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.
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.
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.