm talking about. And if you're listening to the audio piece of it, don't worry. I'm gonna say it all out loud, so you'll be fine. So I want to jump in, and the idea behind it is That we're all watching interest rates because um or at least us in the real estate industry are because they are ticking up and up and up and it feels like it could be a thing.

And so This video does a good job of explaining yes interest rates are important and they do matter, but there are other forces at play that matter so much more. So we're gonna dive into that right now. And I gotta make sure that I actually show my notes so I'm not flying blind.

Okay, so How do I go forward? So here's the number that we're all watching, right? It's as of my recording today, it's at 7. 28 % for a 30-year fixed mortgage, which is uh feels like a big number.

Unless you're older and you've been around for a bit and you're like, oh no, this is like it's totally fine. We're not even in double digits yet. Like what are you worried about? Um but relative to what things were, it does feel very high. And I'm gonna kind of explain where those low interest rates fit in in this broader economic cycle. And if you think about it, uh this was um so and The interest rate that we're looking at are paying is that 7.

28%, you know, a little over 7%. Whereas the federal funds rate has just recently gone from 375 up to 4%. And that's um At least that's what their target has been. And um so yeah, uh that's that's part of the story, but not the whole story And I really think in a lot of ways we're asking the wrong question, right?

Like I know a lot of investors are asking, well, when will interest rates fall? Which believe me, I've been in that camp as well. Um, but I think uh it's a nice question to ask because in some ways it's really easy to measure and to look at and it's kind of a you know it's a big headline. number, but better is to ask is income growing faster than debt?

And I think that that's uh That's important both as a personal investor in a singular investment as well as looking at the broader overall economy. And so uh the kind of people who get this wrong are Rate Watchers, which again, I I can be into that camp.

And then there's also the yield chasers. And these are people who, uh, yeah, they're just trying to get the absolute maximum return on an investment, which, don't get me wrong, is not a horrible thing to do. But it can limit how you're looking at things depending on what cycle we are inside of the economy.

So there are three forces that run the economy. Okay. The first one is productivity growth.

Okay, this is what you want to be just slow and steady. People are getting just more efficient, better at whatever it is that they're doing. And this is the thing that over decades, centuries is ultimately what's going to matter. The second force is the short-term debt cycle. And this has a massive impact, and we're gonna spend a lot of time diving into this one. Um this is about like five to eight years-ish, and it's the thing that the the central bank Uh uh can steer, I guess is probably the right way to say it, has the most control over and can kind of put their thumb on the scale to um To do it, you know, to to make an impact.

And then the last one is the long-term debt cycle. Now these are ones that are like 75 to 100 years old. And this is where debt can raise faster than incomes. And it's not always bad. It's just kind of, it can reach an inflection point where it's it's actually really bad.

So here's my question for you. For every dollar of cash in the US, how many dollars of credit is there? So I'm gonna wait. Have a second, let you think about it. Uh, you know, is it a one-to-one type of thing? Is there more dollars uh that are floating out there for credit, or is there more credit than dollars?

And the answer is that credit dwarfs cash. It's unbelievable. Credit is about 17 times greater than the amount of cash that is out there. And I actually think these numbers, um it was this uh it's a Ray Dalio video um that was made oh jeez, it was a while ago Um so I actually think these numbers are are old.

Um, but the the ratios are still very, very true. And I mean it's it's crazy how much bigger credit is than cash and therefore the like the what is it the M1 money supply is less important. It's really about like what's going on with credit. That's what drives um a lot of markets. So uh there was this cool um analogy that was in the video that will kind of serve as this overall like we'll use it for uh for a lot of examples.

Imagine you got a bar. Okay. You go in and you order a drink and you get it on a tab, right? Which is essentially your promise to pay later, right? And they grab your car, they hold on to it, that kind of thing. And then when that happens, credit is born. It's an asset for the bartender and it's a liability for you.

And that was just created. out of thin air, right? It didn't exist and now it does. And then eventually you settle up, right? You pay the tab, and both the asset and the liability disappear. They're gone. Very simple example, but it will act as the foundation for showing how the overall credit markets work and what their impact is on the economy. Okay, so you can think like every single loan that is out there works like this.

And if you've got credit cards, which I know you do, um you definitely know that this is how this works. And what is essentially happening is that borrowing is pulling spending forward, right? Now you get to spend more than you make. But then later when you have to pay it back, you now have to spend less than you make. Okay. And and that and that dynamic is really important and the timing of when that happens and where everybody is in that cycle of when it's happening is really important.

