Wednesday, September 15, 2010

Perpetual Cash Machine - is $745k the same as $2 million?

Being a bit of a science geek, and I guess having a BSc qualifies that way, I have known about the contests to create a perpetual motion machine.  Throughout history, people have tried, unsuccessfully to create the perpetual motion machine.  This is a machine that goes in motion and never stops and never requires any additional force to be applied.

Some nobody in history, a rather insignificant name, you might not have heard of, Sir Isaac Newton, came up with a series of laws that dictate how motion is governed.  His 3rd law states

For every action, there is an equal and opposite reaction.

In the case of a perpetual motion machine, this opposite force is usually friction.  In the physical real world, this perpetual motion machine is impossible, but in the financial world, this is a possibility.

What is a perpetual cash machine?

I mentioned this idea to a collegue and for them it conjured up ideas of their own ATM machine, that never ran out of money.  Although that is a pretty cool thought, it is not what I am talking about.

Conventional financial wisdom states - get a couple million dollars in an RRSP, project a conservative 5% return and you will have $100,000 pre-tax dollars upon retirement.  This money sits in a stock portfolio that grows during your working years and leaves you retirement ready.  I guess this is top down planning, you look at a big number and work backwards to a result.

This $100,000 results in about $65,000 after tax dollars.  Then you live your life based upon a $65,000 lifestyle.  Simple, right?

It is also important to remember, there are no taxable advantages to the money coming out of the RRSP program.  There are some going in for sure.  For every dollar you contribute you save $0.46 meaning over a working life of 30 years these tax advantages could be significant.  In numbers, 30 years to save $2,000,000 you would have to make $66,666.67 per year in contributions/return to reach the goals.

I, personally, follow a different path.  But remember, the road less travelled is exactly that.  In life, I have always tried to go the opposite direction of the "herd".

I have developed my own bottom up investing idea, that is a perpetual cash machine.  I like to start with an accurate account of what it costs you to live your life.  I would suggest taking a yearly total, working backwards from today and figuring out what the previous 12 months have cost you to live.  Include necessities - heat, hydro, etc and of course extras - vacation, clothes, alcohol, whatever. 

Take that 12 month total and figure out an average monthly cost.  Add 10% for a safety margin. 

For example
- last year, your total was $60,000.00
- add 10% = $6,000.00
- total needed is $66,000, so you need to gross a total of $100,000 (same as above)
- your monthly needs are $8,333.34

This means for the same lifestyle as $2,000,000 provides, you need to earn $8,333.34 per month. 

A step further now says we need to build in a margin of safety for vacancy and renovations in our portfolio.  Experts suggestion 10%.  So, we need to add an additional 10% to our figure, so our adjusted cost of living each month needs to increase by $4,668.40 to a total of $13001.73

To create this type of income, I can show you today, three buildings that produce a combined monthly income of $13,339.15 after all expenses and mortgages payments are made.  This gives you an annual surplus of $4,049.04 - a very nice family trip?

In this case above, you have achieved the following:
Paid yourself - $66,000
Paid your taxes - $34.000.08
built a reserve fund - $56,020.80 (per year)
extra monies - $4,049.04

How much did all this cost?  $745,000.00 + closing costs

So in this case, $745,000 has done the same job as $2,000,000.  Sometimes, all it takes is a paradigm shift in your thinking!

2 comments:

  1. If you're getting 5% return on your RRSP, the same 5% will work as compound interest. Meaning you only have to contribute about $2400/month or $28,800/year to get $2 million in 30 years.

    Of course, $2 million won't be enough to retire off of in 30 years because inflation will eat it up. Assuming a 2% inflation per year, that $100k will feel like $55k in today's dollars.

    The nice thing about the rental property option is that hopefully the rents will also see the same inflation as the economy.

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  2. Good points. Unfortunately, as of right now, we cannot contribute $28k per year, hopefully this will change in the near future, as politicians are finally realizing that the current limits on retirement savings are too low.

    Everyone laughs at the 2 to 3% increase in rents each year, but think of it over the longer term. It is not uncommon for a tenant to stay in a place for 10 years. If they started at $1000.00 per month, in ten years, with no increase you are getting $1,000 per month, with an average of 2.5% increase annually, you will be getting $1248 per month.

    That $248 dollars is a significant difference in the property value and cash in your pocket.

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