The road to financial freedom is difficult and fraught with risk. Reaching financial independence means managing risk. In this episode, Patrick Donohoe talks about risk management, investor wisdom and due diligence. He shares an experience with a bad investment and what he learned from it. Tune in to learn more about what you need to keep in mind when investing.
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Investor Wisdom: Sound Judgment, Due Diligence And Managing Risk
This episode is sponsored by the new and improved Financial Independence Calculator found at TheWealthStandard.com/calculator. One of the driving forces of human beings is freedom, which infers financial freedom too. Several years ago, I set out to discover how any individual, regardless of their financial situation, could evaluate their finances in five minutes or less and have a firm date when they could achieve financial independence. The calculator is going to take you just a few minutes to complete and it’s going to provide you with a specific financial independence date. Go check it out now.
“Life is a series of sensory experiences, then you die.” This statement sunk in at a pretty deep level. Time sneaks up on us. Our survival instincts make us believe that we’re going to live forever. We get those momentary glimpses of our child’s faces, who are now more adult than they are kids. It’s conversations with family members that are in their fourth quarter of life or you hit marital milestones that are calculated in decades instead of years. We can’t get our time back and exchange it for the meaningful experiences we want that were most likely taken up by the mundane work or wasteful, meaningless activities.
You may not consciously link the fleetingness of time to wealth-building and investing, but I want you to consider the possibility that there is almost a direct correlation. In my experience personally and with clients, urgency will breed complacency and impulsiveness when it comes to making financial decisions. This urgency comes from the unconscious realization that you may not have enough money to retire or be financially free. In order to have more money, you must invest and investment requires risk. This urgency is, in my opinion, amplified by the unfathomable amount of information and perspective we are constantly bombarded with, which further limits our capacity to think critically.
We’re all in this tractor beam of stimuli and without awareness and discipline, we have little control over filtering what is constantly fighting for our attention. I saw this report by Statista, a data analytics company, about what happens on the internet in just one minute. It blew my mind. Look at some of these statistics. Two hundred million emails, 69 million messages on Facebook and WhatsApp, 2 million Tinder swipes, 5,000 hours of YouTube videos are uploaded, 695,000 people share a story on Instagram and 9,132 new connections are made on LinkedIn. There’s more. It’s crazy. How do you step out of this tractor beam to make wise financial decisions? I’m going to tell you a personal story to illustrate this.
In 2006, I was introduced to an investment opportunity in a new oil and gas company. The principals had worked at one of the largest oil companies globally. They were stationed all around the world in the Middle East and parts of Texas and Oklahoma. They stepped down to form their own company and were raising money to acquire these unproductive, inefficient oil and gas operations in Texas. I ended up investing almost everything I had initially. I was very compelled by these guys, but I didn’t understand successful business operations, let alone an oil and gas company. I didn’t know even what the word assay meant. I couldn’t begin to understand what an assay report was, the legalities of mineral rights, contract law or the fact that the investment I was putting money into was debt and not tied to any underlying asset, but I invested anyway.
Leading up to the craziness in 2008, I was getting cashflow every month. I felt like this was a wise investment and I was a good investor. I decided to invest even more. I borrowed money to do it. This was when cashflow stopped. It was devastating. I won’t go into that. I tell the story in the book. After the initial emotional meltdown from 2008 to 2011, I went on this witch-hunt to figure out what happened. I learned a ton about business operations and the cost of lousy operations. An example is the discovery of this oil field operator coincidentally having ownership in a trucking company that was transporting the oil. Apparently, they thought it was okay to charge five times the going rate to this specific operation.
I also learned from the assay and financial reports that the interest that was being charged on these promissory notes would inevitably result in ongoing negative cashflow. There were a dozen other discoveries. I’m not going to get into it, but I’m going to segue into the lessons and apply them to your investment experience. First, one of the biggest skills of an investor is knowing how to think critically, which to me is an inhibitor to impulsive response and irrational behavior when it comes to making financial decisions. Why? All investments originate from a hypothesis perspective. The hypothesis is simply an interpretation by an inherently fallible person who won’t tell you that they’re fallible to highlight all the things they’re good at.
The lesson is to evaluate the team that will execute the investment, “Are they green?” If you don’t understand business fundamentals or the industry that you’re investing in at an operational level, at least stay out. You don’t have business there. It’s a huge risk. The principals in this specific investment, I trusted them and that’s why I invested for obvious reasons. They were successful specialists in their respective careers, but they didn’t possess the adequate business acumen to make the investment successful on a business scale. If they did, there were so many red flags that I was able to find as a neophyte that they would have found out if they knew how to do proper due diligence.
Managing Risk: We can’t get our time back and exchange it for the meaningful experiences we want that were most likely taken up by the mundane work or wasteful, meaningless activities.
I would also say that private investments like this one don’t have the level of regulation that a publicly traded investment has. That’s why there’s a greater upside, but also it carries a huge amount of risk because of the downside. There’s still risk in publicly traded investments, but what minimizes that risk is the regulatory criteria that come with severe consequences if it’s not met. There’s a high degree of built-in accountability with publicly traded investments. In order for someone to be successful in that arena, they have to consistently meet these criteria. It includes accounting, legal, business operations, executive levels, managers and hiring, which adds to the expense. That is why dividend returns on publicly traded companies in the oil and gas industry like Exxon or Schlumberger are typically always in the single digits.
