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Control over the Rules
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As students at the academy, we spent a lot of time learning about driving ships, loading cargo, and tying knots. We also spent a lot of time studying the different laws a ship's officer needed to be aware of. Although we were not being trained to be lawyers, we needed to be familiar with the different laws that affected the running of a ship on the water. The laws we studied in depth were admiralty law, which is the law of the seas, business law, which involved contracts and other legal documents used in the business of shipping, labor law, how to deal with crews that were members of labor unions, and the rules of the road, which are the laws that govern the safe operation of a ship upon the water.

There were also classes on the laws involving war as well as how to deal with pirates, a problem that is growing in the twenty-first century. We needed to know that the rules for navigating on rivers were different from the rules on the ocean. There was also extensive study of channel markers such as buoys that ships from all over the world are required to abide by. There were also classes on the different laws of the different ports of call in different countries. For example, we needed to know the difference between the rules for bringing a ship into New York versus bringing a ship into Hong Kong.

One of the more extensive and toughest sets of rules we were required to study were the rules of the road. These were the international rules of ships on the shipping lanes throughout the world. The reason I say this was one of the toughest sets of rules to study was because many of the rules were required to be memorized and written verbatim for the U.S. Coast Guard licensing exam. The rules were fascinating because they were written to amalgamate the changes in technology upon the high seas. For example, Rule #16 had to do with the advent of radar being introduced to the world of shipping. The rule states that a ship which detects the presence of another ship without visually sighting it must stop its engines. In other words, if you could see a ship via radar but not with your eyes, and a danger of collision existed, the rules had to be followed to the letter. There were many times at sea, our ship could see small fishing boats ahead of us on our radar, but we could not see them through the fog with our eyes. Immediately, we stopped our engines. After we stopped our engines, we were then directed by the rules to guide our ship cautiously until danger of collision was over. All ships are still required to follow that rule.

Another set of rules created because of change of technology are the rules between a sailing ship and a ship powered by an engine. Upon the high seas, a ship powered by an engine must always give way to a ship powered by sail. The exception is if the ships meet in a restricted channel or harbor. Then the ship that is more maneuverable must give way to the less maneuverable and often large ship, regardless if sail or engine propels it. These rules were required to be committed to memory because there was often not enough time to call an admiralty attorney and ask for an opinion. A ship's officer had to know the rules and the rules were different for different situations.

Rules of Engagement

As military pilots we were also trained to be very aware of the rules. When flying from one country to another, we were briefed as to distance and alti-tudes over beaches, altitudes over cities, rules for different airports, and many other rules. In war zones, we were also taught the rules of engage ment. Even though we may have been coming under enemy fire, we were still required to follow the rules before firing back.

Rich Dad's Rules

Rich dad was also very aware of the rules. He too required his son and me to know that there were different rules for different people and different situations.

When he drew his CASHFLOW Quadrant for Mike and me, much of his discussion of the differences between each quadrant was a discussion of the different rules that guided the different quadrants. For example:

In 1943, the Current Tax Payment Act was passed. This law basically made it possible for the government to get paid before any employee got paid. When people say, “Pay yourself first,” that statement technically does not apply to anyone in the E quadrant because in the E quadrant the government always gets paid first. My tax strategist, Diane Kennedy, says, “If you are in the E quadrant, there is nothing I can do to help you.” In other words, there is very little an accountant can do to help you with paying less in taxes.

Up until 1986, the people in the S quadrant enjoyed many of the same tax loopholes the people in the B quadrant enjoyed. But after the 1986 Tax Reform Act, anyone who was a licensed professional, such as a doctor, lawyer, engineer, accountant, or architect, as well as some employees, could no longer use the same loopholes as those in the B quadrant and I quadrants continue to use. That 1986 change in the law led to the crash of the real estate market, the stock market, and the end of many savings and loans. Banks, big business, and well-advised businesspeople and investors gained while many others lost tax advantages because of this law change.

In 1933, Joseph P. Kennedy, head of the newly founded Securities and Ex change Commission, and father of President John F. Kennedy, supported a law that in essence keeps the poor and middle class from investing in the same paper asset investments of the rich. As a result people who are not mil lionaires or people who earn less than $200,000 individually or $300,000 as a couple, which is less than 5 percent of the U.S. population, are often unable to invest in some of the best investments in the world.

