Aging RE Investors Need Not be Hostage to a Mediocre Retirement Cash Flow

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The ages of folks calling and emailing me to chat are all over the map.

I have several clients who’ve been with me for a few years who’ve yet to turn 30.

Yeah, it irritates me too. ;)

All but one plan on retiring after 50, half of ‘em insist they’re work ’til at least 60 or longer, as they love what they do. The exception? 28 years old and he’ll not be happy if he’s still doin’ the same thing when he’s 35.

Spoiler alert! He won’t be makin’ the same strategic decisions his peers will. Seven years happens in the blink of an eye. Thing is though, he has the luxury of a future change of heart.

If he’s successful in his Purposeful Plan, the odds of which favor him madly, he’ll still have three decades before he turns 65. He could reinvent himself financially a few more times and still end up at the top of the steps doin’ the Rocky dance.

RelatedPurposefully Planning Your Retirement – What Is Time To You?

Not so when you’re in your 50s staring retirement down, wondering how the $60,000 a year your income properties should provide by then will work out for ya. Maybe if Murphy leaves you alone in your golden years, that cash flow could average $70,000.

Yeah, and maybe Murphy’s only a myth, right?

He’s never gonna die. He knows where we all live, and sooner or later we all serve our time in his barrel. Ever heard of O’Toole’s corollary to Murphy’s Law?

He said, “Murphy was an optimist.”

55 Years Old and Facing a Tight Retirement Budget

Let’s say this investor couple is scheduled to retire around 65 years old or so. Their four little duplexes already free ‘n clear. Using what I’ve come to call ‘Murphy’s Spreadsheet’ he’s projecting cash flow at retirement at 50% of the Gross Scheduled Income — GSI.

The GSI is $120,000 which means their lookin’ at around $60,000 a year before taxes. They’ll pay taxes on all of it as his depreciation by then will be a feint memory at best. Sure, he and his wife will have Social Security. (Keep a straight face, ok?)

Let’s say they have roughly $42,000 after taxes from the properties. What should they do with that dough? I dunno, but they need to do something. He and his Boss know their plans for a fun retirement just ain’t gonna happen with less than $3,500 a month after tax plus their after tax SS check. What to do?

They can buy more real estate every 2-3 years, thereby creating more cash flow. That’s a legit option. Or, they could look into discounted notes secured by real estate, and in first position. Here’s the strategy they might wanna consider.

This isn’t New, and it’s a Tried ‘n True Investment Strategy

Use what works, right?

Let’s say our investor couple, we’ll call ‘em Frank ‘n Louise, decide to refi their debt free duplexes in order to purchase discounted notes. How would that look? More important to them, how would that boost their income in retirement? Remember, they’ve only got about 10 years before they wanna start livin’ the Life of Riley. The duplexes have a combined worth of $1,000,000. They’ll be borrowing 70% LTV, about $700,000, at 5% fixed rate interest for 30 years.

Their home is paid off, though it needn’t be. (Note: Any existing real estate loan they might’ve had on their own home would need to be paid off by the proceeds of the refi. The reason is the recent lender regs disallowing any cash out after four loans. Blech.)

In plain English, if they did have a loan on their primary residence, they’d have a couple choices. 1) Refi just three duplexes. Or 2) refi all four while payin’ off their home as part of the deal.

Let’s Lay the Numbers Out

At 5% interest with a 30 year ammo their payments will be just over $45,000 yearly. Their aggregate Net Operating Income — NOI — is $60,000 yearly using the Murphy’s Spreadsheet rule. (Just divide the GSI by 2 and be happy.) That allows for a comfortable buffer of over $1,000 a month cash flow. We’ll get back to that later.

They now take the $700,000 and enter the discounted note market. They invest in a note fund much like those managed by David Van Horn and his firm, PPR. Note buyers like note funds due to the funds’ need to maintain both quality and performance. The current market return, at least cash on cash is 12-15%. We’ll use 13%. The result is a pretax annual income of around $91,000. Add to that their now much reduced income property cash flow of $15,000, and here’s what they’ve accomplished.

Before refi: $60,000 annual income property pretax cash flow.

After refi:  $106,000 combined annual pretax income from real estate and discounted notes secured by real estate. (1st position)

Let’s say their after tax income on that is roughly $65,000. That figure could be low. Experience tells me it’s likely not high.

