Commercial Real Estate Podcast

JF1439: What You Need To Do To Be Financially Free From You Real Estate Business #SituationSaturday with Josh Patrick

Written by Joe Fairless | Aug 11, 2018 4:00:00 AM

As a serial entrepreneur, Josh has a ton of experience starting, running, and selling businesses. With a focus on financial management now, he helps other businesses manage money and learn how to apply it in better ways, especially with the goal of having financial freedom in the future. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

 

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Josh Patrick Real Estate Background:

  • Serial Entrepreneur
  • Founder of Stage 2 Planning Partners
  • Author of Sustainable: A Fable About Creating A Personally and Economically Sustainable Business
  • Say hi to him at http://www.stage2planning.com
  • Based in South Burlington, VT

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TRANSCRIPTION

Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.

First off, I hope you’re having a best ever weekend. Because today is Saturday, we’ve got a special segment called Situation Saturday. You know Situation Saturday, you’re a loyal listener… But in case you’re listening for the first time, Situation Saturday is all about a particular situation that you might find yourself in now or in the future, and we’re gonna talk through how to approach that successfully.

The situation we’re gonna be talking about today is what you need to do to be financially free from your business. This assumes that you’ve got your own real estate investing business, and what you need to do to be financially free from it, so that you can then go do other things, perhaps if not now, then later down the road.

With us to talk through this approach – Josh Patrick. How are you doing, Josh?

Josh Patrick: Great, how about yourself, Joe? Thanks for having me on.

Joe Fairless: I’m doing great, and it’s my pleasure. A little bit about Josh – he is a serial entrepreneur. He is the founder of Stage 2 Planning Partners. He’s the author of Sustainable: A Fable About Creating A Personally and Economically Sustainable Business. He is in South Burlington, Vermont. With that being said, Josh, how about you tell us a little bit more about your background, so that we have some context, and then we’ll dive right into it?

Josh Patrick: Well, when I was about 24 years old I went into my first business. I ended up actually buying it from my father. Very rapidly, I learned that I was unemployable, and that I had to own my own business. We’re in that business for 20 years; we grew it from one and a half employees to 90 employees. I sold that in ’95, I went into the life insurance business. I realized that when you’re in the life insurance business and my clients all own private businesses, there were lots of needs besides life insurance, so I left that firm.

I opened up my own wealth management firm, which I did for 15 years. Actually, I’m still doing it. Today we do wealth management and we also help private business owners do two things, depending on their size. One is to take a successful business and make it economically and personally sustainable, which means the business lasts past you. And we also help smaller business owners become financially free from their business.

The question that I always like people to ask themselves is “Does financial freedom always feel like it’s five years away?” and if the answer is yes, there’s probably a reason for that, and you probably don’t know what the reason is.

Joe Fairless: Yeah. Is it because it’s not defined, or it’s much deeper than that?

Josh Patrick: Well, it’s actually quite a bit deeper than that, and the truth is in the real estate business it’s probably easier to become financially free from your business than almost any other type of business. Real estate is just great for that, as long as you do your real estate investing based on a cashflow basis, not a capital appreciation basis.

Joe Fairless: Yeah, Amen to that.

Josh Patrick: I just never really understood people buying real estate who wanna say “Well, I’m not getting positive cashflow, but it’ll go up in value so I’ll make my money then.” Bad idea.

Here’s the key… The key is while you’re running your business – this is where people get stuck a little bit. While you’re running your business, you want your business based on the cashflow that gets created by your business. And when you sell your business, you run your financial life based on the cashflow that comes from the investments that you got from selling your business, and other assets that you’ve owned and accumulated while you were running your business.

So for most business owners – and it might even be true for many real estate investors – becoming financially free from your business requires that you look at what the terminal values of all your assets are gonna be… And terminal value basically is just a fancy term that means “What’s the stuff worth when you wanna stop working, or be able to stop working?”

When I first went into this business – I guess it was 1996 – I kept reading about the tsunami of privately-held businesses that were gonna be up for sale, and there’d be this great turnover in wealth. Well, a funny thing happened – it never happened. The reason it never happened was because of what I call PermaFive. PermaFive basically is where everything feels like it’s five years away.