The next lesson is to know your asset allocation based on risk and control. That was another error where I invested way more than I should have given the amount of money I had at that time. This is one of the reasons I came up with the Hierarchy of Wealth. I wrote about this extensively in Heads I Win, Tails You Lose, which is the book I came out with that tells you more about the theory behind it. The Hierarchy of Wealth has four tiers. It will help you easily look at your asset allocation so that you know the appropriate amount to invest in these higher-risk assets.
What do you do with the lesson? First, we have a free calculator for The Hierarchy of Wealth. You can put your assets into it easily. The idea behind The Hierarchy of Wealth is to go in a sequence of priorities. You build your tier-one capital, which is your foundational capital. Your reserves and sleep well at night account. You do this before investing in anything else. Next, instead of investing outside of you, you invest in yourself. You figure out how to earn more money by being more valuable in the marketplace. As you go through this hierarchy, you invest in more safe assets that have good returns, individual rental properties that have at least 20% equity and a 0.8% rent-to-value ratio. I talked about that in the book as well.
When you get to that point, invest in what you understand. My brother came to me and was a great example. He was through his Hierarchy of Wealth and ready to invest maybe with more risk to get the better upside. We had a conversation about his expertise which is mergers and acquisitions, especially in the healthcare industry. He knew it forwards and backward. Understanding the financials, business plan and team involved, he would be able to go in and do due diligence on a very high level. It’s investing in those areas and companies. It could be a REIT in the healthcare space, Real Estate Investment Trust. It’s something that he was familiar with that he can take his knowledge and expertise and do the proper due diligence to figure out if it’s the best place to put his money that will mitigate risks.
There are other examples I have in the book of being able to invest in areas that you understand. The book you can get for free on the website in PDF format. Go to Resources and the book link should be there. The next thing to do is sharing is caring. Share this information and teach somebody else what you guys learned. It’s one of the best ways to lock in the understanding so that the next time you are faced with financial decisions, specifically in the arena of making an investment, you will remember this experience. Chances are, if you don’t teach somebody in 2 or 3 weeks, the information will be gone.
Let’s summarize this episode. First, all investment is a hypothesis by people. Therefore, it inherently is susceptible to flaw and fallibility that requires due diligence. Learn to judge your judgments when investing because you instinctually will make a judgment unconsciously and look straight to the rate of return and the opportunity to build wealth. You also associate decisions with the character and charisma of the person in charge. Make a judgment about their level of competency without going beneath the surface, which is that big lesson that I learned. It was a hard and painful lesson and one that I hope you don’t have to experience.
Finally, another thing you guys can do is there’s a live demo that I’m doing with the Financial Independence Calculator as well as The Hierarchy of Wealth. This is going to happen in 2021 on September 10th. If you already have the Financial Independence Calculator and the Hierarchy of Wealth Calculator, then you will receive an email. If you don’t have it, you can go to TheWealthStandard.com/calculator. There you will be given the opportunity to register for this live demo that I’m going to do. I’m not sure of the time yet, but it will most likely be in the afternoon. Thank you for reading. I appreciate the support. I hope you learned something and stick with me for the coming episodes. You’re not going to want to miss them. Until then, take care.
Investing is a fickle business. There is so much in line that when you fail to do your dues, you could end up in a bad position easily. While the world has become so advanced and giving (opportunity-wise), especially in the private investment world, it still helps to gain a better understanding of what you’re facing ahead. Patrick Donohoe brings in Mauricio Rauld of Premier Law Group. With more than a decade in the business, Mauricio has seen the good, the bad, and the ugly when it comes to deals. He shares his perspective with us, along with questions and insights, that will help improve the way we ask questions and do our due diligence on private investments. Mauricio guides us to understand the accountability structure, value proposition, and the principles of the business at a high level. Don’t miss out on this great conversation, and remember that good business equals good investment.
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Private Investment: Ask Better Questions, Do Better Due Diligence With Mauricio Rauld
This is going to be a fun episode. It’s a little bit shorter but packed with good information around how to ask good questions, how to do good due diligence on the private investments that you make. I’m intrigued by the private investment world. Our culture is going quickly and it’s amazing. The innovation that’s taking place is beyond our comprehension sometimes. It’s continuing to go faster and faster, which is awesome. It makes things faster, easier and cheaper especially from a business perspective. I’ve been able to reduce costs, especially in software, over the last several years because of innovation. It’s becoming a part of our culture. It’s also easier these days to raise money to do deals, to put companies together, to put projects together, to put investment together and those opportunities are going to continue to increase.
My perspective of private investment is based on the experience that I’ve had, but how do you convey that perspective to the typical investor out there that may have some knowledge but not as comprehensive of a knowledge? I brought in an individual that I’ve known for several years. His name is Mauricio Rauld with Premier Law Group. Mauricio has seen hundreds, probably over 1,000 deals, maybe even more than that in his practice over more than a decade that he has been in business. He mainly specializes in the real estate space. He’s done business in other sectors as well as far as raising capital for startups or for technology and so forth. He is agnostic essentially to the actual details of the deal itself.