Let’s not forget they still have about a decade before retiring. Hhmmm, what to do?

Let’s take $5,000 a month and apply it to the new loans and see what happens.

Surprise! Surprise! Surprise! It seems in a bit over eight years the $700,000 of newly acquired debt has been extinguished, deleted, vanquished. They still have almost two whole years to go before retiring. What if . . .

They just did it all over again? Is that even a viable and realistic option? Doin’ the numbers is the only way to know. Let’s see what the numbers are.

Second refi: $45,000 a year in debt service. (Note: Yeah, I know, we’re figuring on the same loan terms as we got years ago. Agreed, it’s foolish on its face, but none of us knows what the rate might be in the future. This is merely an exercise demonstrating options most folks don’t realize they may have.) Assuming the NOI never went up, still $60,000 yearly, the same $15,000 cash flow would result. We also assumed there’d be no increase in value, ever.

After second refi: $15,000 annual pretax cash flow from duplexes, plus $182,000 annual pretax income from discounted notes. Total = $197,000 in yearly pretax income from their duplexes and notes.

We’ll make a judgment call and say the after tax income ends up being roughly $120,000 a year. With just 22 months ’til their retirement party, Frank ‘n Louise need to take a step back and figure out how to spend that income, keepin’ in mind their  main goal of maximizing monthly income. Duh.

In just 17 months they can free ‘n clear one of their duplexes by adding $10,000 to each monthly payment. The income from that duplex would then instantly increase from less than $4,000 yearly to about $15,000. The remaining three duplexes, still encumbered by the 2nd refi would contribute a combined cash flow of approximately $11,000 a year.

Note: Many think it would be better for Frank ‘n Louise, at this juncture, to take the $120,000 a year and buy more notes. Actually, that’s a very solid option, one they could act on for sure. However, I like the idea of having at least part of their real estate portfolio debt free.

Why? Simple, cuz when they have a need for cash in the future, it’s a phone call away by a simple refi. Without that free ‘n clear duplex in the wings, they’d be forced to either borrow against their home, or sell a note or two, incurring cap gains tax liability. I prefer the tax free option of a refi. You may or may not. That’s why we like to say that the investor with the most options wins. :)

So, let’s tally up the results of Frank’s and Louise’s 10 year program, and see what we’ve got. 

Income property pretax cash flow: $26,000

Pretax note income: $182,000

Total investment income at retirement, sans SS checks: $26,000 + $182,000 = $208,000 pretax income. 

RelatedCapital Growth,Cash Flow, Taxes And Timing: Planning for Your Retirement the Smart Way

Some Points to Ponder on the Way

These numbers were based on the assumption that the duplexes’ values and their respective NOIs would never increase, ever.

Though the notes were bought at handsome discounts, therefore with builtin profits, the process never predicted any of their notes would pay off in the 10 years subject to analysis. This is unlikely in real life as the latest data dump shows the average homeowner now pays off their home loans in about nine years or so. It used to be less than that, but the bubble added a few years, which makes sense.

When their notes do begin paying off, a completely random process to be sure, their taxes will be calculated on the less onerous capital gains rate, not ordinary income.  The taxes on the interest received each year, however, will be based on ordinary income tax rates.

I strongly suspect that by the time they retire, 10 years from the first note purchases, that a significant portion of those initial notes will have paid off. That would have made it potentially possible for them to have paid of another one or two duplexes. But that’s pure speculation, and ‘average’ pay off times go out the window when talkin’ about specific notes. It’s all a matter of complete and utter randomness.

If they’d done nothing, just stayed the course, their retirement income from investments would’ve been less than 30% of what this plan produced.

Yes, notes are relatively riskier than real estate, as higher yields almost always mean a commensurate increase in risk. Duh. What buying notes secured by real estate is all about is mitigating that risk to the extent reasonable and possible.

Professionals know how this is done. Knowledgeable investors buy pretty almost every note put up for sale by the aforementioned note funds.

Why is this? They’re not stoopid. They’ve assessed the risk and decided to invest. They like the track record.