That’s why I ask that question – does financial freedom of your business always feel like it’s five years away? If the answer is yes, what it means is you know there’s something you need to do, you don’t know what it is that you have to do, but over the next five years whatever it is you have to do is going  to magically appear… And if I go back to somebody two years later, they still think the same thing. So we developed this process – we call it the Financial Freedom Project – which helps free you from being stuck in that five-year loop.

If you’re not able to leave your business, you’ll know why you’re not able to leave your business. And once you know why you’re not able to leave your business, then you can do something about it. But if you don’t know why, you never can do anything about it. Does that make sense?

Joe Fairless: It does. Correct me if I’m wrong, but from what I’m hearing, first we need to know what our terminal value is for the business, so what’s it worth when we stop working, and then based on that, that will help us approach the questions that we need to ask ourselves, and we can then come up with a plan for how to approach it?

Josh Patrick: Yeah, but it’s more than just your business. I call this the Four Boxes of Financial Independence. First we start off with “What is the value of your business?” and that value needs to be the value after you pay taxes and after you pay fees to sell the business, if the business is saleable at all.

The truth is about 80%-90% of the businesses in this country are never sold, they’re just closed down.

The second thing is investment real estate, and that’s where your listeners are gonna really shine – if you’re buying investment real estate and you know what your cashflow needs are, and you pay that real estate off, when you’re retiring, you’ve got a heck of a cashflow-producing asset, that requires very little work.

The third area is your qualified retirement plan, which is your 401k plans. For many businesses, the value of the 401k plan will be much higher than the value of the business when it’s time to leave, and finally there’s other investments. So you need to take a look at the entire financial picture, which are — and I’ve put it into those four buckets, because it’s pretty easy to understand that.

Joe Fairless: Okay, let’s dive into each one of them just a little bit more… Would you mind going through each one?

Josh Patrick: No, not at all. First, the value of your business. Business owners typically over-value their business by four or five times…

Joe Fairless: [laughs] Not surprising.

Josh Patrick: Not surprising. There’s actually a very good reason for that… When business owners take a look at their business, they look at the cashflow they’re getting out of their business… And when they look at creating that business into an investment, it’s never gonna come close to the cashflow to get out of the business, so to get to that cashflow to get out of their business they have to inflate the value by four or five times to get there. And again, that’s if the business is saleable.

For a business to be saleable, there’s two things that have to happen and two things that are nice to happen. The two things that have to happen is you have to have a recurring revenue stream, because that’s what buyers are actually buying. And the owner has to become operationally irrelevant for the business, because if the business is built around you, no buyer is gonna be really interested in buying that business.

Now, the two nice to have things – actually, one I think is crucial… It is to have clear values about what your business is about, because that sets the tone for everything else, and the fourth area is having great systems in place… Those lead into four different buckets of profit: lifestyle that you live on, having an emergency fund so when things go bad (and they always go bad) you have money to fall back on, having enough money to grow your business, because not bank or investment company can fund 100% of your growth, and money to fund a retirement plan, because you’re gonna need that retirement plan to get yourself to financial independence.

If you do those things, you’re gonna have a business that’s in pretty good shape, and probably – not guaranteed – somebody else would wanna own it. You’ve gotta take the value of that business and multiply the free cashflow, which is profit + depreciation + interest + taxes, and multiply that somewhere between 3 and 6, because that’s gonna be the value of your business.

The smaller your business is, the less employees you have, that multiply is lower. The bigger your business is, the more stable your business is, that multiply is higher. Does that all make sense?

Joe Fairless: It does make sense, and it’s very helpful going through the four items – the two that were needed and two that were (as you say) nice to have, but really would be more towards the needed side. One is a recurring revenue stream – that’s what they’re buying – two, the owner has to be operationally irrelevant… That could be a dagger in the heart for a lot of listeners, because that is tough… I believe it’s harder for real estate investors to be operationally irrelevant, compared to other industries… And perhaps I’m just so into real estate investing that–

Josh Patrick: Actually, I would argue that…

Joe Fairless: Okay, good, so you would argue against what I’ve just said?

Josh Patrick: Yes, absolutely.

Joe Fairless: Okay, alright, so maybe I am looking through a tunnel vision, and based on my own experience. And then three, clear value of what the business is about, and four, having great systems.

So on the comment I made about “it’s harder for real estate investors to be operationally irrelevant” and you said you’d argue the counterpoint – why would you argue the counterpoint?