But the the key part is that when you're using credit, you are pulling spending forward. I mean think about like up for home loans, that's like that's the That is the selling point. Get in a home today and use debt to get to it because if you wait until you have the hundreds of thousands of dollars saved up, you're going to be too old. And you're gonna have to wait 30 years, right? Or more or something, right? And the idea is you can get it today.

And ideally, you know, the the pitch is that the asset will continue to go up on over value over time as you're paying it down. And so it's a good investment That's kind of the the idea behind it. But again, using credit lets you spend, it lets you pull spending forward. That's the big idea. But here's where things start to get a little bit crazy. So When you're spending, that is someone else's income.

So in this example, you earn $100,000 and you borrow $10,000. Therefore, you are spending $110,000. Easy peasy. But again, you spent that somewhere. So that was someone else's income, you know, in the aggregate, right? And so they earn $110,000, because that's what you spent. Maybe they go off and borrow eleven thousand because they can borrow 10% of it.

And so they're spending $121,000 And then it goes on and on and on. And and you can see how this starts to balloon really quick. And that's exactly how you get to 17 times the credit versus the cash that's out there. So when a lender is trying to figure out should we lend it to you, they're really asking two questions.

They're asking, do we have the ability to repay? And I'm kind of like I'm I've got a couple different concepts that we're gonna kind of pull together into one. But anyways, uh they're asking, do you what's your ability to repay? And they have a whole bunch of different ways of measuring that, like what's your income relative to your debt? That's a huge one. And then they also want to know, is there any collateral that we can like a valuable asset that can be sold if you don't repay? And if you can combine the two of them together, man, that's awesome. They are happy to give you a loan.

Uh in the In the investing world, um, these kind of translate into uh the DSCR, which is the debt service coverage ratio. That is essentially the ratio of the leftover income versus what the mortgage payment is. Depending on the lender, they want to see your income to be twenty percent more, sometimes more, than what your mortgage payment would be. And then the collateral piece, that's measured in that loan to value. They want to make sure that there's plenty of value in the actual collateral so that if they have to sell the buyer sell the loan, essentially, they're not going to lose any money plus all the other fees and expenses and stuff like that.

So if you got both of them, awesome. And if you're lacking on one of them, you can kind of like you can kind of combine them a little bit. Like you may not have, maybe you don't have a strong income, but if it's a super low LTV, they might be willing to do it. And if your income is amazing, they will oftentimes, especially if you personally guarantee something, they can be a little bit more flexible on the LTV. So it's kind of interesting how that works. The other really important thing is what are you buying the what are you getting with the credit That's kind of how to say it.

Are you getting a tractor or are you getting a television? Right? So the tractor, right? You borrow it, lets you harvest more, earn more, and you repay it. It's a it's a productive asset. It's an asset in all the ways that you would like to think of an asset, right? It brings accrues all sorts of benefits to you. Or are you getting it a television?

Right? That's where you borrow it, you watch more, but you don't get any additional income to repay it. Less of an asset, some would call that a liability. Um, but uh but the the rental, the tractor rental, that is the that only I don't want to say it, um a rental a property rental that you invest in is a tractor only if it covers the payment.

And that I think is is a key distinction when Um when you're thinking in terms of is this an asset or a liability, like if it's actually putting money in your pocket, it's a very derived Kiyosaki concept, it is therefore an asset. If it's not, if you're losing money,

it's not really an asset to you. It's um it's subtracting from you And uh let me check my notes here. Yeah, so um, oh, there was this uh this one liner in there that I thought was good. It's um You have leverage on income versus leverage on hope, right?

And so you want to have leverage on income. That's why rental real estate is really good and awesome. And that's also why the stock market can be less good and awesome because oftentimes it is based on it growing in the value as opposed to some sort of recurring income for it. Not to say asset real estate, not to say that the stock market is bad. It's just it's just different. Okay, let's talk about that short-term debt cycle. That lasts five to eight years. So here's kind of the the pattern of of how it works, right?

You got credit, it's flowing easily, life's great, and people like, yeah, let's go out, let's get stuff. And so as a result, spending rises. Life is good. As a result of spending rising, you get the old supply and demand curves. If demand goes up, eventually supply is going to go up. And or if supply stays the same, you're gonna have prices will rise because you know if you have a lot more people asking for it, you can you can get more for it.

