Posted on January 4, 2007 @ 10:16 pm - Written by BawldGuy
You would like to quit your day job and retire on the cash flow from the many rental properties you own. You have a problem though because the income just isn’t quite high enough yet, and probably won’t be for a few years. Yet you want to retire because you have so many other things you want to experience and accomplish. Is there a solution out there that might make it possible to move up that retirement party? The answer for some is depreciation. Say What?
Let’s take an example out of my own client files. The Millers have been clients for several years having come to me with only their home and less than $100k in cash. To make a long story short, in a few years they’d parlayed a strong market, the ability to take action, strong wills, solid FICO scores, and decent five figure incomes into enough sheltered income for Missie to quit her job. She was 37 and Scott was 40. They had three kids. Their Plan, which they executed to near perfection was to buy property using leverage wisely, trade when the market said it was time, and keep doing so until she was in her mid-40’s. At that point the conversion to a cash flow emphasis would make a very comfortable retirement possible.
Since they’d been so focused during the beginning years in acquiring as much property as possible, they had also accumulated an impressive amount of annual depreciation. As a matter of fact, through the use of well timed tax deferred exchanges combined with prudent use of leverage, and pulling the trigger when their Purposeful Plan called for it, they found themselves with about $200k of depreciation!
They told me they’d changed their minds about working until Missie was 45ish or so. She wanted to be a stay-at-home mom. A modification of strategy was necessary. With only Scott working now and their job income just below $45k, they had a ton of unused depreciation. Most of that depreciation remained available because in anticipation of Missie staying at home now we’d arranged for some of the properties to be refinanced for a higher cash reserve. This resulted in these properties yielding much less cash flow. This was fine with them because they liked my Plan modification which would generate more non-taxable income while maintaining the growth position.
Here’s what we did.
We simply chose a property or two we knew would yield about $100k in net equity if sold. The unused depreciation would offset any capital gain. Now they had cash reserves, Scott’s income, plus another totally tax sheltered $100k. They took one look at that picture and Scott quit his job too. Now we sell a property or two a year, (not a problem) they don’t pay taxes, and they’re both home with their kids. Their portfolio is still growing at a magnificent rate, and the Plan calls for them, in 2007 to trade some of their Phoenix properties into either Boise or Ogden. In fact they were listed just the other day.
Don’t you love it when a Plan comes together?
Posted on January 3, 2007 @ 10:14 pm - Written by BawldGuy
You wish to invest in real estate, or maybe you already have, and are now ready to move on to bigger and better things. You realize the agent who sold you the investment(s) you have now is really a home agent who said the right things, and talked about cash flow, return on investment, and ’write-off’.
But now your gut says he’s not the guy. You need answers to too many questions as you get deeper into this new area of investment, and more of your future is at stake. You’re beginning to think your agent may not know much more than you do. It could be a lot like going to your doctor who is fine for annual checkups, joint pain—but at the first sign that your heart is acting up—it’s time to call in a specialist. Same is true of your agent—better to work with a guy who is experienced in real estate investment properties.
Among the many other skills home agents must master, very few of them have anything to do with investing, or any sort of related analysis. What an investor needs is a real estate investment broker to know what is critical to their long term success — because your retirement should be a beautiful experience.
The agent you choose needs to know the following.
- How to analyze your current financial position– especially as it relates to establishing a Purposeful Plan.
- How to create an after tax cash flow analysis. Not always needed, but an incredible tool.
- How to construct a viable Plan integrating the investor’s predictable retirement cash flow needs, financial abilities, tax ramifications, accounts for reserves, which he can execute without having to be Houdini on a good day.
- Which loans make sense for which Plans and what kind of property.
- The ins and outs of a tax deferred exchange and when NOT to use it.
- An overall understanding of how all this needs to be integrated into a seamless execution of the investor’s Plan–and be able to make it happen–with the correct timing.
That last one is the one I’ve seen trip up more investors than anything else. You can know analysis from A to Z, understand financing backwards and forwards, write books on tax deferred exchanges, but if you don’t have a sense of timing that integrates perfectly with your client’s Plan, huge opportunities can be lost. And lost opportunities can mean hundreds of thousands of dollars in the long run–sometimes even over as short a time as a year.
