Many of my old school clients, though keenly interested in the concept of discounted notes secured by real estate, wonder why I counsel them to add notes to their overall Purposeful Plan.
It’s entertaining to watch them slowly transition into complete discounted note evangelists, at which point they wonder why they even own as much income property as they do.
I usually tell ’em to pull back on that throttle a bit. 🙂
Here’s an incomplete list of reasons why I would advise clients to stay invested in both real estate AND notes.
How to Purchase Real Estate With No (or Low) Money!
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4 Arguments for Investing in Real Estate AND Notes for Retirement Income
1. Multiple sources of income is rarely a bad idea because it is more secure — and more fun.
The vast majority of those I advise arrive at retirement with two or more income sources.
Sometimes the same vehicle is wrapped in more than one ownership “envelope.” For example, you might own notes in both your name and a qualified retirement plan like an IRA or 401k, be it traditional or Roth in nature.
The only practical differences between the notes you and your plans own are tax issues and when the income becomes available. When you own them, the income is available from the first payment on. You’ll pay taxes on the received interest at the income tax rate you pay at work.
If your plan(s) own notes, the payments aren’t taxed as long as they remain inside the 401k/IRA. If any of them are Roth, they’re not taxed as they come out either, as long as you didn’t take the income out before the regs allowed it. That’s almost always 59.5 years old, with rare exception.
NOTE: The infamous 70.5 year birthday on which the government then begins forcing you into taking more income (read: your principal) doesn’t apply to Roth IRAs. It applies to other Roth plans, and yeah, I know it makes no sense.
But that’s why I have investors transfer from say, a Solo 401k (Roth) to a Roth IRA before they reach that “deadly” age. As a rule I like to have them do it annually or at least every couple years. It’d truly suck like a Dyson if they’d waited ’til the last date only to find the government had changed the rules in the middle of the game. Would they do that? 🙂
By having more than one source of retirement income — each source independent of the others — the investor can afford to feel a bit more secure if Murphy visits the economy (or you personally). Typically the various sources provide their own solutions to acquiring cash, dealing with downturns or outright emergencies. Having multiple income sources allows more options when dealing with urgent cash needs or taking advantage of new opportunities.
Keep in mind the BawldGuy Axiom: The one with the most options wins.
2. Though note profits are built in, they don’t tend to appreciate the same way real estate does.
They can, and I’ve seen their value increase over the price I’ve paid, which allows for a profit merely by reselling the note. I know, cause I’ve seen them do it. Generally though, that’s the exception and not the rule.
The built in profits created when buying discounted notes secured by real estate aren’t the same as profits generated while investing in real estate. That is, the appreciation of real estate value can far exceed the built-in value “appreciation” of discounted notes.
Here’s what I mean.
If you buy a note with an unpaid balance of $100k for a price of $75,000, you’ve made a total of $25,000 profit, when the note eventually pays off in full. VERY simply put, you made just over 33% profit, when only principal in and principal out is measured in terms of yield.
However, if you put that same $75,000 into an income property valued at $300,000, there’s no “built in” profit. If over time the property experiences some consistent rise in value due to market appreciation, profits materialize. Furthermore, due to your 25% down payment, every 1% of value appreciation is really 4% capital growth for you. 1% of $300,000 = $3,000. $3,000/$75,000 = 4%.
For example, if that property rises in value for 3 consecutive years at the annual rate of 8%, the value would then be around $378,000. Even with selling costs of roughly 8%, your profit remains nearly twice that of the note. That doesn’t even take into account the fact that the note is far more likely to take longer than 3 years to pay off.
Notes will generally have a higher cash on cash return than will real estate. This assumes the investor hasn’t compromised location quality for the mirage of higher cap rates, a common mistake.
3. If significant inflation rears its ugly head, having real estate makes you less vulnerable to the lost purchasing power of the dollar.
This is owing to the fact that both real estate prices and rents have shown a propensity to “track” inflation. Put more simply, property values and rents tend to rise along with inflation. We like that, right?
When inflation strikes, our buying power weakens.
When in the 1970s we saw double digit inflation for several years, we were all forced to batten down the hatches. Our family budgets suffered big time.