We see this in the real estate market all the time. There's a ton of demand, sweet, we're gonna charge more for the rentals. But that starts to cause an inflationary pressure, and so the central bank raises their rates. They want to increase the rates to try to keep inflation under control When that happens, payments have to rise. And we've all seen that with the interest rates, right? I was listening to someone, I guess this was last week. Um He was saying that the general math here is that a 1% rise in the interest rate is about a 10% increase in the monthly payment that you have to make.

It's very rough, but it's a good general rule of thumb. And so that's kind of the they raise it. So when they raise the rates, payments are going to rise for the same amount of debt. And therefore, your spending and income is going to drop because you are now putting more towards debt payments. And therefore, think about that supply and demand curve again. Demand has now dropped, assuming supply stays the same. You are now going to have prices drop back down.

Sometimes, you know, that might be a recession. Oftentimes not good. And therefore the bank goes, oh no, we got to make sure that people stay employed and that things are working. So we're going to lower the rate some Which then ultimately frees up the the the cycle, right?

And so that's kind of the cycle what it looks like. And this is this line here shows that um That it will keep growing. And here's what's kind of crazy about it is um so this is a squiggly line that is generally in the up in the upper direction, and that is showing that each cycle ends with more debt.

Okay, so and that was because of that little cycle that I that I just showed you. Uh that was very much showing, you know, in each situation, you're still going into debt, you're still buying stuff, you're still doing it. And that might be okay, and when we'll look at that in just a little bit. But I think it's just really important that that debt in the within that five to eight year cycle continues to grow.

It's just a question of well, how fast is it growing? And again, for an individual, it might go down because it causes a problem. But at a overall society level, it it may not be one. And we have seen this been and we have seen this happening uh most recently where It seemed like we're you hear more and more reports about how world credit cards are maxed and people are mixing payments and and it's like it's that cycle is just it's it's continuing through.

Here's what's kind of nuts. When he made this video, his uh his rates were a lot less. And so uh where we're at today, again, that Fed target is at like 375 to 4%. We're at 7. 28-ish. And a year ago, mortgages were at 6.

34. So they have gone up about a percent. And therefore, those debt payments are about 10% higher for anyone taking out new debt right now. And um, so it's kind of a big deal. And I got a I have a story about that. Um where uh I was looking to buy a property.

It was a forty unit place up in Astoria. This was a few years ago now. This was when that initial raked hike happened and we had it under contract and we're looking at the deal and I don't remember exactly what the percentage was. I mean it was like it was like a three percent type of mortgage and the numbers all worked. And what was interesting is that the owners took their time to to kind of get back with the paperwork.

They wanna have lawyers check it, which is totally fine. It just It drug out and it drug out over a couple of months because it was just like we'd get the feedback, they would take their time to look at it, and it would just kind of like that would be the thing. Well, it just so happened that in that amount of time for when we first got it under contract, again, rates were in like that 3% range, over that two-month period, they were up to 6%. And again, if you think about the that cost difference there, it was a 3% rise.

All of a sudden my cost rose 30%. And the price that I was gonna pay for the building didn't make sense anymore. And I had to lower the price about 30% in order to make it happen, which ultimately they said no. And I Totally get it. And um but it was tough, right?

And so I've I felt that. And um and that was that that's That's that exact issue. And honestly, in some ways, that's why they do it, right? They're trying to keep the prices under control because inflation was starting to creep up. And this is what happened, right?

It like Obviously it didn't work out, but I was trying to lower the price of that property to match it. So in a lot of ways, that was that was a central bank's plan working. Kind of kills me that the way that it works is by disincentivizing people from doing things. Because if you think about that supply and demand curve The demand isn't the only thing on that curve, right? There's also the supply. And if you can increase the supply, that will also decrease prices. But um our central bank doesn't worry about that, um, which is how the system's set up, which is fine.

I would guess that would be more of our uh just the the overall government trying to figure out how to do things and We won't get into the tariff discussion because that also doesn't help um at all and I guess I'm more of a free trade kind of guy Um keep the supplies wide open. Outside of, I mean, I guess I you could protect US jobs. That's fair. But anyways, um, that's kind of where where I live in that.

All right. So my question to you, that was my property where we like we felt it in real time while it was happening. Uh my question to you is have you had any where you have felt that? Um is it either an existing one that you've tried to refinance? Or one that you've tried to sell and suddenly everyone else is like, dude, sorry, man, like that the this doesn't the numbers don't work it out anymore. Or how has this impacted your underwriting for um deals that you are looking at?

Curious to to hear how that's felt for you. But ultimately what matters isn't necessarily the amount of debt, it's the ratio, right? It's uh Let's see, what do we call it? It's called the debt burden. That's what uh Dalio calls it. So it's your debt, whatever that is, your debt payment, divided by your income.

