Essays, Jazz, Musings
Published writer, jazz musician, investor and bon vivant, David combines a broad education in the classics, and experience in business and the arts to bring you in-depth essays that focus on political economy.
For an individual, the most fundamental of all economic goals is financial independence —freedom from worrying about the state of the economy, from following the news every day, from making a profit, from producing a product—financial independence made possible because there is no relation between earning a living and acquiring assets, no relation between income and wealth. It is why an employee at McDonald’s making minimum wage, can, within 10 years, become financially independent.The basis for this way of thinking is the Efficient Market Hypothesis: in a competitive economy, all investments produce the same rate of return—meaning it’s not important what investment you make, that what’s important is that you make an investmentThrow a dart at the stock market page; buy whatever company it lands on. That company will produce the same rate of return as any other. Why? Because in an efficient market, whenever a stock produces an above-market return, buyers rush to purchase it; within seconds, its price rises such that its return is again equal to the others. Observe traffic backed up on a freeway; when one lane starts to flow, cars move over; right away all lanes are moving again at the same pace. No need to invest in a different lane; profit is zero.Hidden, then, in the efficient market hypothesis is the fact that not only do all investments produce the same rate of return, but that long run, all profit is zero. Why?
Because basic rates of return are not profit. They are the time value of money—historically one to two percent for savings, two to three percent for mortgage lending, three to five percent for venture capital. When a rate is higher, risk is higher.
But what about high income, even unconscionably high income? That also has nothing to do with a rate of return: high income is entrepreneurial compensation, that portion of a firm’s total revenue generated by a particular individual. In professional sports, athletes, no differently than CEOs, are paid a portion of the revenue they personally generate—perhaps two percent of that revenue. The high compensation, however, does not last. It comes at the early stages of a product and drops off as the product starts generating less income. At that time the entrepreneur may leave and the replacement CEO has but one function: to slow down the rate at which the firm is losing market share.
So, why are some CEOs paid $100 million a year? Because market reality is that few people are capable of holding a large corporation together. The natural law of demand, that price is a function of demand, demands that their compensation be bid up. It may take a $100 million a year to entice a multi-millionaire to give up those mornings at the country estate reading Essays of Montaigne, setting up childrens’ birthday parties in the afternoon, or GOLF, what comedian Jerry Seinfeld calls “Gone Out, Left Family”.
The correct insight is that wealth does not come from salary: wealth is a function of acquiring assets through the use of leverage—purchasing an asset with a down payment, borrowing the balance—the reason someone on a modest salary can be as successful as someone on a high salaryTo illustrate, let’s take an employee at McDonald’s who earns $10.00 an hour, 10 hours a day, 6 days a week. That’s $600. If the spouse also works at McDonald’s, the $600 becomes $1,200, times four, $4,800 a month or $57,600 a year. For ten years the two employees save half of what they earn: $28,800 a year.
At the end of each year they invest their $28,800 savings as a down payment on a $150,000 asset, say, a one-third interest in a $450,000 residence. At the end of 10 years, ten such $150,000 assets, each appreciating at 4% a year, will be worth $1,872,856, and will generate $93,746 annual cash flow, a 39% yearly rate of return on total cash invested of $288,000 ($28,800 times 10). The spreadsheet below shows equity build up for Asset No. 1.
Asset No. 1
end of year
|Annual loan amortization
The owner’s equity in Asset No. 1 is the value of the asset at the end of year 10: $222,020, less the ending loan balance of $98,557, plus the total cash flow of $18,003 a year:
The national average in the fast food industry is $9.24. McDonald’s Corporation pays on average $9.40 an hour (January 30, 2019, PayScale.com).
At the end of ten years, the equity in Asset No. 2, purchased one year later, is the value of Asset No. 1 built up through year nine. The equity in Asset No. 3 is the value of Asset No. 1 up through year eight. Asset No. 4 through year seven, continuing to Asset No. 10 through year one:
Total value of the assets:
|Asset No. 1||$222,020|
|Asset No. 2||$213,481|
|Asset No. 3||$205,271|
|Asset No. 4||$197,376|
|Asset No. 5||$189,785|
|Asset No. 6||$182,486|
|Asset No. 7||$175,468|
|Asset No. 8||$168,486|
|Asset No. 9||$162,240|
|Asset No. 10||$156,000|
Total value of the loans:
Total value of the flows:
At the end of 10 years, the owner’s equity is the total value of Assets 1 through 10, $1,872,856, less the total value of the loans, $699,043, plus the total value of all the cash flows, $93,746.
|Total = $1,267,559|
If the McDonald’s couple then sells the ten assets and purchases a single $1,267,559 asset that earns 4% interest per annum, their yearly income will be $50,702. (Or, if they keep the ten assets, the return is the same.) The young couple no longer need to maintain their Spartan lifestyle. They can live on their annual cash flow $50,702 a year, which is more than the $28,800 they had been living on. They are now financially independent.Of course, for two people, $50,702 a year is minimal financial independence. Yearly income could be greater under other circumstances: if the couple each earned twice minimum wage, $20.00 an hour, or worked twice as long, 20 years (because they couldn’t keep up the Spartan lifestyle), or were active in the management and development of their real estate so that the value of the real estate increased at more than four percent a year. The point, however, is that even at minimum wage, it’s possible to acquire enough assets so that wealth is no longer a function of income, rather, that income is a function of wealth.