He is putting together the documents and the structure so that those that are spearheading this project are doing it legally. He’s not getting into the logistics and the credibility or the legitimacy of the actual value proposition itself. It’s more of the legal documents and ensuring that money’s being raised the right way. He’s been able to see good deals, but he’s also seen a lot of bad deals, things that have gone sideways. I’m hoping that his perspective gives you some questions, some insight and things that you can do to improve your due diligence, so that when you are taking your money and you are expecting somebody else to be a good steward of it, that you do as much as possible so that you leverage them, not just delegate the responsibility to them getting you a rate of return.
It’s understanding the accountability structure, understanding the value proposition at a high level, understanding the principles of the business. Remember this season we’ve been talking about good business equals good investment. If you have bad business principles and acumen, you’re most likely going to have a failed investment at some point in the future. You want to be aware of all of that upfront as well as get the appropriate financial education in order to ask the right questions, the best questions, those quality questions. Mauricio is going to give you that perspective. It’s going to be awesome. You’re going to love this episode.
I have a good buddy on with me, Mauricio Rauld of Premier Law Group. Mauricio, thanks for taking a little bit of time. You’ve been on before. We’ve known each other for the better part of a decade. I look at your position as far as what you do professionally. It’s very unique because you get to see investments from a vantage point that nobody else gets. You get to see a lot of it. Would you talk specifically about what your specialty is when it comes to private investments and then we can get into the experiences you’ve had over the years?
The short of it is I’m a syndication attorney. I’m an SEC lawyer, which means I help primarily real estate investors raise capital to then placed into real estate investments. Those are multifamily deals. They might be single-family, self-storage, mobile home parks. It’s all kinds of variety of investments. I’ve seen the gambit over the last several years now, primarily multifamily let’s be honest. That’s been the hot asset class, but that’s not exclusive. People raise money to invest in all kinds of things. I’ve had the privilege of seeing all types of little different asset classes, how people have been structuring and how successful they have been in acquiring that capital.
This is the novice person that doesn’t understand the legality of it all, but someone can’t go out and say, “Give me your money and I’m going to invest it for you.” That’s not legal. You can’t do that. There’s the public world, which most people are familiar with where you have high levels of accountability. You’ve very liquid capital markets. The barrier to entry is high, but you have private investment. It’s been around forever and it’s massive. You don’t hear much about those types of investments. At the same time, there’s a legal way of doing it and an illegal way of doing it.
The illegal way of doing it gets a lot of people in trouble. You’ve seen that and you write about it quite often, but there’s the right way of doing it. You ensure that the right way is taken when a person raises money to make sure that they do it the right way. You’re agnostic to the type of investment. You specialize in real estate, but you’re agnostic to where the project is. Who’s the principal? Who are the investors? You’re on the sidelines putting the paperwork, the legalities together and a lot more than that. I’m summarizing, but I know there were a lot more than that. In a nutshell, what else comes to mind as far as your position and what you do?
That’s exactly what I always tell people. There are two things you’re doing. One is you’re raising the capital and number two, you’re deploying it in whatever you’re doing. I handled the raising capital. I’m totally agnostic. We do non-real estate deals. We’ve done a couple of cryptocurrency funds. That’s been a hot thing, so some people put together cryptocurrency funds. I’ve also done startup tech companies that are software companies. They are putting a fund around to raise. By and large, 100% of my clients are real estate investors. They happen to sometimes venture off in other things.
Let’s get into the topic at hand. The outcome that I wanted to help the audience with is to ask other questions, do better due diligence, look for things inside of an investment or a business. What they’re putting money into, which will make them a better steward of their investment so that they’re not blindly handing money over to somebody and crossing their fingers that it will work out. Your vantage point is that you’re able to see all of these different types of investments and meet a lot of different syndicators those that have been doing it for decades. Not to say that those who have been doing it for decades are going to be successful.
They equally get stuck in their ways and ultimately make bad decisions based on the modern economy and not end up well. For those that you’ve seen consistently do well by their clients, those that have succeeded with raising money and deploying it in a way where they not only return the investment but a return on the investment. Ultimately most private investments fine print in a nutshell like, “You can lose all your money and we’re not legally responsible if that happened.” That’s ultimately what it says. What are the things that you see consistently that are done the right way and done the wrong way conversely?
I like the way you framed that. It’s one of my favorite things. If you want better answers, you’ve got to ask better questions. What are the right questions that investors should be asking or at least looking at? One of the things clearly that I see people are doing successfully is they’ve got a track record. The track record is huge. Anybody can put together a fancy business plan, anybody can throw numbers in a spreadsheet and make it seem like the investments are out of this world. Somebody has to execute on that plan and make it happen. That’s a lot of times easier said than done. One thing is to raise money. You can get people who are great at marketing and great communicators, but somebody has to do the work. Having a track record is very important. It doesn’t necessarily need to be a track record in syndication. This might be somebody’s first-ever syndication, but at least they’ve got a track record of doing that themselves. They’ve had a successful track record where whatever thesis they’re putting forward, they’ve tested it and they’re doing well.