If my own mom had capital to acquire notes I’d make it happen. Shortly, my kids will be in notes also. They know how it works. :)

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About Author

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

12 Comments

  1. So much of this strikes true. Everytime I try to talk to my friends about the future, 40 years down the road, they’re like, “Nah, it’ll be fine. I can just work my way up in a job and then retire on my savings.” I always reply with a ._. face. It just seems really odd that I can’t find anyone my age who wants to invest xD All my friends just want to get a job, put a percentage of their salary in a retirement fund and let random strangers handle their money @_@

    I wonder if I can show them this article to convince them :D

  2. Great article, Jeff, as usual!

    However, you did not mention that PPR note fund is for accredited investors only and your fictitious couple does not qualify based on their income or liquid assets mentioned (they may have a few millions stashed under the mattress though).
    Oh, and the most important question – where to buy these notes from – is still up in the air :-(
    I found one source that sells 1st position commercial notes with 9% interest and 50% LTV (they originate the loans and require 50% down-payment) but they have everything sold out and could only offer a waiting list.

    PPR sells 1(ONE) note a week to the general public and most of the time that note has negative equity. But even then, it is sold within 10 minutes after publishing.

    Is this market so small and fragmented that there is nothing to choose from?

    FCI Exchange shows many notes for sale but the discounts are ridiculously low or non-existent.
    Here is an example of an NPN offered for 110% of UPB: http://www.fciexchange.com/TEXAS/Residential/Non-Performing/0014218.html
    Are they out of their mind?

    • Jeff Brown

      Hey Nick — Mr. Dorkin only allows me to write about a post a week, not a book chapter. :) But I get your frustration, which is why I worked hard with PPR to set up the BawldGuy Note Fund. It specializes in first position notes secured by real estate. AND, as you so accurately pointed out, to be a member one must be an ‘Accredited Investor’. For those unacquainted with that term, here’s how you know if you’re accredited.

      Income: $200k/yr if you’re single; $300k if married. OR . . . net worth of a million bucks EXCLUSIVE of your primary residence.

      The good news, Nick, is that I made sure with PPR, dealing directly with Dave Van Horn, that those investors not qualifying for accredited investor status would still be able to buy notes. You merely sign up with PPR as a registered note buyer. There are two downsides there. First, since you wouldn’t be an official fund investment member, you wouldn’t benefit from the preferred return, which is electronically deposited monthly and automatically in the bank account you designate. Second, fund members will be notified of newly available notes roughly two weeks before non member investors.

      I can give you a detailed explanation of how things work if you’d like. You know how to get a hold of me.

  3. Sharon Tzib on

    I didn’t realize the interest and payoffs would be taxed differently – great little nugget there. Thanks, Jeff :)

  4. Sara Cunningham on

    Great article Jeff. Love the Aging RE investors title, right up my alley with the time frames and everything. So I start thinking this is the plan for me, then realise its not quite as easy as it seems with the parameters needed to sign up with PPR. With the Bawldguy Note Fund how realistic is to actually ever get the chance to buy anything worthwhile when all the accredited investors are always getting the first bite.

    On the other hand I might just have to find a way to qualify as an accredited investor. Assuming you qualify under the terms of income or net worth are there any other criteria you need to fulfill?

    Thanks for getting my brain cells working on this one.

    • Jeff Brown

      Hey Sara — No other criteria. Either the income or the net worth will qualify you. Both aren’t required. If you have any questions, don’t hesitate to email me, as I’d be happy to address your questions.

  5. How do the taxes work on the notes?
    Regular income on interest income is obvious.
    But the payoffs seem more complicated.
    I’d assume any accrued interest would be ordinary income still.
    Question is what is the gain?
    If they are getting principal paid back there is no gain. I assume the gain is on the discount they bought at? So simple numbers buy a note with $100k principal balance for $80k. So there is a built in $20k gain as long as it doesn’t default.
    I see it is easy to call a gain if there is a lump sum payoff at some point.
    what isn’t clear is how you’d treat it if they just make payments. A”gain” would be any principal once the $80k is paid.
    So at that point is each payment a portion income (interest) and a portion Capital Gain (principal)?

    • Jeff Brown

      Hey Shaun — I mentioned some of the tax treatment in earlier comments. However, there are basically three possible segments to any given payment or payoff. 1) Interest 2) Return OF capital (not taxed) 3) Return ON capital, which is taxed. Whether it’s taxed using short or long term cap gain rates depends on the time held, of course.

    • Hey Rennie — Excellent question. The payments on a $700k loan at 5%/30 years is roughly $3,757/mo. When we add the aforementioned $5k/mo the payoff happens in around 98 months, or 8 years and a couple months. Make sense?

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