When you look at the game board of CASHFLOW 101, you see two dif ferent tracks:

The CASHFLOW 101 game board reflects the 1933 SEC ruling. The smaller circular track is the rat race. That is where the poor and middle class invest. The larger track, the track known as the fast track, is where the rich invest. The point is that not only is the game different on the different tracks, the rules are different as well. Rich dad insisted that Mike and I know the differences be tween the games and the rules.

Rules of the Quadrants

I want as little money as possible coming to me from the E quadrant. I do not have nor do I ever want any income as a specialist such as a doctor, lawyer, or accountant from the S quadrant. Today, 90 percent of my income comes from the B and I quadrants. Why? The answer is because the rules for getting rich are better in those quadrants.

If you are to become the captain of your own ark, you may need to be very aware of the different rules for the different quadrants. Now that does not mean going back to school to become an accountant or attorney. It sim ply means you will need control over competent advisors, a subject covered in the next chapter. The reason you want to be aware of the different rules for the different quadrants is simply because as skipper of your ship, you need to know the differences.

At the academy, a very important course of study was labor law. The rea son we had to study labor law was because as ship's officers, we had to deal with unions, union labor, and union rules. If we as ship's officers were not aware of those rules, we would not have been effective leaders. So that is why we studied labor law.

On a similar note, rich dad had his son and me pay particular attention to the rules of the E quadrant. Once we understood the rules that govern workers in the E quadrant, Mike and I knew which quadrants we wanted to be in. The following are a few simple examples of some of the differences and the reasons why, as captain of your ark, you too want to know the differences.

1. Saving money versus borrowing. As covered earlier, most people think that saving money is smart. Yet, if you look at the tax laws governing each quadrant, you will see that saving money in the E quadrant is a losing proposition. For a person to save a dollar in the E quadrant requires that the worker earn nearly $2 since taxes take nearly 50 percent of a worker's earnings. When looking at the taxes a person in the E quadrant pays on the interest from those savings and the loss of value to inflation, saving may be a good habit but it is not a financially smart way to drive a ship.

In the I quadrant, I would rather borrow money than save money. In fact, the more money I borrow and the less of my own money I put into the real estate investment, the higher my ROI (return on investment). In other words, the more I borrow, the harder my own money works, and the higher my returns . . . if the investment is a good investment. Using an overly simplified example to make a point, if I purchase a $100,000 property and put 20 percent, or $20,000, down and borrow $80,000 at 8 percent interest and net $200 a month income after all expenses, my return on investment, or ROI, is roughly 12 percent.

If all things stay the same, and I only put $10,000 down, or 10 percent, borrow 90 percent, or $90,000, at 8 percent interest, my monthly net income drops to approximately $130 a month but my return on my $10,000 investment jumps to approximately 15 percent. That 3 percent difference is more than the interest rate banks are paying savers today.

If all things could be held equal, and I could find a similar investment, I would be better off buying two properties, putting less down, and earning more money by borrowing more money. If there were capital appreciation on both properties, then my return on capital would be even greater.

Again this is an overly simplified example. But the point is, if the invest-ment is a sound investment, the more I borrow, the higher my returns. That is why I would rather borrow than save, while most people think it smart to save and get out of debt. The difference is a difference of quadrants, rules, a difference in basic financial education, and a difference of experience.

Taking this example further, if you compute in depreciation, the returns go even higher; depending upon which quadrant you are in. If you are a doc tor or lawyer in the S quadrant, or an employee in the E quadrant, the fol lowing example may not work for you.

There are many times when Kim and I will earn a 15 percent return on our cash just from rental income. Because of the rules, we can also earn an additional 30 percent or more from depreciation, which is also known as phantom cash flow. So what appears on the surface as a 15 percent return may really be a 45 percent return. For example, on a $10,000 down payment on a rental property that returns $1,500 in net rental income, there can be an additional $3,000 in reduced taxes from depreciation, or a total of $4,500 cash flow per year from the $10,000 down payment. And if you structure your corporate entities, in which you hold title to your properties, correctly,

that $4,500 in real money can stay virtually tax free as long as you follow the rules. Try getting that kind of return from $10,000 in savings from your bank. At the bank down the street from me, if I had $10,000 in savings, I would be earning $200 a year and would be paying approximately $100 in taxes, net ting me $100 instead of $4,500 per year on the same amount of money. That is why I do not save money and would rather borrow.

