Fairly often, I am approached by clients keen on creating a real estate investment portfolio. The initial challenges in our conversation arise from the identification of goals and in understanding the distinctions and separation between investments and other sources of income. At the outset, the very purpose of a wealth creation portfolio should be to augment incomes and any existing wealth creation plans.
Usually, the client has taken few if any steps towards their wealth-creation goals by investing in real estate. They likely already own a primary residence (or have taken out a mortgage towards the same) and have made some property investment decisions in the past that could have performed better with the right approach.
These clients invariably hold the view that any income-generating activity undertaken with their resources qualifies as an investment. More precisely, investments in their view are everything else they do to generate income outside of their jobs. They also tend to be either employed or self-employed.
Distinguishing investments from other sources of income is a good place to start in measuring and comparing income from passive and active sources.
Investing Compared to Other Income Sources
Typically, a conversation where I ask the client what investments they have will elicit a response where something in the nature of possessions, savings or a business are all collectively described as investments.
For instance, the responses range from owning a car or a house or some livestock (possessions) to leasing a farm, or owning a PSV vehicle or some other type of equipment/machines, to operating a small retail shop (businesses). Some will cite their membership savings in a Chama or SACCO (savings) and yet others will also cite their holdings in shares, or bonds or some property (investments).
Investments are both a source of income and capital growth. The key distinction not often made between investment and any of the three other levels of generating income is that investments do not require the active engagement of the individual making them.
Savings on their own do not represent investments but can be harnessed and leveraged to create investments. Owning a business, say a farm, would be unproductive without some form of active involvement whether in the direct management of the production processes or in the management of hired hands, supervision of supply chains or even in the marketing of the farm produce. Unmanaged, livestock may not get fed, crops may not be tended to and produce may not get from farm to fork!
Let’s take another example of owning a public service vehicle (taxis, matatus, buses etc.). A public service vehicle is a working/business assets. On the day(s) that it is not put to work, it yields no return. And on the day(s) that the operator(s) fails to turn up to work, or on the one(s) that it is inoperable or out of commission, or detained at a police station or has to be taken in for inspection or licensing; then not only shall no returns be forthcoming, but the owner will be compelled to get involved. The level of active involvement on the part of the owner may extend to directly operating the asset or managing the crew and all the attendant issues that come with the territory. As anyone who has operated one will tell you, it’s no walk in the park.
The same applies to the employed or even self-employed individual. You go to a job where you spend the productive hours of your day with the promise of a reward for the time when you put in work – the reward is called a salary. You run the risk of losing your salary when you fail to turn up to work and your wages are primarily the product of an agreed rate (hourly/daily) by the number hours or days you give up to the job you were assigned.
What then are Investments?
Typically, an investment is an asset that generates returns to its owners without the active engagement of their time. For instance, if you buy shares in Company X, at the end of the year, the company will pay you a dividend in the percentage of your ownership in it. You needn’t be employed or otherwise actively involved in the day-to-day running of Company X in order to qualify to be paid your dividend. Similarly, a bond or other financial instrument purchased from a private borrower or from the government will have an agreed rate of return on the funds loaned out by an investor. Owning treasury bills and bonds is not the preserve of government or treasury employees.
Another similarity is the acquisition of property, land. The appreciation in value of a property does not necessarily result from any activity undertaken on it but instead from the perception the market has of that value. Even though an acre of land ten years ago in Nairobi is still the same acre of land it is today, its price (perceived value) has changed dramatically.
The growth in property prices happens for any given number of factors, primarily:
- Perceptions on the security of the area,
- Increased private developments on neighbouring properties,
- Increase in settlement and local population in the neighbourhood creating additional demand for housing or property,
- Accessibility and infrastructural developments around the property,
- Installation of mains services such as water and electricity,
- The scenery and propagation of green areas,
- The establishment of facilities including trading centres, markets, transportation corridors, hubs and stations within easy access to the property, places of worship, schools and other institutions, and;
- New commercial investments in the neighbourhood.
Why Do People Invest?
The rational reason anyone should make investments is really to be able to take back control over their own time by using resources at their disposal to generate wealth. The ultimate goal is to increase productivity by leveraging resources in such a manner that they create enough wealth so that we are not obligated to trade our time in exchange for money.
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Looking at it differently – active income is usually the product of two resources:
- Effort/Skills/Competencies/Abilities (physical, manual, mental)
Because time is limited, the function of investing – wealth creation – should primarily be to extend effort in ways that time cannot allow – increasing our productive abilities beyond the time at our disposal. So in its very nature, investing is supposed to be a way to get something that would otherwise be inaccessible.
Those resources are primarily the time of others and the money at our disposal (savings, access to credit) which we can then provide in exchange for some consideration (money) to the one providing them.
A case to make this point is when an investor pays to acquire a stake in a company in return for a dividend. What typically happens in that exchange is that the company receives money (capital) from an investor and gives up a share of ownership in itself to the investor guaranteeing that the investor will, in return for the acquisition, receive a dividend at the end of the year.
The capital gains made by an investor in shares are created in the market in form of share price appreciation. The company is leveraging its products, its people, its working assets, its great ideas and offering part of that to the investor in return for capital from him/her. The investor is doing the same thing – he is leveraging his money to earn more money in the form of dividends and capital gains in the from the price appreciation of the shares that results from both strong market performances as well as investor confidence in the company. This is the essence of wealth creation.
So, two key things:
- The asset is generating a return
- It doesn’t engage your time (passive as opposed to active)
Are all Assets Investments?
This is a question for the ages and any response I may offer will elicit some controversy. Suffice it to say that to effectively meet our goals, there should be a distinction between assets that generate income actively (business assets) and those that generate income passively (investment assets).
Whichever side of the argument you favour, bear in mind that the ultimate goal in wealth creation and the attainment of financial security is the freedom to choose how you spend your time, doing what you want when you fancy.