The silver lining, though, came from income property values and rents. Since they’ve historically tended to track inflation, more or less, real estate investors were able to increase their overall cash flow per month. For example, San Diego duplexes sported values in the mid 70s of around $30-45k, give or take. By 1981 duplexes were selling at $100,000 and more. Inflation had been the real estate investor’s friend. Since the interest rates were fixed, the increase in rents over those inflationary years went almost completely to the bottom line, i.e. cash flow.
Moreover, once things returned to a relative “normal” around 1984 or so, those duplexes were sold or exchanged for up to triple their original purchase price — and much more by the end of that decade.
You just ain’t gonna get that while in notes. At least I haven’t. What those investors often very happily learned was they didn’t need to sell if refinancing was a better option. Since their $25,000 duplex loan balance was now representing a mere 25% LTV (loan to value), they could pull a whole bunch of cash out on a refi, which the vast majority of the time isn’t even a taxable event.
Yep, inflation is a nasty intruder, but it does float real estate prices and rents along with it.
4. If the investor owns notes in their own name, they can then combine the strategies of notes and real estate synergistically.
That is, the after tax monthly note payments can be applied to debt reduction on the RE part of their investment portfolio. Doing this allows the investor to multiply their holdings of BOTH vehicles more rapidly than would otherwise be possible.
The ability to combine 2 or more strategies synergistically can increase potential retirement income and/or net worth. Many find themselves able to accomplish both. Furthermore, they learn they are able to reap the benefits sooner, sometimes remarkably sooner than if they hadn’t executed multiple strategies simultaneously.
Here’s an example.
You own a couple 1-4 unit residential income properties. They each have $100,000 loans on ’em, payable at 5% fixed rate interest. What if you spend that $50,000 cash, which is now burning a hole in your Levis, for notes instead of more real estate? What might you accomplish?
An example scenario.
Let’s say your 2 props are cash flowing at $150/mo each. Your new note(s) are spinning off monthly pre-tax income of roughly $500. Due to state/federal income taxes, that $500 note payment turns into a whole buncha $350. Likely more, but let’s err on the conservative side. That means each month, between real estate cash flow and after tax note payments you have around $650/mo to add to one of those prop’s loan payments.
Here’s what would happen.
I assumed the beginning loan balance was about $105,000, and had been paid down to around $100,000. If they apply the above $650/mo to the balance of one of those loans, the investor will have free ‘n cleared that property in approximately 8.5 years. That, my friends is synergy in action in real life — and real time.
Now, for sure there are virtually an infinite number of scenarios to ponder. If those scenarios don’t include notes? The guy without the notes will not end up with nearly the net worth or cash flow of those who sported real estate AND notes.
I don’t have time to do the numbers, but common sense and decades of experience have shown me that the second loan will be paid off FAR sooner than another 8.5 years. In fact, my guesstimate would be another five years or less.
There are a few reasons for this. During the 8.5 years the other prop’s loan balance was still being systematically reduced by its monthly payment. In fact, its balance would be just over $81,000 the day the other loan was eliminated completely. Then there’s the increased cash flow of the newly free ‘n clear rental.
In other words, not only would the beginning balance be nearly $20,000 less at the start, but the extra amount added each month would be appreciably larger. The wild card, of course, would be whether or not one of the originally purchased notes had paid off. If it/they had, that means the investor would’ve taken the after cap gains tax bucks and bought more notes with higher monthly payments. See how this works?
Meanwhile, back at the ranch, this approach has produced a new page of options the investor didn’t have before. These options will have the power to allow the investor 1-3 more “cycles” of this synergistic strategy. A cycle is the time it’d take to refi the now debt-free rentals, buy more notes, then take the cash flow and after tax note income, combined with previous note income from original purchases.
Rinse ‘n repeat a few times, and find out how much real estate and note income can really be created. Compared to the real estate only school of thought, the investor with real estate and notes will likely end up with 1.5-4 times the retirement income than the one using real estate alone.
As I said earlier, that’s a woefully incomplete list, but they cover the major concepts and principles involved.
Though this post barely scratches the surface as to what’s really possible, I hope it’s opened a new door for you to at least explore.
How have you strategized your investments in preparation for retirement? Does this argument sway you to take a look at putting money into notes AND real estate?
Let us know your thoughts below!