[For a more accurate (and surprising) accounting of the above example, see Appendix.]
Two McDonald’s employees
San Francisco, California 2019
Total = $124.72
|per hour—minimum wage in San Francisco (January 2019)
hours a day
Total = $46.76
|per hour overtime (time-and-a-half)
hours a day
Total = $1,028.88
days a week
Total = $53,501.76
weeks a year (including two weeks paid vacation)
Total = $107,003.52
Total = $18,190.57
|Social Security tax, 7.5%
Federal tax, 7.5%
State tax, 2%
Total = $60,012.95
The Cost of living in San Francisco:
Rent on a large one-bedroom apartment in San Francisco is $3,000 a month, yet, if shared with another couple, is $1,500 a monthIf the couple live in one of the condominiums they buy, their living expenses will be lower:[The $450,000 condominium would have a mortgage of $363,600 with interest at 4% per annum amortized over 30 years. The down payment would be $86,400, with each owner contributing $28,800. The three owners expect rent from the condominium, $36,000 ($3,000 a month x 12), to cover their expenses plus generate a 1% cash flow of $4,500 a year.]Income: $36,000 $36,000 $3,000 a month rent x 12 = yearly rentExpenses: $5,275 $2,400 $1,655$2,880$2,880
Property taxes per year in San Francisco, with add-ons, are approximately 1.17% per annumProperty insuranceWater ($50 monthly), garbage ($35 monthly), gas and electricity (50 monthly), telephone ($35 monthly) Repair, 8% of yearly rent Capital improvements, 8% of yearly rent Total expenses, 42% of yearly income
Net income: $20,945Income less expensesMortgage: $18,829Annual mortgage payment. Cash Flow: $2,116 Net income less mortgage. ($616 more than expected.)Rent: $18,000$1,500 Annual rent of $36,000 divided by two (because Asset No. 1 is shared with another couple)Monthly rentTax deductions: Interest payment on the mortgage, $3,078 (4% of $230,880
divided by three), is subtracted from the couple’s gross employment income.
In year two, there will be a depreciation deduction from gross employment income of $4,016 each year, and for each $150,000 investment they subsequently acquire.[The deduction is 3.57% of their share of the value of the building, $112,500 (which is 75% of the value of the property, $150,000), for a period of 28 years (100% total depreciation divided over 28 years = 3.57% per annum), which is $4,016 ($112,500 × 3.57%).]Cash flow from each investment is added back. For each property, cash flow of $2,116 is subtracted from depreciation of $4,016. Starting in year two, and continuing thereafter, for tax purposes, the couple’s gross income will be reduced by $1,900 ($4,016 – $2,116).Total tax deduction:
TotalTheir gross income of $107,003 drops by $4,994 to $102,009. 7.5% federal income tax calculated now on $102,009 decreases from $8,025 to $7,650; and 2% state income tax decreases from $2,140 to $2,040. The tax savings is $475 per year [($8,025 – $7,643) at 7.5% plus ($2140 – $2,040) at 2%], $39 per month. Monthly rent in year two:
Mortgage interest ($3,078 divided by 12)
Federal and state tax savings ($475 divided by 12)
Depreciation minus cash flow ($1,900 divided by 12)
Adjusted monthly rentLiving expenses: When agencies such as the Bureau of Labor Statistics determine cost, living expenses are often figured as: housing (30%), food and groceries (15%), transportation (10%), utilities (6%), health care (7%), and miscellaneous expenses such as clothing, services (including repairs) and entertainment (32%). Taxes and savings are not included.The question, however: living in an expensive city such as San Francisco, during the first few years of their investment program—before the deductions kick in— can the couple survive on $60,012 a year (the original net income of $88,812 less $28,800 savings)? Housing alone, at 30% of that net income, will be $26,643.
|Food and groceries||(15%)||$13,321|
The couple has no money to spare.However, they have ways to increase their net spendable:
- Some utilities and housing repairs are already calculated in the housing
expense, plus, three tax deductions lowered their rent from $1,500 to $1,047 a month.
- As employees of McDonald’s, they receive two meals a day.
- As employees of McDonald’s, their health insurance is provided.
- Transportation: walk to work.
- McDonald’s provides a 401(k) pension plan. The amount of an employee’s
contribution reduces gross income for tax purposes, but is taxed when withdrawn for investment. Still, some employers will match the employee contribution, meaning the couple would have more to withdraw.
- Tax deductions increase every year
- They attend McDonald’s University and become more highly paid employees.
Yes, the couple can work at McDonald’s at minimum wage, save $28,800 a year, and live on $60,012 a year, but if they move to Sacramento, California, where rents are lower, the example is more realistic.
Is this whole scenario unrealistic? No. It is the scenario for immigrant families to the U.S.
David Parker Essays Copyright © 2009