Worshipping At the Altar of Cash Flow – II

There are many schools of thought when it comes  to investing in real estate for retirement. Two of them dominate.

One says you buy property and hold it forever. When you’ve saved up enough to buy another one you do — and hold IT forever. The idea is you allow rental income to pay off debt as quickly as possible, arriving at the point of a free and clear cash flow machine. Do this more than once and you have the basis for a nice retirement income stream. Or so the story goes.

The other says cash flow comes from the yield on either capital or equity in an asset. The larger the capital amount or equity in the asset, the larger the income in terms of dollars. The ‘yield’ itself is expressed in terms of a percentage. For example, 8%. This school says that since the yield is the same, more or less, for a larger figure or a smaller figure, why not arrive at retirement with the largest amount of capital and/or equity possible?

The ‘Buy & Hold’ school (BHS) gets you there. But in what condition, and how much cash flow relative to the ‘Capital Growth First’ school (CGF)?

Buy and Hold

• Limited to how fast investor can save capital for down/closing on each purchase
• Properties are old, having high maintenance/expenses when investor retires
• 100% of income is devoid of any tax shelter —  right when they need it most
• Properties more likely than not to exhibit functional obsolescence upon retirement
• Older properties generally don’t compete well for highest quality tenants
• Props are old when you retire, & only get older each year — not a good trend
• Rents will be less likely to keep up with the competition — or inflation

That’s the short list, but you get the idea. Buy and Hold should be called Buy and Mold.

Capital Growth First

• By ensuring a more or less superior capital growth rate — net worth increases
• Capital growth is maintained by exchanging equities when the market dictates
• Exchanging keeps the power of prudent leverage working
• This results in significantly larger capital/equity base
• Larger capital/equity base = larger income in terms of dollars using same yield % at retirement
• Arrive at retirement with higher income, mostly tax sheltered
• Able to execute strategies completely unavailable to Buy & Hold

Again, that’s a short list. You can readily see the advantages.

Now let’s look at an example with some real numbers for illustration.

Exploring Real World Examples

“Dan”, 72, came into my office a several years ago — a real born again buy ‘n holder. His pride and joy was the fourplex he bought when he was in his 30′s, now free & clear, generating a net income of roughly $2,900 monthly. This is in addition to two other income sources — Social Security and a taxable annuity.

He’s paying significant taxes on the income from the annuity and the fourplex — neither of which is keepin’ up with the cost of living. He retired in 2005. He bought his fourplex in 1975. We both live in San Diego, so I’ll be using that market as an example. The principle works in any market — especially over the long haul.

He paid about $80,000 back then. Upon retirement the value was 8-10 times that. Where would he be today if he’d gone the capital growth route? So glad you asked.

The market would’ve told him to exchange his enlarged equity position in the first quarter or so of 1979. Having put 20% down, his equity at that point would’ve been around $100,000 — more than quintuple his originally invested capital. His cash flow for the period won’t be added into that, except for the paying of closing costs on his newly acquired exchange property(s).

He now owns roughly $400,000 in 2-4 unit properties. He’s conservative, so due to interest rates back then, he puts 25% down. He now waits for the next time the market will speak to him. This time it’ll be longer than four years, as the recession took its toll. Meanwhile, his properties are rented, with slightly increased rents over the long haul. The recovery hits around the end of 1983. He waits to be sure. Values again begin to rise. He waits. In  early summer of 1988 he executes another tax deferred exchange with the following results.

Note: From roughly 1985 to the beginning of 1990 appreciation rates in SoCal were double digit, more or less depending what specific market. San Diego did well.

His exchangeable net equity at that point was approximately $275,000. Again, he chose to put 25% down on his exchange uplegs. (newly acquired props)

Let’s pause at this point to assess his capital growth rate. It’s been 13 years since he began with about $18,000 to close his first investment back in 1975. He now has $275,000. That’s an annual capital growth rate exclusive of tax benefits and cash flow of about 23%  – a figure nobody with a three digit IQ would predict, but historically accurate nonetheless.

Anywho, he now owns about $1.1Mil dollars of property. It not only pays for itself, but cash flows — not heavily, but enough to make him happy. For the record, he does two things consistently along the way — one I recommend sometimes, and one on which I insist. He has way more than adequate cash reserves. I call it a Sominex Account, as when Murphy visits, you can still sleep at night.