Years ago, rich dad taught me that investing in real estate through a busi ness generates the investor four types of income. They are:

1. Rental income

2. Depreciation

3. Appreciation

4. Tax advantages

That is why he played the game of Monopoly with his son and me for hours and hours. It went far beyond simply making money. One of the main reasons was to teach his son and me the rules of the B and I quadrants. When all four types of income are factored into the simple example above, the $100 received from the bank is losing value, as is the $10,000 due to inflation. The $4,500 has a good chance of increasing due to rental increases, and the chances of additional capital appreciation of not only your $10,000 but also the bank's $90,000 is good, if the investment is a sound investment.

In other words, if the property increases in value, the bank continues to receive only 8 percent on the $90,000 and you get the rest. If the property goes up in value, let's say from $100,000 to $200,000, I can go back to the bank and borrow an additional $75,000 or more tax free or I can sell the property through an exchange, putting the additional $100,000 to work without having to pay taxes on the capital gains at that moment. In other words, the more financial education you have and the more you know about the rules of the quadrants, the more money you can make.

This simplified example just scratches the surface of what is possible if you understand the rules of the B and I quadrants. In other words, the actual returns can be even greater if you know what you are doing and have competent advisors. I will not go into the more technical information because I do not want to go beyond the scope of this book. If you have questions on the above example, you may want to talk to an accountant or a real estate agent who specializes in investment real estate. They may give you greater insight into the different rules of the I quadrant.

A caution: For these numbers to work, a person should have several years of real estate investing under his or her belt. If a person does not have that experience, I would not recommend using your banker's money to get ahead financially. Debt as leverage can be very dangerous on a ship with a green captain. Warren Buffett says, “When you combine ignorance and bor rowed money, the consequences can get interesting.”

If you are interested in learning more about what my rich dad taught me about the six steps of real estate investing, you can read about a new prod uct we have created with Time Life at richdad.com.

2. Owner of a business rather than an employee of a business. As the cap tain of your ark, you will need to know the differences between an owner of a business and an employee of a business. When you compare the financial statements of an employee versus those of a business owner, the differences speak for themselves:

I realize many of you have seen this diagram before and understand its importance. It reinforces the differences in the rules of the different quadrants. As an employee, all expenses are after-tax expenses. As a business owner, you have some degree of control of what you spend with pre-tax dollars versus the employee's after-tax expense dollars. Again, the issue is a difference in rules . . . and there are many other differences in the rules. As captain of your ark, you want maximum control over the use of the different rules of the quadrants. An ark consists of all four quadrants and that is why you need to know the rules.

Taking Control of the Rules

One of the reasons I want as little income as possible from the E quadrant is simply because I have the least control over the rules. In the E quadrant, the government controls the rules. Even when it comes to an employee's socalled tax free retirement plan, the government still makes the rules.

In America, the government allows an employee to place a limited amount of money into their DC pension plan but when it is pulled out, in many instances the income is pulled out at the highest tax rate possible, the tax rate of the E quadrant. In other words, even though employees today are investing, in many ways, ERISA forces them to invest into the rules of the E quadrant rather than the rules of the I quadrant. I do not like the rules of E quadrant because the rules of the E quadrant limit the amount I can invest and often limit me to savings, mutual funds, and stocks, which are the investment vehicles of choice for the middle class. People who invest in only these investments often have small arks. If you want to have a large ark, you need to invest in the invest-ments of the rich. To do that, you first need to take control of the rules.

The diagram below appeared earlier in this chapter.

When you look at the I quadrant, you see the date 1933. That was the year the 1933 act required that all offers and sale of securities be registered, unless they fell within certain exemptions. This resulted in a difference be tween paper asset investments for the rich and for everyone else.