Josh Patrick: Well, you have to take a look at — operationally irrelevant means you’re not tactically involved in your business anymore, but you are strategically involved… Because buyers always think they don’t need the strategic part, but they need the tactical part, and they don’t want you involved in that. So what is the one strategic decision that real estate investors would make?

Joe Fairless: Well, there’s a lot of strategic decisions real estate investors make. Ultimately, it’s about profitability, so how you buy, how you manage and how you sell.

Josh Patrick: See, I would submit that the strategic decision that the real estate investor makes is what to buy. If you know what to buy, you’re gonna do that based on the cashflow. And when to sell – there’s a whole variety of issues in that. I would agree that that would be a strategic decision… But everything else in real estate is tactical. You can hire people to do that, and if you have a team of people who does do that — now, you’re not gonna be able to do those with three pieces of property; you’re gonna need lots of pieces of property. But I know plenty of people in Burlington where I live that are operationally irrelevant in their real estate operations and they have property management companies, and handymen, and fix-it people, and lawn people, and all that sort of stuff that goes into running a real estate operation, that they actually have nothing to do with. The only decision they make is when to buy, what to buy, and when to sell.

Most of these guys work five hours a week, if that.

Joe Fairless: Okay, so those are the four points for how to be saleable, and there are sub-bullets underneath the value of your business… What’s the second one that you’ve mentioned?

Josh Patrick: The second one is having investment real estate. Investment real estate – this is an interesting thing… Most people in business — now, your listeners are gonna be different, but most people in business will likely own the building they operate their business from, if they’re smart… And if they’re really smart, they’ll make sure that building is paid off by the time they retire; so instead of having to sell a piece of property, say for $600,000, pay $200,000 in taxes and be able to spend $16,000/year, they’ll keep the real estate and rent it and put $60,000/year in their pocket. So that asset becomes a really nice cashflow-creating tool, as long as they bought it really enough and paid it off before they retire.

Now, for your listeners – again, the less debt they have, the better the cashflow is, and as long as the free cashflow coming out of their real estate is enough for them to retire and they’ve put together a good property management system, there’s really not a whole lot for them to do, except to make decisions if they’re gonna buy something or if they’re gonna sell something, and how long does that take.

Joe Fairless: It depends on the person.

Josh Patrick: That’s true. But if you’re good, you can do it pretty quickly.

Joe Fairless: So when we were talking about the process for financial freedom, according to you, one is identifying the value of your business, two is having investment real estate, and three…?

Josh Patrick: Three is having a qualified retirement plan, a 401k-type plan that will accumulate enough money that it will put a significant portion towards providing your retirement needs. There are very good investment options and ways of doing this – there’s a thing called a cash balance plan, and we always have people take a look at it.

When you’re 50 years old you can put as much as $200,000/year into this plan and make it into a tax deduction, and you can fund that up to about 2,5 million dollars in value. So if you’re putting away for  a period of 10-11 years $200,000/year and you get to 2,5 million dollars in value, that’s gonna provide $100,000/year for you on retirement… So that goes a long way with most people, helping them get to where they can afford to leave their business.

Joe Fairless: And number four?

Josh Patrick: It’s just other investments: social security, taxable investments that you might put into, investments in other businesses… Anything that doesn’t fit into those other three boxes, that’s an investment.

Typically, we don’t spend a lot of time on that, because if we manage the first three buckets properly, we’re gonna get you to financial freedom.

Joe Fairless: Let’s talk a little bit about the terminal value that you mentioned earlier, what is our company worth if we stop working… How do we determine that?

Josh Patrick: Well, again, we never know what your value of your business is gonna be ten years from now. It could be a lot higher, it could be about the same, or it could even be lower. So let’s just freeze the value you have today, just for analysis purposes… And again, we take the free cashflow. The technical term for that is EBIDTA. It stands for Earnings Before Interest, Taxes, Depreciation and Amortization.

Now, I take that number and I multiple that from between 3 and 6 times, and I take that number and subtract 40% of the value, which leaves 60% left, because that’s what you’re gonna have after you pay taxes and fees for selling the business.

Joe Fairless: Hm, 40%…

Josh Patrick: Yeah, taxes are 30%, and the average business transaction has 10% or higher in fees. You’ve gotta pay your broker, you’ve gotta pay your accountant, you’ve gotta pay your lawyer, you might have to pay an appraiser… Those are all costs that nobody thinks about when they do a plan for somebody who’s gonna sell their business.