This is actually something that we look at while screening tenants. Because I care, I mean I care some about their actual credit score itself, um, but this is a ratio that we calculate for for everybody because if they have too many debts Even if they are making enough income, it doesn't matter, right? And so um so we care a lot about this this uh this ratio. And um And it as long, and so here's what's interesting, right?

You can continue to have more debts and they can go up as long as the income is also going up, right? It's the ratio that is important. And The interesting thing about like real estate and even the stock market is those are assets that will go up in value. And even though it's not necessarily cash in your pocket, it will make you feel like you have more money and that you have more income And so, um, and even banks will look at it that way because they oh cool, more collateral than we can collect.

Awesome. So it makes you more credit worthy. So you are more inclined to increase the debt, even though the actual income coming into your pocket may not Like it's not a one-to-one correlation that it's actually there. And so um it's really important. Uh that that ratio you want to look at it.

And as you can imagine That if that as that ratio gets closer and closer, and eventually if the income doesn't keep up in the debt anymore, that becomes a problem. And so let's talk about that. When repayments outgrow your income, what happens? So you got repayments, they're just growing faster. And they could be for all sorts of reasons, right? Um Maybe you don't get a raise that year.

You know, it doesn't have to be extreme, like you lose your job or whatever. Um, though it could be. Or yeah, you have a loan that gets reset or Something, something comes up, whatever. Um, they're they're just going faster. And so as a result, people rightly so cut their spending as they should.

Okay, we gotta tighten the belt, make it work. Well, when you do that, remember what we talked about at the very beginning. My spending is someone else's income. Therefore, incomes will fall because spending has fallen. And when that happens, because your income has gone down, you are now less credit worthy, as we were just looking at. And so you can borrow less money because the banks go, ooh, your income is less.

Not great. That ratio doesn't look as good as it used to. And so as a result, and here's the part that like That kind of like gets me is that your repayments will keep rising on you. Like those don't necessarily stop.

And so this is a point where in the long-term debt cycle, your debt payments will that debt will peak, right? And that's just because the debts simply become too big uh for for you to handle. And this is where like it you can get into yourself into a lot of trouble, both as an individual and as an overall economy.

And I know that like that's something that um people will talk about with the US uh, you know, the federal government debt. Like, oh my gosh, debt payments are getting so big. What do we do? Which is not a perfect analogy because the US government can print its own money and it can print itself out of the problem if it wanted to. It just chooses not to for some crazy reason. And uh But uh but that's the cons that's the same concern that everyone talks about when they talk about the the debt increasing for the US.

They go, oh my gosh, we're paying more in interest than anything else, and blah, blah, blah. Yeah. That would matter if the US didn't print its own money, but whatever. It's like borrowing from itself. Um it's very strange that You ever know what we think it's an issue? Outside of we're anthropomorphizing our own personal finances, because we are not fiscally sovereign.

and um uh on to the US government. But um those changes all sorts of rules. But again, the important part is that your repayments outgrow income and your spending is cut and your income falls and it causes all sorts of problems.

Um let me make sure. And this has actually happened multiple times where we hit this point where this happens as an economy. It was in 1929, the United States, great recession. Just a recession, bummers. Uh Japan went through it in 1989. And then the US, Europe, and much of the world got to experience it in 2008. And depending on how old you are, you very much remember it.

I bought my first property in 2009. It was a duplex. It was like right on the tails of this. And um, which made me seem like a genius investor, but it was more like I caught the wave just right. And um and for every single one of them, the reason is the same. It's just debt burdens became too big. And so things had to change.

And they do. Okay, there's a difference between a recession versus deleveraging. And um, and this was something that I didn't actually know the difference between before kind of diving into this video and trying to understand it. So if you're in a recession, you just cut rates. No big deal. Borrowing picks back up, the economy restarts, we're good to go. And this is the one I think we all know and love, right? And in some ways we're like, all right. Come on, Fed, cut them, cut them rates so we can start doing this again.

Or you could be going through a deleveraging, which is where rates are already near zero, and this is what it was like. Geez, four or three years ago now. And and and like you have no room to you can't do anything about it and debt burdens are already too big. Lenders stop lending, borrowers stop borrowing, and it's just like, oh, this is no good. You just you just run out of options.

Not completely, as the US showed, but you do run out of some options, and we'll talk about one of those options. Um right now. So here's what's also really interesting, just as a personal level, is that paying down debt can actually backfire. And I know I can hear you saying that, James, what is wrong with what's wrong with you? Dave Ramsey is gonna come after you like what are you talking about?