Just ask someone who should have traded their San Diego property back in 2003-4 into either Phoenix, Boise, (here are my previous posts on Boise) or any number of other better growth markets. It was obvious then that San Diego wouldn’t support either leverage or cash flow approaches at that point. For that reason alone it was time to make a move for many investors. Timing, as the lady once said, is everything.
One final note and I mention this at the end because it can be like chocolate sauce on your favorite ice cream. It makes a world of difference. As you’ve read before here, I’m an advocate of incorporating a professional Financial Planner into the mix with my clients. This is only a recent development because it took me until this year to find a financial planner who didn’t think real estate was a satanic creation. The Certified Financial Planner (CFP) adds a huge dimension to the Plan. Allow me just one quick example.
One of my long time clients recently agreed with me that refinancing one of their properties was prudent. They’re going to get $6-700K tax free cash as a result. They’ll add a small portion of this money to their Boise investment Plan, but retain roughly 80% to purchase, over a five year period, a tax free annual income of about $55-95K–for life. This will be in addition to the six figures they already receive totally tax sheltered, from their real estate portfolio. In five years they’ll only be 63 years old, with $150-200K after tax income yearly.
OK now, a show of hands, who likes that idea?
Posted on December 30, 2006 @ 4:08 pm - Written by BawldGuy
Zero - your home’s equity has no return. It is simply there. It doesn’t do anything for you except maybe give you a false sense of security. This isn’t debatable on its merits. Until you decide to do something with your equity it does nothing for you whatsoever, at least tangibly. It’s not liquid by anyone’s definition. It has a certain value when kicking back with friends, talking about how you’ve amassed X hundred thousand in equity recently. But talk is all you can really do with it. Until it dawns on you that converting inert equity to cash is a net worth neutral act.
For most people their home is the only real estate they own. If they should pull one or two hundred thousand cash out, their net worth wouldn’t change one iota — just their asset list. Now they have much more cash, and less 
home equity. The good news is now they can actually put that ‘equity’ to work. That’s now possible because the newly acquired cash is still, conceptually speaking, home equity. It’s just useable now instead of just laying there looking cool.
But now what? Like most things in investment real estate, the next thing isn’t rocket science. It’s got a fancy name though — arbitrage. Now there are many ways arbitrage is used, but in this example the definition is simple: Borrow money at one rate and invest it at a higher rate. You don’t have to have been on the short list for M.I.T. to understand that’s probably a good thing. I’m reminded of the banker who was asked the secret to his staggering wealth. He replied, “I just borrow from my depositors, paying them 3%, and loan their money out for 5%. I’ve learned to be content with the 2% I’m making.” We all know of course, that he was making far more than 2%. As a matter of fact, let’s go on a quick tangent.
Ask yourself: If I ‘lend’ you a million bucks and ask only $50,000 a year for rent (5%) , and you turn around and lend it to your buddy for $70,000 a year rent (7%), what’s your return? Hint: It’s a trick question. You didn’t invest a dime. How can you figure a return when you have no money invested on which to figure a return? You used my money to generate a quick $20,000 profit. Yeah, it’s over-simplified, but you get the point. But I digress.
All the fuss out there about how ‘untouchable’ home equity should be has always been a mystery to me. The fact is you can take $100K in cash from your home’s equity, and in literally the most conservative way there is, in 30 years you can have more than $1,000,000 — tax free. Even a 6% return (after tax of course) on a million bucks is $5,000 monthly for life. And remember, we built up to that amount by using one of the most risk averse vehicles in existence. (I’ll talk about that in more detail in another post.) It’s so conservative I’d put my 93 year old grandma in it. Seriously.
So let’s review. You borrow $100,000 from your home’s equity. Then you invest it at a higher rate than you’re paying on the borrowed money. Then you live your life for the next 30 years. Then you have more than a million bucks. And that’s investing in something that even makes depression-era grandma comfortable.