Too often I see financial planners – and this is one of the problems and why I developed the Financial Freedom Project… I saw these guys do presentations and they would take the value the business owner said it was, and they would never subtract taxes and fees from the business value.

So they were going into a planning process with inflated values that were never gonna be there when it came time to retire.

Now, maybe 10% for tax and fees in certain instances might be a little bit high, but frankly, I’d rather have a little bit more money than I need at retirement than a little bit less.

Joe Fairless: It’s like saying you bought a property for 100k and you sold it for 200k, put in 75k and you made 25k. Well, what about the closing costs? [laughs] What about lender fees, or broker fees, or holding costs, financing fees, all that good stuff?

Josh Patrick: All that stuff… And people don’t think about that when they do financial planning. The financial planners don’t know the great question to ask, nor are they willing to push back hard enough to tell people their business is worth less than it is.

Joe Fairless: Anything else as it relates to becoming financially free from our business that we haven’t discussed, that you wanna mention?

Josh Patrick: Well, it’s actually easier than people think. You don’t have to start when you’re 30, and there’s another option that goes in along with this, which I call the Wind Down Strategy.

Let’s say I’m a real estate investor and I have 80 properties, and I’m getting close to retirement and I don’t wanna manage all those properties anymore. I’m gonna be that if I took those 80 properties — are you familiar with the 80/20 rule?

Joe Fairless: Very much so. But maybe other people aren’t…

Josh Patrick: I’m gonna explain how we do that. So if I was to take a look at my 80 properties, and do the 80/20 of it, I’m gonna be that 16 of properties (which is 20% of the 80) will produce 80% or more of the cashflow. So if I was to sell off 64 properties and just keep the 16 properties that are the good ones, I’m gonna work a whole lot less, have a lot less headaches, and make almost as much money as I was making before. That leaves me the opportunity of not having to sell my business.

I do the 80/20 with all small business owners, because the truth is the reason these businesses aren’t selling is the owner can’t afford to, and with the extended lifespans that we’re having today – we’re not dying at 65 or 70 or 75, we’re dying at 85 and 90. So if you just stop working at 65, you need to plan for 25, 30 or 35 years [unintelligible [00:19:27].11] or two days a month to have some supplementary income coming in [unintelligible [00:19:31].24]

The longer you work, the easier it is for you to get to financial freedom. So when I say work, it doesn’t mean work full-time, it means work part-time… But still control your business, still run your business.

Most people I know actually like the businesses they’re in, they just don’t wanna work as hard. That’s a really good, viable option for people.

Joe Fairless: Absolutely, and there’s 80/20 in sales and marketing, a book I highly recommend. The author’s name escapes me, but I’ve mentioned it multiple times on this show… There’s a couple books on 80/20.

Josh Patrick: Yeah, that’s Perry Marshall’s book.

Joe Fairless: Perry Marshall, there you go. Thank you for that.

Josh Patrick: Yeah, Perry is a great guy. I like Perry a lot.

Joe Fairless: Yeah, ditto. Well, Josh, thank you so much for being on the show. How can the Best Ever listeners get in touch with you and learn more about what you’ve got going on?

Josh Patrick: They can find me at stage2planning.com, or www.sustainablebusiness.co. Or they can send me an e-mail at jpatrick@stage2planning.com, or give me a phone call at 802-846-1264, extension 102.

Joe Fairless: Well, thanks again for being on the show, talking about what we need to do to be financially free from our business. Even if we enjoy what we’re doing right now, it’s important to know what an exit strategy is, just like we would if  we were buying a property… We always wanna know what the exit is; even if it’s a long-term hold, we wanna know what are the potential exits, should some unexpected situation occur and we need to make a change and pivot a little bit.

You walked us through four steps to financial freedom. One is the value of our business, so we need to determine that; how do we determine it? Well, we need to look at what is it worth today, a snapshot in time, and what does it need to be in order to be saleable? It has to have recurring income, we have to be operationally irrelevant for tactics, not necessarily strategy. We have to have a clear value of what the business is about, and we have to have great systems in place.

Then you talked about number two in financial freedom – having investment real estate, check that box. We love that.

Three, having a qualified retirement plan, and four – other investments. Then you also talked about terminal value and the Wind Down Strategy. Thanks so much for being on the show. I hope you have a best ever day, I really appreciate it, and we’ll talk to you soon.

Josh Patrick: Thank you.