The recommendation at this point is to apply a portion of the cash flow to the loan balance. Back then it was almost a built in practice for my clients, due to interest rates 2-4 points higher than today’s. It just made sense. It’s called keepin’ your eye on the ball, which in this case is growing the guy’s capital/equity safely over the long haul with retirement in mind.

It’s at this point the S & L Crisis hits San Diego like sledgehammer hits a thumbtack. It was beyond terrible. Not only did we experience what everyone everywhere else did, we had the added excitement of losing a couple huge employers overnight. Talk about both barrels of the shotgun goin’ off. Vacancy rates went from virtually nonexistent to 10-15%, sometimes more depending upon your location. Rents tumbled even more in  some cases. Bottom line? This guy’s cash flow went from cool to break even faster than Mickey D’s makes a Happy Meal.

This forced a holding time of about a decade, more like 12 years. What’s an investor to do? Life happens. It certainly did back then. It seemed Murphy camped out in San Diego the whole time. Ever heard of O’Toole’s corollary to Murphy’s Law? “Murphy was an optimist.”

Dan executed another trade in the early spring of 2000. His portfolio by then had risen at a much more modest rate than in previous times. Real life. It’s now worth a total of $1.6Mil give or take. His net tradeable equity is about $645,000. Relatively speaking, interest rates are a tad lower, but he insists on a 30% down payment, overruling my advice to try 20% this time. It’s his money, so guess how much he put down? He’d been made nervous by his experience of the early 1990′s. Um, me too.

When the smoke cleared he ended up with $2.15Mil in property. It wasn’t cash flowing much, give or take $25,000 a year. His retirement was, according to him, a long way off. He changed his mind about that later.

In fact, he decided in early 2004 to call me about setting in motion his transition from capital growth to cash flow — he wanted to retire no later than spring of 2005, about 30 years after buying his first investment property. After much analysis and a few meetings of the mind, Dan and I agreed — he needed a property outside of California. The prices were simply outa whack, a fact we both agreed on immediately. The search was on.

First we had to ascertain how much equity we had to trade — cue the Happy Feet music.

Seems his luck had turned around again. From his latest acquisitions in 2000 his portfolio had grown in value from $2.15Mil to the neighborhood of $4Mil. His net tradable equity was about $2.2Mil. Let’s take a pause for the cause here, OK?

Is that a white flag I see being waved by the buy & hold crowd? Just askin’…

We now didn’t care much about growth, as we wanted stable markets, not much prone to big swings either way historically. Idaho, Texas, New Mexico, Montana, Ohio and Kansas/Missouri ended up on the short list. We really liked KC though, which is where we landed. We ended up with about $5.5-5.7Mil in cash flow properties. (Larger properties this time.) The cash on cash return averaged around 7-10% conservatively. This resulted in a yearly cash flow, the majority of which was tax sheltered by the way, of $140-200,000 yearly.

For discussion sake, discount the low part of that range by half. You still end up with $70,000 a year at retirement — mostly sheltered — not in ancient properties with ever rising operating costs. Even discounting the low part of the income range by 50%, he still finds himself with just short of double the retirement income he did applying the buy and mold, um, hold school of thought.

Of course, he won’t hafta discount all that mostly sheltered cash flow. A retirement income of five figures monthly. Sweet.

Back to Dan’s current reality. He’s now retired on just under $36,000 a year from his fourplex. His SS income and annuity supplement this. However, as pointed out earlier, every single dollar of the annuity and the real estate is taxable. Ouch. Furthermore, he’s now discovered, much to his chagrin, that he didn’t retire, he just started serving a life sentence.

His option from the beginning was to end up with so much sheltered retirement income that his SS check would simply be spending money.

So I restate the principle: Worshiping at the altar of cash flow when capital growth is the appropriate approach will not have the happy ending you envision.

Next — How does the real estate investor manage to avoid capital gains taxes without always relying on a tax deferred exchange?

Photo: Tabbie-cats

Related posts:

1. When Is Cash Flow NOT the Be All End All?
2. Real Estate Investors: How to Find Great Cash Flow Deals
3. Current Market Conditions and Rental Cash Flow
4. How Would You Like $1,200 a Month In Positive Cash Flow?
5. Return on Investment (ROI) Versus Cash on Cash Return (CCR)

Article Author: Jeff Brown

Jeff has written 111 articles for us.
Visit Jeff's Website: http://www.bawldguy.com

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Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.