Alright, so here's the deal, right? Everyone cuts their spending. Cool We do it. But again, as we discussed, one person's spending is another person's income. So therefore, incomes fall. And the problem is that the incomes can fall faster than the debt is being repaid. And as you remember, that the the ratio, the debt burden gets worse.

Ah can you imagine? It's like you're you're your income is and again this it's weird it feels but it feels weird from an individual level and individually like everyone you 100% should do this like it's a highly rational thing to do But it's in the aggregate where again the overall aggregate spending, if that starts to decrease, therefore companies like they have to cut costs, means fewer jobs, higher unemployment.

Therefore, overall there's less income happening. Which means, and this typically will happen faster than the debt can be repaid, and therefore that ratio starts to creep up. And so even though something that started out as like totally rationally makes sense to do as an individual, as an overall aggregate economy, causes a problem. And um it can it can hurt.

And you're kind of like I can hear you saying like, okay, James, so like what do I do about it? I'm like, yeah, that's a great question. There's some hypotheticals on how to handle it. I part of me is like as an individualist, I just go for it. Um don't worry about the aggregate economy. other than understanding what is happening within the broader cycle, and then you can make your own best uh choice for it.

So there's four ways That debt burdens can come down. Okay. Cause this is this situation that we're in. We're like, okay, now what? Number one, as we already talked about, cut spending. Go for it. Um, someone called this austerity. Um, this is usually what you do first.

Like it's 100%, hey, um, our debts are a lot. We need to stop eating out as much, right? Rice and beans, beans and rice. Back to the old Dave Ramsey line. The other one is you figure out ways to reduce your debt, right? This is through defaults and restructuring. Classic pain in the butt.

No one wants to go through it. It kind of feels like you um you cheated, I guess. Um 'Cause you weren't supposed to. Though I do find it interesting, and we talked about this in uh previous episodes somewhere, um, that this is an example of uh one of the things that actually makes the US pretty great is we actually give you this option. You don't go to debtor's prison. you can refinance not refinance, but you can restructure and actually get out of it and move on, which is pretty cool.

Uh the other thing that you can do is um you can redistribute wealth, right? From the haves to the have nots. And and um and we've seen some of this happen. as well. Um and then the final one, which is generally different than all the others, is you print money.

Oh man, the US is good at this one. Right? And and this is what we saw happen in the 2000 eight to twelve time period where they like they really got after the printing of the money. And and If you think about it, printing money works in such a way where if you print money, money becomes like the individual dollar becomes worth less than it was earlier.

So therefore your debt amount is now worth less, relatively speaking. Um just so it's kind of one of those like, yeah, having debt around and some inflation for debt is actually fantastic because again, over time, it just makes it not worth as much. Uh you could think of it this way. If you bought a house, I don't know. 30 years ago, let's just say, and they were interest only payments. And um that 30 years ago for that house, you spent, let's just say, a hundred grand on the house.

And I just for the sake of argument, it was a hundred percent leveraged and you're doing interest only payments on that hundred grand. Over the 30 years, it's like, you know, at the time, you're like, oh man, that was a huge number. That was big. Now, fast forward thirty years later, that same house, I don't know, let's just say it's worth half a million dollars. Right? Like that debt's amazing. And you're like, oh, I love that I have this and it's only this amount so great.

And that's the effect of inflation. I'm there making it worth less, even though the payment from an absolute dollar standpoint is exactly the same. So uh printing money can be good when done responsibly. And and that's the goal. that Dalio was talking about is you want to have a beautiful deleveraging. And part of his point is like this is going to happen.

Like it is a thing, it is part of the cycles. deal with it. So how do we do it in such a way where it doesn't totally disrupt everything? And um this is his ideal scenario. Where you find a balance between the spending cuts and the defaults and a redistribution and the printing of the money. And again, he's talking about like from an economic standpoint. And our government tries to do this, but man, you just have competing interests and and other things in there beyond um just the economy, which is as it should be, right?

There's a lot of other competing interests that are more important than the economy itself. And so uh so it's trying to find those, trying to find that balance. It doesn't work out very well in my experience. Um, but the goal is to try to find it, and mathematically, like it could happen. Um, so What you want to do is you want to have debts falling, ideally relative to income, right?