They hit a wall like everybody does, which is you’ve run out of your own money, you’ve run out of your own resources or you want to scale. If you suddenly find an investment that’s working well and you’re limited by your resources, syndication is a great way to pool other people’s resources, whether it’s cash or credit or relationships or experience or whatever those resources are. It’s a great way to scale. A track record/execution because if you’ve got a terrible track record, that doesn’t work. A good consistent track record of executing is important. You and I know a lot of syndicators who’ve been doing this for a long time who are able to raise tens of millions of dollars on one email or one quick webinar or something because of the track record as opposed to if this is your first time, it’s a little bit harder to raise the money. To me, the track record is the first thing you want to look at for sure.
Private Investment Due Diligence: Syndication is a great way to cool other people’s resources, whether it’s cash, credit, relationships, or experience. It’s a great way to scale.
What are maybe some other things there? Obviously, track record, you want to make sure that this isn’t the person’s first rodeo or maybe if it is, I came across an investment where it’s the first time this guy was syndicating. It took me about six months to put money into it, but I did it. It was a private investment in the energy and startup sector. I did it because he had a partner and his partner had 25 years of experience and had done these massive billion-dollar deals. Sometimes if a person doesn’t have a track record, it doesn’t mean that it’s not going to be a good investment. Essentially looking at the principles involved, which is usually the case, different partners, a board potentially like the team involved, that’s also an important element. What else do you commonly see that frustrates investors or investors end up losing because of?
The only one that’s sometimes frustrating for me is understanding the assumptions that the sponsor or the person raising the money and doing the investment is relying upon. That’s important because if they’re wrong on their assumptions or thesis or maybe more importantly if their assumption is not aligned with your assumptions. I’ll give you a great example. In the multifamily space, there’s an argument to be made. A lot of people are arguing that we’re at the end of the cycle or at the top of the cycle. If that’s your belief that we’re at the top of the cycle, you probably shouldn’t be matching up with somebody who thinks we’ve got five more years to go.
I see that specifically in the underwriting. One of the things you want to be doing is looking carefully at the business plan, all the docs and the underwriting, which is essentially the assumptions they’re making and look out for some red flags. Based on my personal beliefs, but some of the red flags, for example, if you believe that we’re a little bit frothy on the cycle, that there might be some headwinds coming in the next few years, having somebody put a short-term bridge loan or a short-term debt in place to get you to the permanent financing a few years later, that’s a little bit risky if you think that something’s going to happen.
In a scenario like that, you only have one exit strategy, which is to refinance into a permanent loan. If you cannot do that for whatever reason, then now what? You’d probably have to sell the property and now what happens? Probably you’re having an issue getting financing because we’re in a recession and that was probably the worst time to sell. That’s one example of assumptions you want to look at. The other one that I see a lot, and again my job is not to question them. As the attorney, my job is to make sure I understand what the assumptions are and that we make sure the investors understand, so we disclose all those assumptions.
The other big assumption is rent growth. If you’re looking especially on a real estate deal, rent growth is important because that at least on an underwriting will show you an increase in revenue year over year because rents are going up 2%, 3%, 4%, 5%. There’s an assumption being made that because rents have been going up a certain percentage over the last several years in a particular market or submarket, that rent growth is going to continue. That’s an assumption. Whether you’re right or wrong, I don’t know, but that’s an assumption. It could be an aggressive assumption where you might be assuming it’s been 5% increase for the past several years so we’re going to assume 5% every year or maybe 2% or 3%. What people forget is it’s possible there would be no rent growth or even negative rent growth. You need to make sure that your personal investment philosophy or your assumptions are matching up with what the assumptions are of that particular operator.
It would be interesting to look at if those assumptions ended up being the worst-case scenario, negative growth or zero growth or occupancy not going up or what is the minimum occupancy, especially in a multifamily deal. See if the deal makes sense. Sometimes assumptions can layer risk onto the underlying investment. That’s the importance of going through the business plan, understanding what’s been done in the past. That’s where you’re going to start to differentiate the true value proposition and where you’re going to get your return.
Here’s a great question for investors to ask, have you stress tested this model? How low can our occupancy be so that we can still sustain our debt? You’ve got a requirement that typically you have a debt coverage service ratio of probably 1.25 or something. If it drops below that, your lender is not going to be happy. How much can the occupancy drop and still maintain those levels so you’re still good? You can cover your mortgage even though maybe your investors won’t be getting money, but at least, you’re not at risk of losing the property. How much can rents drop and still cover it? You want to stress test. Most of my clients do a stress test, but it’s not just stress testing, it’s finding out what that stress test is. The first one you should look at is how low can we go for us to break even. At what point are we having problems? Stress testing all of these is important.
This has been super helpful because it comes down to the statement you made. The quality of an investment you could even say is a corollary to the quality of the questions that you ask. That leads to your understanding of what the value proposition is, what the syndicator is doing, and how your money is going to be put to work. Without that knowledge, it’s a gamble. What else do you see as far as things to look for that you see when investors go crazy in a bad way. They do a suit. What happens between the time money is raised and the time that return started to be paid out, the investment comes to fruition. What are some other things that frustrate investors that you can identify upfront?