Now, imagine those 30 years, or 20, or 10, (or 5?) were spent investing that $100,000 in something that had a long term return on investment much higher than the super conservative vehicle used above. How about real estate? Yeah, that’s the ticket. I’ll invest in real estate with my $100,000 in original seed money. If the investment period was indeed 20-30 years, your ultimate net worth would be life changing — which leads to my final thought.
The majority of long term real estate investors live a more financially abundant life in retirement than they did while working. Let that sink in. And let me say it more clearly. The majority of long term real estate investors earn more money after tax in retirement than they did while working.
Now, tell me again about your untouchable home equity.
Posted on December 29, 2006 @ 11:20 pm - Written by BawldGuy
I believe that risk isn’t born of having all your eggs in a very few baskets, but rather from not knowing exactly what you’re doing — and where your eggs should really be. You’re never guaranteed success. So the next best thing is to use superior knowledge, research, and judgment to insure your baskets are the right ones.
So here’s what we’re going to do. We’ll give you a million bucks to invest for the future — your retirement. But we have some strings. (Well of course we do - like you’re surprised?) We insist that you limit the amount of money you can invest in any one asset. No matter how much it might be growing, or how much cash flow it generates, you can’t invest over the prescribed amounts. Even if it costs you hundreds of thousands of dollars in growth, you can’t violate the parameters. You must spread money around in order to spread risk. You may not invest more than 25% into any one asset.
And the different assets will often be contradictory to one another. Stocks, bonds, commodities, cash, and real estate. Or, precious metals, oil, wheat futures. Your pick.
Sounds a little artificial doesn’t it? The winged tip crowd calls it diversification. And they never say it without holding on to their suspenders, rocking back and forth on their heels, and looking over their glasses at you. I guess it sounds more credible that way. And if their hair is silver, all the better. It’s in the unwritten investor’s handbook.
Let’s climb aboard the ‘Way Back Machine’ and see what you’d do if you already knew the outcome. Of course, in the real world you’ll never actually know the outcome, because you’re not a seer. Your crystal ball is just as cracked as mine, right? Right.
You’re now back in the spring of 1999.
Would you have spread your million bucks into several baskets back in 1999 if you knew then what you know now? Not likely. You’d have mortgaged your home, your kids, and your soul to invest in real estate in San Diego, Phoenix, Boise, or any of the other regions that have more than doubled in value since then. You would have taken that growth and parlayed it into an impressive net worth by well timed tax deferred exchanges.
The financial definition of diversification is as follows: The practice of spreading one’s money among different investments for the purpose of reducing risk.
How it works in practice: The method by which an investor may guarantee a much lower return by spreading his money around into many different investments. This is an excellent technique for insuring relatively slow growth. It works better when investing solely in products available only on Wall Street. It works best when the ‘return’ is fixed at a rate barely higher than inflation. It usually makes the investor feel ’safe’. That’s because he doesn’t know what he’s doing. If he knew what he was doing he wouldn’t be so fearful in the first place.
In sports we call that playing not to lose, as opposed to playing to win. If you’re setting up the defense for a football team, and it’s 4th down and six inches to go for a first down, what do you do? Do you defend half against the pass and half against the run? No — you put eight of your guys on the line to stop the run and the other three to watch out for the 5% chance of a pass. The 50/50 approach? That’s football’s version of diversification — playing not to lose.
OK, back to your million bucks. It’s for your retirement so you really want to limit the risk as much as you can, right? Ah, and there’s the rub. What constitutes risk? Ask 10 relatively knowledgeable investors and you might just get 11 answers.
Risk comes from not knowing what the heck you’re doing.
But don’t take my word for it. What two multi-billionaire investors define risk as not knowing what you’re doing?
Warren Buffett and George Soros. Arguably the two most impressively successful pure investors in the last 50 years — worldwide.
Fear isn’t productive, and will extract much of the return, or potential success out of anything. Investing can be compared to surfing in that to the degree you’re afraid of the shark in the water waiting just for you, it might just make an appearance, even if only in your imagination. Beware the Great White Diversification. 