Rich dad said to me, “One of the problems of ERISA is that it confined investors to the paper asset investments of the middle class. Those are the riskiest investments with the lowest level of returns.” The reason he said they were the riskiest is because the investor has very little control over the ups and downs of the markets. The reason he said they provided the lowest level of returns is because most mutual funds are diversified. To that point he said, “When you diversify your mutual funds, you are diversifying something that is already diversified. Diversifying mutual funds is like taking a high-octane gasoline and adding water and then adding orange juice to it. Why would you advise someone to diversify something that is already diversified? Why not just tell them to keep their money in the bank? The net return will be about the same in the long run and it's probably less risky.” As a side comment rich dad said, “Diversification keeps the stock market floating at unrealistic values. Because a mutual fund is a diversified fund, many stocks are purchased instead of just one good stock. That gives the less valuable companies a higher than realistic valuation.” In other words, mutual funds inflate the stock prices of average companies, which causes a bubble . . . a bubble that will eventually burst.

If you will look deeper into the I quadrant, you may notice that there are more investments than just paper assets. In the world of investing, the three main asset classes are businesses, real estate, and paper assets. Again, by investing in paper assets through your retirement plan, by law, you can only invest in the paper assets of the middle class. But if you invest in the other assets, assets such as businesses and real estate, you can use the same rules the rich use and gain the same advantages of the rich. To me, that makes more sense.

Using the Rules of the Rich

When a person realizes that their DC pension plan is not going to carry them the distance, and they ask me what to do, I say the same thing rich dad would say, which is, “Stop using the rules of the middle class and start using the rules of the rich.” I then offer the following suggestions and remind the person that they are only suggestions. I would not force anyone to do what I recommend unless they really wanted to do it and they were willing to in vest time into study and real-life experience.

Build Your Own Ark

SUGGESTION #1: KEEP YOUR DAYTIME JOB AND START A PART-TIME BUSINESS

This activity immediately gives you the following advantages:

1. The tax advantages of the rich. The diagram comparing the income statement and balance sheet of an employee and a business owner explains this advantage.

2. Allows you time to practice learning the skills and the rules required for the B quadrant. You have to start preparing now because the years of greatest change are still coming. Starting a part-time business now will give you a number of valuable years to gain priceless experience.

3. More control over your life. Rather than dreading being downsized or forced to retire before you can afford to, starting a business gives you a cer tain degree of control over your future.

4. When the stock market crashes, business goes on. In 1950, the economy was booming while the stock market stayed depressed. It was only when Charles Merrill, one of the founders of Merrill Lynch, introduced storefront retailing of stocks that the stock market took off again. The reason you want your own business is because if your business is part of the legitimate economy, business and trade will continue even if the market stays down.

Warren Buffett says, “I never attempt to make money in the stock mar ket. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

The stock market is not really attached to the smaller but real economy. The economy may be depressed but the economy will go on. Businesses such as food stores, dry cleaners, gasoline stations, insurance agents, real estate sales, pest control, retail stores, professional services will continue on. Big business may be hurt but small legitimate real businesses will do okay.

5. Small businesses can grow into large assets. For example, let's say someone starts XYZ Small Juice Company with a $10,000 initial investment. Ten years later, the company has no debt and nets $100,000 in earnings. Using a ten times earnings formula, if that company were sold, it would be worth $1 million to the owner.

If ABC Big Juice Company comes along and licenses the use of XYZ Small Juice Company's secret formula, that license alone could possibly be worth millions of dollars in royalty payments if ABC Big Juice Company markets XYZ Small Juice Company's products worldwide. That licensing transaction is invisible but very profitable. It is also intellectual property.

Every successful business has intellectual property. Intellectual property includes patents, trademarks, copyrights, trade dress, reputation, licenses, goodwill (reputation), and much more. As the future becomes more invisi ble, intellectual property has never been more important. It is the key to great wealth now and in the future. Educate yourself on intellectual property by reading Protecting Your #1 Asset: Creating Fortunes from Your Ideas by Michael Lechter, a Rich Dad's advisor.

6. A higher rate of return. The DC plans are forecasts based on an aver age 8 percent to 9 percent gain. Small business owners, if they are good, can get a significantly higher rate of return. So rather than investing a dollar into a DC retirement plan, a dollar invested back into your own business could easily get you a 40 percent to 100 percent return, with tax advantages, again if you are a good business operator.