One of the ones that are critical and it goes both ways. I’ll give you an example of how this particular topic goes both ways. It’s something that investors don’t like and will result in them not coming back a second and third time is a lack of communication with the investors or lack of transparency. One of the things that a good operator will do not only be consistently communicating with their investors in good times but especially when bad times come, that’s when they continue to communicate. Sometimes, the operators that I know that are doing it well, they over-communicate when things aren’t going well.
One of our mutual friends likes to say that builds trust. Not only respect but trust because it’s a lot harder to get on the phone call and tell people, “You’re losing money or you’re not going to get distribution,” but people understand it. In general, most people understand, especially if it’s not your fault. Things happen. Things never go according to plan. Having that communication level goes a long way for investors. The flip side is the same too. I’ve got clients who will pick up the phone and have a one-on-one phone call with all their investors when the distributions are made because nobody’s happier in the deal as the day they get a check in the mail or an ACH in their bank.
Giving them a call and say, “Patrick, it’s payday.” That creates that rapport with the investors when it’s a happy time. This particular client of mine does this. He is very successful in raising capital over and over again because he is building that level of trust and communication. Our buddy, Ken McElroy, does this a lot too. He puts together events with his investors so he can get to know them well and try to provide more and more value. The old adage is we do business with people we know, like and trust. The more you can get to know them better and had them trust you, communication goes a long way with that trust factor.
Transparency is involving and it’s enrolling because this is money that people have worked for and have earned. They’re handing it over to somebody that didn’t earn it. Looking at how they place their expectations is vital. I look at the track record. Sometimes I try to find out when things didn’t go right when things went sideways, what did they do? That shows the character. It’s not a guarantee, but it shows you what they will likely do if things don’t go according to plan in the future, which is huge.
Another good example that triggered is a lot of clients will forego some of their fees when things aren’t going well. You may have an ongoing asset management fee, for example, as the manager, as the operator to keep the lights on and maybe that’s 2% or 3% of the gross. If the investors aren’t getting their money, even though legally you’re entitled to take that, you don’t want to be in a situation where you’re getting paid and the investors are not or getting paid less. A lot of my clients will forego the asset management fee. I also have clients who, if things are going south and a cash call is required, a lot of operators will step in and not do a cash call, but come out of pocket themselves and try and avoid that at all costs. That goes back to the track record and the reputation of that operator and those who do that tend to do well the second and third time, especially when you get these referrals. When you’re asking somebody else, “Patrick, I know you’ve invested with this operator before, what can you tell me?” When you say, “The last one wasn’t great, but this is what they did during those tough times.” That goes a long way.
Private Investment Due Diligence: Make sure that your personal investment philosophy or assumptions are matching up with what the assumptions are of that particular operator.
This has been super helpful. They’re simple things. Usually, it’s those simple things that make the biggest difference. It’s like a game between a gold medal and fourth place. Gold metal is known throughout history. The fourth-place could have been second behind. Nobody remembers it. It’s those marginal things, those details are what usually makes the biggest difference because, in the end, there’s always going to be an opportunity. There are always market cycles. There are black swans. There are many things that come out of the woodworks that people can’t anticipate. At the same time, when that happens, you have two ways of reacting. You have your gut and your chemicals, which pretty much leads to your bad decision or your principles and your values that you could identify upfront in people, especially experienced people and that’s what’s likely to happen when things go sideways.
When things go tough, that’s when you find out a lot about the person, their character and their work ethic. Are they people who bail on you or are they the ones that stick around until the end and beyond?
For those who are exploring SEC attorneys, those that help businesses, help an opportunity to raise money legitimately the legal way. How can people get a hold of you, learn about your firm and ultimately do business with you?
The website is a good one, PremierLawGroup.net. I put a lot of content and I’m starting to upload those more and more into my YouTube channel. If you go to YouTube and put in, Mauricio Rauld, my YouTube channel should pop up there. I try and add as much value as I can. I do some educational videos on there. I’m on LinkedIn, Facebook, it’s hard to miss me.
That might be great for the majority of the audience because if you go to YouTube and you see how Mauricio is educating those syndicators/investors that are raising capital and doing different private investments, you can see what he’s teaching them. That can help you be more informed in the ways in which capital is being raised, especially with private investment to help you become a better investor. That might be a great thing for you to do is subscribe to his channel. You can visit us at TheWealthStandard.com and access all of the things we’ve talked about. I’ll give you the final word. You’ve got any words of wisdom for us?
Be a good steward of your money. Don’t hand over your money to anybody without doing some due diligence. The due diligence is on the frontend. It’s not that long, but do it once and sleep better at night knowing that you’ve done everything you can as opposed to blindly handing over your money to somebody else.
It’s good to have you on. I appreciate your time, Mauricio. We’ll have you on again for sure.
Mauricio Rauld is one of the premier syndication attorneys in the country helping real estate syndicators raise hundreds of millions of dollars to pursue their dreams of financial independence.