So that ratio that we were talking about doesn't get out of whack. You wanna you can also do it in such a way where the real growth is still positive, maybe not as positive, but it's still a little bit positive. And ideally, inflation isn't that much of a problem because of the printing money piece, because you're you're kind of balancing it all together. Again. It's hypothetically doable. Does it happen very often? No, not really. But um but that's like that's the goal uh to get the machine to work.

So he gives us setup of an example here where he says, okay, let's say you've got your debt-to-income ratio is at 100%. And interest rates are at 2%, which means the debt's growing at about 2% a year. And then your income growth is about 1%. Okay. So that's kind of his his setup. So the question is, who wins the race?

Debt costs rising by 2% each year or income growing at 1% each year? Do you think your situation will get better or worse over time?

Thinking about it. What do you think? Alright, I'll tell you what's going on. Worse is the answer. Uh this chart here shows that when they start at about the same level. uh that two percent will just very quickly outgrow it. Even if it wasn't at a hundred percent and your income was significantly higher.

Uh this given the curve at a two percent uh growth rate, it's definitely going to be bigger than the income eventually. And so as a result, you will never reduce your debt burden in this situation, in this hypothetical situation. Right. At the end of the day, in order for that debt ratio to work better and to have the good deleveraging and to stay where you want, your income growth must beat the interest rate. Has to happen. And and so the central bank's goal is to try to push income growth above the interest rate on the accumulated debt.

Like that's that's the goal. But it's really hard to do because of all the competing things like we've talked about. But that's the goal. And here's the crazy part, right? Like he's given this example of 2%, which is kind of like the world in which things were when he made the video. And today we're at seven point two eight percent. Like it's crazy.

And so like here's what I want you to think about, right? If the goal is still to have income outpace Uh the interest rate, dude, it's a massive amount of income growth that you need to have in order for us to be able to sustain the current path that we're on. It's just really hard to do. And you can kind of see why when people talk about oh the the economy is maybe not doing as well and it's on shaky ground and I don't know. This is one of the ratios that they are looking at when going like, oh my gosh, like income growth just it can't even compete.

I mean you see that with inflationary stuff right now. You go to the grocery store, even you're like, oh my gosh, like this is unbelievable. And you think about like, how much was my raise last year? And you know, and you're like, and you're trying to do the math, even though your income is ideally significantly greater than your overall expenses. And so it can withstand the growth not being as much over time that erodes and can cause a problem.

Ideally, the income growth is greater than your expense growth. Like that's the goal. Same with uh a property as well, which let's look at that, the property version of that. So uh Dalio, he's talking about income growth versus the interest rate. But in our investing world, that is the yield on cost versus the loan.

And so the yield on cost is um it's a ratio that essentially is saying It's uh it's not exactly this, but it's saying like what's your return and then on on um on your money.

So it's uh your yield is with your net operating income, essentially. Um So you have you have that. And then um, because it's not quite cap rate. So a cap rate is your net operating income divided by your price.

Um is kind of the idea, and it's some it's a percentage as a result of it. The yield on cost is your price plus whatever money you've put into it. So it's a little bit bigger number Um, because you know, oftentimes you'll also raise money to do repairs and fixes and other stuff like that when you first get started, or you're like you're not even raising it, you're just investing that yourself. So you want to pay attention to that number. And ideally that that cap rate, the yield on cost, is bigger than the loan percentage.

And this actually is what caused the problem a couple years ago because interest rates were so low, they were sitting in like 3%. You could have cap rates that were sitting in the 4% range and you're like, this is fine. The ratio works. They're still bigger. And then when interest rates suddenly shot up to six percent, that equation flipped and you went, uh oh, shoo. Like Any in honest investor said like these numbers don't work anymore.

Like you don't the only way that you could make it work was to force it by doing a massively large down payment, but then your returns like weren't very good at all because you were no longer leveraged. It didn't work. Like which the crazy part to me is like there were still people who were making huge cash purchases purchases.

I was like Like, wow, what's going on? Other than they were like, I gotta put my money into an asset. And that's like a hard asset, something like that. Um, but that was the issue that happened a few years ago. And Cap rates have been slowly going up, especially in Oregon, trying to reach those interest rates. But again, interest rates like because they've they've risen again.

you get that momentary, oh, okay, these ratios don't work as well. And so if you're borrowing at 7%, but you're looking at a capri that's only five percent, you're like, nope, I'm out. Like just doesn't, the math doesn't make sense.

And I just for the record, you gotta be careful with this analogy, right? Um, that Dalio came up with um because he's not taking into account lone amortization. And he is saying like things are interest only and he's not looking at floating and he's not looking at refi dependencies, things like that.