Quoting Warren Buffett: “A lot of great fortunes in the world have been made by owning a single wonderful business. If you understand the busi ness, you don't need to own very many of them.”

7. Getting started. So you have decided to buy or build a business. There are many decisions to make. The following is adapted from You Can Choose to Be Rich (available at richdad.com):

Build it. Of all the business options, starting your own company is the most difficult because you'll be developing every system on your own. However, it is also potentially the most rewarding. In choosing a business it is always best to solve a problem or serve a need. When you have decided on the type of business, here is a partial list of the next steps to follow:

Name your business.

Begin to seek funding sources. Search for outside advisors.

Select your business entity and form it.

Obtain any necessary licenses and permits. Set up a relationship with your banker.

Protect proprietary information (intellectual property). Write a business plan.

Select your location.

Form your manufacturing or procurement or service procedures—i.e., how you will manufacture and deliver your goods or services. Plan ahead for bookkeeping, accounting, and office systems. Decide on pricing strategies.

Determine employee needs. Prepare your marketing plan. Seek insurance coverage. Address legal issues.

Fine-tune your cash flow budget. Set up your office.

Hire employees.

Announce your business.

Buy it. If you want to avoid the headaches of starting a business from scratch, you may decide you want to buy an existing business. Here are some pros and cons to consider:

PROS

No long risky start-up period All systems in place

Existing customer base

Faster route to profitability than with a start-up Existing goodwill of the business

The danger of buying a lemon Skeletons in the closet

Sticky personnel issues due to the transition Potential competition from the seller Existing ill will of the business

Buy a franchise. You may want to buy a ready-made business system that offers a support structure to you as well. If so you may want to consider a franchise.

PROS

Tried and proven business systems

Licensed trademark and recognition of brand Training program

Operations manual

Specifications, quality standards, and blueprints Ongoing assistance in systems and operations

Expensive

Restrictive, as you must conform to the operations manual

Join network marketing. You may want to join a network marketing com pany where the entry cost is low and there are training programs to help you succeed. The companies are typically based on direct sales with homebusiness opportunities.

PROS

Minimal start-up costs

Comprehensive training

Can be either fullor part-time Can work at home

Work with a national or international brand Build passive and residual income

Develop communication and leadership skills

Automated order-processing, distribution, and accounting systems prevent many of the headaches associated with traditional start-ups

Low start-up fees can mean low commitment Need self-discipline

Need to deal with rejection

This activity gives you:

1. The ability to use your banker's money to invest. Instead of trying to save money for retirement, if you learn to invest in real estate, you can bor row money to become richer faster.

In an earlier illustration, I used the example of a 15 percent return using 90 percent borrowed money. On top of that, if you know what you are doing, you can gain an additional 30 percent in real phantom cash flow. While this sounds easier than it really is, it is also not that hard. One of the reasons I am excited about the joint venture product with Time Life on real estate investing is because this product goes into great detail on my rich dad's six steps to becoming a better real estate investor. The six steps are important, regardless of where you live, because if one or more of the steps is missing, the real estate investment will go sour. That is why all six steps are important.

1. Decide to become a real estate investor: You have to make a commitment and set your goals.

2. Find an area to concentrate on: If you're just starting out, stick with an area you're familiar with or that is nearby.

3. Find properties that meet your criteria: By learning how to analyze properties, you'll be able to tell good deals from bad ones.

4. Negotiate the deal: After analyzing the numbers, you are ready to make offers, negotiate, and reach an agreement.

5. Put the deal together: From due diligence to financing and settlement, it's important to keep on top of all the technical details.

6. Manage the property: It is not as much hassle as you think—and it is one of the best ways to make the most of your investment and get the cash flowing.

(This was adapted from Rich Dad's Roads to Riches: 6 Steps to Becoming a Successful Real Estate Investor, available at richdad.com.)

2. The awareness that real estate is real business. When you look at the financial statement of your tenant, you will see why the property you rent to him is so important.

Looking at the financial statement you can easily see that rent is a high priority expense for your tenant. Rent for many people is more important than their DC pension plan.

For those of you who are concerned about the management of your real estate investment, the real estate investment product created with Time Life goes into how to find good tenants, keep them happy, and keep your cash flowing in.