Mauricio is the founder and CEO of Premier Law Group and spends 100% of his practice on syndications for real estate investors. With over 20 years of securities experience, Mauricio specializes in Reg D exempt offerings and educates investors from around the world on how to navigate the complex world of securities laws.
Named as one of the Top attorneys under 40 by Super Lawyers magazine, Mauricio regularly shares the stage with The Real Estate Guys and the likes of Robert Kiyosaki, Ken McElroy, Brad Sumrok, Peter Schiff, and others.
An educator at heart, Mauricio regularly travels around the country speaking to real estate investors and entrepreneurs, educating them about how the syndication legal piece fits into the overall syndication puzzle.
He is also a constant on the real estate investing podcast circuit, regularly contributing to The Real Estate Guys Radio show (consistently one of the most downloaded podcasts on real estate investing) where Mauricio is Robert Helms’ personal attorney. He has also been featured on The Lifetime Cashflow through Real Estate (Rod Khleif), The Ken McElroy Podcast, and The Best Real Estate Show Ever (Joe Fairless) among countless others.
A graduate of The University of California at Berkeley, Mauricio obtained his Juris Doctorate degree from Loyola Law School in Los Angeles and lives in Southern California with his wife Heidi, and children, Adelina and Alessandra.
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Humans are designed to grow, to expand, and to solve new problems. It may be at various levels and capacities based on our uniqueness, but we all have that within each of us. With that in mind, how do you get a 10% raise for life? There are actually more opportunities to work from home or work in a place you want to live in because of how society is progressing. Everything is within your reach because of the internet. Knowing that all these options exist creates focus and ultimately a path to build your value statement. In this episode, Patrick tackles how to make more money or make the same amount of money with less time and do it every year.
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Italy – The Past, The Present And The Future
I am in a different location than Salt Lake City, Utah, my home office. I’m actually in Florence, Italy. My wife has had a dream of coming here for so many years and there’s actually a conference that I’m attending so we’re excited to extend a little bit and visit a few cities. We were in Milan, then went to Venice for a few days, then came here to the conference in Florence. Then we’re headed to Rome for a few days. We’re hitting all of the hot spots. I thought what would be appropriate for this episode is to talk about Italy, the past, the present and the future, and what that has to do with you specifically in regards to the idea of compound interest. Get ready for another episode.
Let’s first talk about the past. I’ve mentioned this in episodes of the past, but Italy is actually credited as being the ground zero for banking. It’s really the more robust organizations. They had massive influence that started here in Italy and you can still see signs of that. One of the most prominent families, probably one of the more well-known ones was the Medici family. You could see their coat of arms everywhere and it’s popular here. I learned a few different things I thought that would be interesting for you. First off, they’re the first prominent banking family that had tremendous influence during the Renaissance era. Eventually part of this line became Popes and lots of influence. From a banking perspective, here’s something that’s pretty fascinating. They’re credited with the creation of double accounting using two variables: credits and debits. The banking family also funded the creation of the opera and they also funded the creation of the piano. These are things that we look at every day and realize that they’re just a part of our culture, but they weren’t necessarily here several thousand years ago. It’s interesting to see that history behind it and that it was funded by credit, by somebody taking a loan, using that loan to make something. In this case, it was opera and the piano.
However, a lot of the early banking families like the Rothschilds, obviously the Medici family is also part of it, they lent a lot of money to the Catholic Church. In addition to these ventures, the opera and the piano, the Medici family also funded the construction of St. Peter’s Basilica, which is at the Vatican City. That’s also very interesting. Then there’s a bank in Siena, which is the oldest bank still running today and it was founded in 1472. Before Columbus sailed the ocean blue, there was an Italian bank that was up and running and it’s called the Banca Monte dei Paschi di Siena. That’s essentially very instrumental in creating what we know as banking now.
Let’s get to the transition to the present. You look around Italy and it’s such an amazing culture. I’ve never been here before, but there’s beauty everywhere. The art, the cathedrals, the ornateness of everything, the food, the culture is so rich. Why don’t they have the power that they once did? They were the superpower of the world. Obviously, Rome being one of the greatest examples of a society that rose and then subsequently fell. There are many variables. If you look at why they lost so much power, I put it into two primary reasons. The first reason is the wealthy that were clearly intelligent, mainly coming from banking and being able to lend on ventures that were suitable for lending, such as the opera such as the piano, there are lots of different trade ships and the shipping industry being funded by banks. They had it going really well and there were some incredibly wealthy nobles and non-nobles.
What you started to find was that there became this idea that in order for the wealthy person to get into heaven, they had to make some pretty big donations to the church for them to be permitted to go to heaven. It was interesting. There are several different comments on some of the tours we took that talked about how much of the wealthy’s money went into funding, just these incredible cathedrals and churches, which is nice because we still have that today. At the same time, you look at the productivity and the wealth that was created in the first place, the ability to analyze and price-risk that it wouldn’t do something that really did not produce anything.