And so um he's assuming that the overall debt stays the same, which I think like We're just we're just we're tweaking the equation. The overall directionally totally right. I agree with him. You just gotta be a little bit careful in like all the ratios and stuff. Um just my little caveat there.

He's thinking like interest only loans for all of his examples. But again, I think for the real estate stuff, like that's still very like those ratios matter a lot and are really important. And those are things that we are regularly looking at when thinking about an investment. Alright, so uh as we're rounding this thing out, um Dalio has three rules.

I'm gonna translate that into real estate investing for us. So the first one Is his rule is don't let debt rise faster than income. We've kind of already talked about this. Personally, right? You want to make sure that that is not true. And for us, that's all in the underwriting.

And that comes back to that ratio, right? When you're looking at the the yield on cost versus the interest rate, you want to make sure that those numbers, that the yield on cost is higher than your interest rate. Unless you have a really, really, really good reason why. Like you're gonna go in, do a massive capital improvement and like significantly increase the value of the property. That way. It's almost like it's a total like repositioning type of thing. Okay, maybe, you know, take a look at it.

Um, but uh I think for normal rental real estate Like that's that doesn't happen very often. And so gotta pay attention to that ratio. Super important. Rule number two, uh don't let income rise. faster than productivity. I thought this was um kind of an interesting rule um that he had there. And and again it comes to the That productivity is the very long-term trend that will ultimately create the long-term wealth and growth.

And that's you do want that steady eddy. The problem with incomes rising faster is the credit rises faster as well. And so things can get out of whack. And eventually Those things uh they don't coincide very well together.

Um let me give you an example of how they can work out really well. Um I the way that I often think about it is it's when uh I'm gonna say like demand outpaces innovation. Um, so small example, um, a lot of our incomes have risen over the last uh Geez, I don't know.

We'll say 20 years, right? I think that's a pretty good ratio. Because the iPhone has been around for 20 years. Now think about this, right? 20 years ago, none of us had a data plan. None of us were playing paying for smartphones. None of us were buying apps. And none of us were doing, we're not even really doing like online subscriptions and stuff. And so as long as our income, and that's productivity, is increasing, and it is allowing our income to be spread out among a whole bunch of new things, right?

Like before there was cable. Now you've got Netflix and all these other ones. And so as long as it's spreading it, your your money is being spread out between a bunch of different services, it doesn't give an opportunity for any individual one to rise because it's share of the wallet. Is is shrinking and therefore its overall number has to stay the same.

The problem you run into is when innovation stops or can slow down. it can cause an issue where, well, now if incomes keep rising and the share of wallet stays the same, that means demand for it is going up. Therefore, you can start to charge more, prices start to rise. I actually think this is one of the exciting things that people have about AI. is it is enabling yet one more new thing that people can start paying for. And so it's gonna start sit taking some of that share of wallet, which means The demand is going to stay flat or decline for other services, which means the prices will go down for them.

That's uh that's kind of the the theory behind what's going on here. And And I think the the real estate equivalent of that when investing is you don't want rents to raise faster than tenant wages. That's actually one of the things that we look into when we are deciding how much to set rents for.

We actually look at that ratio for the area to try to pay attention to like, well, what's going on there and how is that impacting the rents? Because you might have a situation where Yes, technically these are the rents on average for this area, but it's actually above say like three times what the what the actual average rent is. Now for an individual property You know, sure, you can always find a high income person for the right property who's gonna rent there and and it breaks all the ratios. But when you're looking at the overall market Ideally, you say it, no, I want to be in a place where those ratios are right.

That's a healthy market overall. And that is going to be a tailwind for my overall investment. I'm not trying to fight the dominant trend in order to make this work. That does mean you'll tend towards uh like smaller, more average types of places. But again, like if that's where the majority of people are at, like there's nothing wrong with with being average for those type of investments His third rule is raise your productivity, right? And again, long term, that's really good.

And so for us, I think that translates to the operations, right? Where you can get the operator edge where Um, get better at what you're doing as an investor, or in my case, as an operator, as a property manager, that leads to other sorts of good stuff. That is one of the reasons why I am investing heavily in um software systems and AI support things.

That is me trying to increase the productivity of my team so that we can be better than what we were last month, last week, and and just trying to improve things um because that's that steady growth overall that will lead to um lead to good things Um, if you are curious about learning more about them, we have other episodes. Episode 111.

Um, we talk about tenant income being that limit. And then in episode 107, we talk more economic stuff. And we talk about the fix in fixed debt plus inflation and why that could be a good thing and why rents beats uh your mortgage. over time. So if you're interested, check out 111 and 107 for um some more in-depth thoughts on those particular topics there.