The investor who hasn’t lost money either started investing last month, or is lying. But in the final analysis it’s not really about the risk you take. It’s more about how much you profit when you’re right, and how much you lose when you’re wrong. If you know what you’re doing in a particular field, why would you ‘diversify’ into something about which you know little? Is it because you don’t feel safe unless part of your portfolio is providing ‘balance’ by just lying there? A Folgers can buried under the morning glories in the back yard will serve that purpose.
Remember, knowing what you are doing, really knowing — reduces risk substantially. You have to decide what you know how to do. If it’s real estate, great. If it’s mining you know about, invest in mining stocks. Investors fear losing because they know deep down they don’t really have the minimum required know-how to make prudent decisions. To make up for this deficit they buy a little of everything, hoping that if one crashes, its ‘opposite’ will rise, avoiding losses. Sometimes they just don’t invest.
Diversification is why the average 55-60 year old man has less than $60,000 in his 401K or IRA. When he hits 58 and realizes the reality of the retirement headed his way, panic often ensues.
It’s called playing not to lose, and isn’t a winning strategy for an abundant retirement. If you don’t believe you have the necessary know-how in something, then find somebody, a professional, who does. You may have money to invest, or you may have equity to tap. But what you don’t have under your control is the passage of time. Your retirement is coming at you faster each day.
Does that thought put a smile on your face?
Posted on December 27, 2006 @ 6:08 pm - Written by BawldGuy
Investing in real estate without significant cash reserves is, shall we say, not recommended. An investor without reserves might as well send an engraved invitation to Murphy to come over and party. You’d think real estate investors would include this ingredient in their plans. The paradox I’ve observed so many times is that investors love that I insist upon it, but they’ve never incorporated it in their own planning.
The importance of a generous cash reserve cannot be overstated. I simply will not work with an investor who won’t set aside adequate reserves. It’s only happens rarely, but if they’re not willing to do so, I won’t take them on as clients. Period.
I’m talking about real reserves. CASH reserves. Enough to allow child-like sleep nightly. The rare exception to this rule in fact isn’t an exception. If your day job income is so abundant that your after tax savings are mind boggling, reserves might not matter in your case. I currently have a client who is a good example. He earns $3-400,000 after tax yearly. Since his investments up until now number only two properties, the worst case scenario would be to have both of them vacant for say three months. This would result in a negative cash flow equiailent of about 8-10 days of take home pay. In other words, he an handle this in stride.
The rule of thumb — have enough cash in your Sominex account to sleep like a kitten no matter what happens.
However, he’s about to pull the trigger on a tax deferred exchange, using both properties. This will result in the acquisition of roughly 6-8 properties. Though the numbers will show each property will break even or better, he’ll hear from me that relying on a break even analysis is folly. Murphy is alive and knows where he lives. Have you ever heard O’Toole’s corolarry to Murphy’s Law? He said, “Murphy was an optimist.”
Before we even begin the exchange process he and I will discuss in depth what could go wrong during his holding period. Having 6-8 properties now begins to have a real affect on your sleep patterns even if you’re making the money he is. Using the worst case scenario again, Murphy could cost him nearly a month’s take home pay. I will insist he set aside a cash reserve account of no less than $35-50,000 BEFORE we even begin selling his properties. This account will be used for the expressed purpose of securing those investments when Murphy decides it’s his turn in the barrel. And make no mistake — at some point in your investment life, it will be your turn.
My time in the business has allowed me to weather the ‘74-75 recession, the terrible runaway inflation which immediately followed, which resulted in interest rates sounding more like shoe sizes for NBA players. That was followed by the late ‘79 through ‘83 so-called recovery. I still remember being grateful that a client who was in love with a seven unit building was able to secure an 11.75% loan! Nirvana was just around the corner. Then after the late ’80’s run-up came the double-barreled shotgun-ambush of the early ’90’s. Not only did San Diego get hit by the S & L crisis, but simultaneously lost a couple of the largest employers in the entire region.
In over 30 years I’ve only had two clients have serious problems with their investments. Both dipped into their reserves for non-emergency items. (One was for the new kitchen the wife ‘had to have’.) In both instances I was kept out of the loop until it was too late. They knew what my response would be.
A generous reserve account is not merely an option. In no way is it a luxury. How long can you go without sleep?