Second variable is that disruption happens. What happened in 1492? Columbus sailed the ocean blue, new trade routes were created, new trade partners were created. It no longer was the Mediterranean Sea. It really became to the Americas and slowly the Roman empire as well as Italy and their significance started to falter. It’s interesting to see how us as humans and our race, how we innovate and we’re always making things better and new things are created that we don’t necessarily anticipate. It ruins businesses sometimes. Just look at what the retail industry is becoming because of Amazon, you have disruption and you have cycles and you have new ways of doing business. It puts the older businesses, established business on the fritz. You see that quite often, especially in our day and age, and it happened back then too.
Let’s transition to today. Italy today is part of the European Union. This is the present. It’s not doing so well. However, Italy has a pretty big economy. It’s about a $2 trillion economy. It’s part of the European Union. I think it’s either fourth or fifth as far as its GDP. $2 trillion is its GDP. The issue with Italy is that from a banking perspective, they should be the experts in loans. If they’re the ones where banking originated, right now their GDP is over 150% and their credit rating is one notch above junk. Junk is considered a very high-risk bond or a high-risk investment. That’s where Italy’s bond rating is right now. One of the riskiest countries out there, one of the poorest situations, they’re in a recession. They had some negative quarters of GDP in 2018.
I’m going to give you one example of some of the stuff they’re spending money on. They’re taking out loans, you would think with a background in banking that they would know how to price the risk of different ventures just as a culture. They committed money to building this tunnel that goes underneath the Alps and it connects to France. I know the European Union has pledged money for it as well as France and a few other countries. However, Italy pledged 30%, 35% of the project and the project from the get-go has a negative $7 billion return. Obviously the point of making an investment with debt is to have a positive return. That’s the nature of debt. Oftentimes when you put debt in the hands of government politicians, they don’t necessarily have the incentive to always be profitable. It’s to do what’s good for everyone, yet there are a lot of unintended consequences with that, such as the situation they’re in right now where they have way more debt than they have GDP. As interest rates should be creeping in on their ability to go into Junk status and possibly be defunct and bankrupt. What’s interesting is the whole concept of bankruptcy originated in Italy, banco rotto, which is like a broken table because banking used to happen on a table. That’s where banco comes from.
This is where Italy’s at. I looked at where they’re priced in the market and they’re priced at a very interesting interest rate. In the United States, typically to understand the medium of short-term and long-term bonds, you have the ten-year yield. In Italy, it is basically at the same level as the US’ ten-year bond. That shows you just how mispriced the markets are when it comes to the underlying collateral, which is in this case, Italy’s government and being on par with the United States who has the best credit rating that’s out there. It’s just fascinating. The reason why it’s priced like that in the present is because you have the European Union, the European Central Bank, is ultimately going to be forced to bail them out. Who knows what the future is going to be? Oftentimes the fundamentals, the logical way of thinking as far as A plus B plus C equals this, “If this happens, then this should happen. Then this should happen.” It’s the human being’s ability to deduce and the ability to be rational and understand connections. At the same time, human beings also have the tendency more often than not to be irrational and their behaviors don’t reflect logic.
That comes down to the future. That in the future we don’t really know what’s going to happen. We can speculate but right now, Japan has been operating at over 200% debt to GDP for a really long time. They keep on going. Obviously, they have their own central bank, which is the Bank of Japan, whereas Italy does not see the European Central Bay because they’re part of the European Union. They can’t create their own currency. It would be interesting what the future holds. What this does show is that there are a lot of things that are out of whack and things are changing very quickly as far as technology, as far as the new people coming online, new technologies. That disruption is what creates companies going out of business, countries having major issues politically. What does that have to do with you? That has a lot to do with you because we live in a world that is interconnected.
The majority of American savings, which I’m assuming the majority of my audience are Americans, the majority of savings is tied to markets and markets are affected and impacted by a few things, the speculation of what things are right. For instance, the two and a half percent-ish that the Italian tenure is at as far as yield is concerned. That’s priced into expecting that the European Central Bank is going to bail them out. If they don’t bail them out, what is going to happen? You’re going to have a tumbling in the bond market, which means prices are going to go down quite a bit and the yield is going to spike to where normal levels should be for a country that has a bad rating. Right now, the expectation is that the European Central Bank’s going to bail them out. Therefore, the yield is still pretty stable. You look at other aspects of the market and what it prices and sometimes it’s rational, sometimes it’s not. The disruption and how quickly things are evolving shows that there is going to be volatility. When you have volatility, you have a much higher probability of loss when asset prices go down.
Let me hit on one more point. I look at my experience here in Italy because it’s not just the debt to GDP, which is really high, but there’s super high unemployment, almost 11%. Walking around the streets of these different countries, you wouldn’t think that there is a high unemployment rate. The people of Italy seem to be very productive. What I mean by that is they don’t open until 10:30, 11:00 in the morning, stores, cafes, restaurants, and then they close for the majority of the afternoon for like a siesta. Then they open up at night and they still are profitable. I look at the amount of youth that are on the street as well as a lot of the businesses that I have observed. There’s a lot of productivity. It’s a very dynamic people too. You look at how beautiful the hills are, the environment is the tourism that exists here. It’s incredible. Those resources are there for the Italian people. Yet oftentimes that’s not what is relied upon for things to rebound. It’s typically government who intervenes and thinks that they know the right decisions to make. Apparently that’s not working out so well for most companies, but we’re not going to have to be talking about that more than what I’ve already mentioned.