And so I guess the question for you, right, are you an amateur? Are you a pro? Are you waiting for rates to cut or are you testing the income? and seeing how the income actually compares to things, not just worrying about the rate. And, and this one's kind of a big one, when you are looking to invest, are you assuming that you'll be able to do a refinance or are you looking in such a way where it can survive without one.

And I think it's I think it's really important to look at to look at both, but ultimately say, no, I'm only gonna move forward with this assuming it survives without because Interest rates might rise dramatically and you're like, nope, not gonna do a refinance. I mean you think about like you might you might find yourself thinking like oh my gosh rates are all the way up to seven point two percent Like, yeah, yeah, yeah, we'll do a refinance because the next three to five years they'll be back down.

Yeah, not necessarily. Like they could go double digits pretty easily over the next three to five years. I that's highly possible. And so you want to assume things will be fine without it. I got six questions for you to ask before you invest in anything. And ideally, like if you hire me as a property manager, these are questions that you've already worked through and we can help. you know firm things up on the operation side so the first one is does income growth beat the loans rate again really important that's that yield on cost ratio to your debt payment super important Number two, whose paycheck is the denominator?

Again, this is like who's making the payment? And uh ideally it is a tenant who is paying for it, not you, and that the property is not underwater. Number three, are you buying a tractor or a TV? And so essentially you're asking, like, duh uh what does that debt buy you? Right?

Is it an asset that can generate more income? Or is it a liability that takes money out of your pocket, which could be masquerading as an asset? So again, just like you want to buy good investments, good rentals. Um, I do not subscribe to the theory of someone who buys a rental and loses money on it every year saying, oh, but it's part of my retirement plan. It's all good. Like, no, dude, like buy a place that actually like cash flow is positive. All the way until retirement.

That's the way to do it. Turns out those assets are easier to sell in the future as well because people like it when the income is higher than the expenses. Crazy, I know. You also want to know like what resets and when. When do loans come due? When you gotta reset them. Super important to know. And does it survive flat rents, no refines, and no cuts on expenses?

Essentially, does the deal look good today? Is the question that you want to ask? And then finally. Um you want to look at those three rules that Dalio had and is there any of those that the deal breaks that it's not doing Um I know like a lot of times like we'll go in and it's the operations side, right? It just wasn't managed well.

We can go in and manage it better. Yay, that's a win Um but maybe that's not the case, right? Maybe it is one like you get like new construction, you're like, man, there's not a lot of upside here for this one. The property's already great Meh, you know, not necessarily a lot of opportunities for growth. But anyways, those are the three rules that I think are um worth asking when you're looking to invest.

And so I think what you want to do is you want to pick your number, right? If you have a property that yields 6%, cool, awesome. What's the highest loan interest rate that you would be willing to sign? You know, is it six percent? Is it five percent? Is it seven? Um I would not do seven. Six is kind of like I don't know about that.

Uh for me, I'm like, eh, I I I like And I in some ways this is kind of a backwards way of asking for it, but I'm like, ah man, like if rates are at seven percent, like I gotta find cap rates that are in that eight to nine percent, which is hard. Totally hard. I get it. Or I mean investing in such a deal where it's not about the cash flow.

It is more of a a capital gains play, which is honestly the majority of the types of investments I've recently been doing, because those are what makes sense in this area. And so um my my takeaway here is that your debt must not outgrow income.

That is really, really important on a personal level. And yes, it is important as an overall economy as well. You have no control over that. But what you can do is make sure that that is true for yourself. And um Yeah, and the rate honestly doesn't mean much without income growth.

Like it's fine, but um the income growth is really what's important. Like you gotta put that rate in a context. And um and that analogy, right? That every loan is a bar tab. If you remember that system and it's the idea of it's pulling money forward, pulling spending forward. Which eventually means it has to go away.

That's really important to understand, not only for yourself, but for the society as a whole. And so my final question, my parting question to you is is your income outrunning your interest? Or even your optimism. And so that's uh that's my question. And that's what I learned. It was a cool video. Um it had a lot of fun little graphics, but that's me kind of diving a little bit deeper into it and explaining how it is relevant for real estate investors.

And so if you like that, awesome, appreciate it. Thank you. And if you are interested in investing with us or having us manage your properties so that you can take advantage of some of those operational games Would love to talk with you. You can learn more about us at Furlo. com. So with that, thanks for listening. Have a great day.