I often hear people say, “Many people have lost a lot of money in real es-tate.” To them I reply, “That is true. But the facts are, more people have lost a lot more money in the stock market through their retirement plans.”

Another comment I hear is, “Real estate is not as liquid as stocks and mu tual funds.” To them I reply, “Every month, Kim and I receive tens of thousands of dollars in rental income as well as income from tax advantages. That is the kind of real liquidity we want.”

If you are concerned about your DC retirement plan, and do not want to make a large commitment to real estate, you may want to consider owning four houses. You have one house to live in, and three houses to provide you income when the stock market crashes.

John Maynard Keynes, the famous economist, once said, “The markets can remain irrational longer than you can remain liquid.” Small real estate properties can provide you the liquidity until the market crash is over, re gardless of how long the recovery takes.

SUGGESTION #3: PLAN ON BECOMING RICH RATHER THAN BECOMING A HIGH-INCOME PERSON WITH A LOT OF MONEY

In other words, use the rules of the rich, which are the rules of the B and I quadrants. Many people who are high-income people, people such as doctors, lawyers, and high paid executives, are severely penalized for their high income. By utilizing the rules of the rich, a high-income person can gain more control over their money and become rich faster, safer, and more efficiently.

In other words, a DC pension plan, a Roth IRA, Keogh, and other plans really do not help the high-income wage earner. (To further understand how the rich get their money and keep their money safer, you may want to read Loopholes of the Rich by Diane Kennedy, CPA, Own Your Own Corporation by Garrett Sutton, attorney, and Real Estate Riches by Dr. Dolf de Roos. These three Rich Dad's Advisors books can help high-income people become rich people.)

SUGGESTION #4: UNDERSTAND HOW PROFESSIONAL INVESTORS PROTECT THEMSELVES FROM MARKET CRASHES

When I purchase a piece of real estate, my banker requires me to insure my investment. The same is true for my businesses. When professional investors invest in stocks, many use insurance to protect their assets. But most people with DC pension plans have no insurance from catastrophic loss. When the market crashes, they find out they have no control. As captain of your own ark, anything you invest in must be insured.

In Retire Young Retire Rich I wrote about how to use options to insure your paper assets. Find out how to use options as insurance, and you will find out how experienced options traders make fortunes with very little risk and much higher returns. Once you know how options work, you may never want to purchase a share of stock or mutual funds again. The advanced game CASHFLOW 202 teaches technical trading in a fun and risk-free environment. However, you must master CASHFLOW 101 before you tackle the advanced version.

SUGGESTION #5: DON'T DE-WORSIFY . . . DIVERSIFY

When I hear people say they are diversifying, I ask them what they mean. Many simply diversify into more paper assets such as sector funds, large cap funds, bond funds, and money funds. This is not diversifying . . . this is de-worsifying. All a person is investing in is more and more paper assets, often more mutual funds. Instead, I recommend investing in different types of asset classes and truly spreading the risk . . . but also improving your chances of higher returns.

My rich dad taught me to build businesses and then invest the profits from the business in real estate. I have followed this formula over and over again.

Case Study

Scott is a dentist and real estate investor in Seattle, Washington. He became a dentist because his father, a life-long employee, encouraged him to be his own boss. A couple of years ago, he took the time to analyze where he was in designing and building his financial ark. He owned two practices as well as the buildings for both practices. Even with this setup, he realized he would still have to work for the rest of his life. The major portion of his income was still from his physical labor as a dentist. He also knew he did not want to join the typical rat race of buying a big house and bigger car, supporting wife and kids, and so on.

At this point Scott read Rich Dad Poor Dad and realized that while he had built a successful practice, he needed to diversify more into real estate. Following the Rich Dad philosophy, Scott developed and took control of his own set of investment rules. He started saving 20 percent of the dental revenues weekly and put it toward real estate investing. After starting with small properties, he used his time and discipline to invest in bigger and bigger deals. He has now invested in warehouses, gas stations, strip malls, and other commercial properties. In fact, he owns one warehouse that generates $17,000 every month in cash flow. He also invests in real estate contracts, which are paper assets that pay him 14%. He attributes his success in moving to the right side of the CASHFLOW Quadrant to the lessons he learned from Rich Dad. Today, he even passes out copies of the book to his friends.

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