Let’s get to the last aspect of this short episode of Financial Friday, which is compound interest. One of the things that I see as the biggest misunderstanding or financial point that is made that is never questioned, which is the idea of compound interest. Compound interest is typically defined when an amount, typically money, is earning interest and then that interest earns interest, and that continues to grow. The hockey stick example is often used, exponential growth is often used. The rule of 72 applies to compound interest. Whenever it comes to something that can lose, when there is a loss available and anything that is assessed as being a compound interest, the whole notion of compound interest must be questioned. Here’s why. I used this example in the book that I wrote in Heads I Win, Tails You Lose. I hit on it a few different times because a lot of the claims in financial services with typical financial planning, is that because the market has earned certain rates of return in the past that they use that even though they disclaim that the past results are not indicative of what future results are going to be, they still use it. They use an interest rate to determine how interest compounds over time. If the market has averaged let’s say 10% over the last 30 years, then that 10% is used every single year without loss to determine what an end value will be.
Raise For Life: As you’re doing research and due diligence on what is available to you to make more money, make sure that it is fulfilling and aligns with who you are.
Here’s the problem with that is if you actually look at the nature of markets, when a market goes up and interest is earned, but then the market goes down and there is a loss, what happens next is very important. You can’t just measure the number because if you look at an average return, if you lose 50% in the market and then you earn 50% that next year, so one year you lose 50% in the next year and you gain 50%, you’re not going to be at zero. If you earn 50% and then lose 50%, you’re going to be at zero. Why is that the case? Let’s look at 2008. The markets collapsed in 2008 and the S&P lost about 40%. Math shows that if it lost 40%, it’s going to get back to breakeven if it earns 40% because negative 40 plus 40 is zero divided by two is zero. However if you have a $200,000 balance, you lose 40%, $40,000 and then you gained back 40%, you’re only gaining back 40% on $60,000.
Let me do that math for you again. If you start with $100,000 and in 2008 you lose 40%, your balance is $60,000. If you earn 40%, you’re earning not on a hundred, you’re earning on 60% which is only $24,000. You’re at $84,000 not back to a hundred but yet the average return is zero. There was an event that boil my blood because he’s talking about compound interest and talk about average returns and they were showing what the future will look like if these average returns are earned. The claim was made that if you didn’t participate in the 300% increase in the market over the course of the last ten years, then you lost out. I’ve heard that quite a bit, not just from this group. This group particularly hit home because there’s an affinity that I have with so many other of their teachings. This thing totally spun me because of the notion of compound interest and just how misunderstood even at very high levels this concept is.
I ran some numbers. The numbers show that from 2008 to 2018, the eleven-year period of time, the market losing was 38.49% in the S&P 500. The gains that it earned since 2009, if you look at the increase that it’s being talked about, it’s the level of the S&P and the level that it’s at now, which we argued that those two levels show almost a 300% increase. However, that is not how money works. That’s how math works, where you can measure those two points and show the increase but you’re missing time. Number one, you’re missing ten years there. 300% in one year is amazing. Over the course of ten years, not so much. Even if you look at a 30% average, which you just took 300 divided by ten. That’s not reality. The average return is actually only 6.74% over that eleven-year period of time if you factor in the 38% loss. If you factor in management fees, 1%, then you factor in taxes, the actual return is just above 2.5%. That is how profoundly misunderstood this concept is.
When you hear average returns, that’s something that you want to call into question. If it has to do with an account that can lose money, where your balance can actually have a loss in a year. The notion of compound interest must be analyzed at a much higher economic level where you are able to factor in the actual losses of money, not just the losses of an interest rate. I didn’t want to lose you too much. I’m going to post a video that I did on compound interest because this will help kind of go through these examples. When you think, do you like what you’re reading? Is this interesting to you? Do you like some of the history of banking? I hope that you take some action and actually go and study what compound interest is, how it works. These videos are very short, ten, twelve minutes the particular one I’m referring to. I know that it will make a big difference because it will give you some knowledge, give you some education that as you’re learning about finance and seeing how it applies to you specifically, most people will ultimately run some compound interest calculations, make so you do it the right way.
If you wouldn’t mind and if you’re not subscribed to the YouTube channel, subscribe. If you aren’t following me on social media, Instagram, Facebook, I love to connect with you. I try to post as much as possible. I’m posting about being here in Europe. It’s a fantastic trip. I hope you get to come here if you haven’t already. Also if you would do some reviews, if you review in iTunes, that really helps us get the word out, get the message out. I love to hear your feedback. Thanks for tuning into this episode of Financial Friday.
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Patrick is the President and CEO and started Paradigm Life in 2007 after learning from his mentor Kim Butler about financial strategies outside of Wall Street.
With a background in economics and marketing, Patrick immediately realized the opportunity to teach investors, business owners, professionals and families on a large scale using modern digital media and communication technology. Since 2007 Paradigm Life has worked with thousands of individuals in all 50 states.
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