Last week’s post talked about various strategies that didn’t work as advertised when it comes to real estate investing.
Now, to be clear, the “tried and true” strategy of acquiring rental homes ’til one has 10 homes, then eliminating all debt by retirement, will defeat most-non real estate approaches, hands down. That’s true and has been for quite some time.
Let’s talk about the side-by-side comparison of the above-mentioned strategy B&H (Buy ‘n Hold) versus selling/exchanging or refinancing to acquire more property, while also takin’ advantage of other related vehicles. In others words, we’ll just add flexibility to the mix.
Sometimes analyses tells us it’s better to refinance to buy more than selling/exchanging. It’s different virtually every time, especially considering all the surrounding factors existing for each individual investor.
We’re gonna use a 35 year period from history — 1975-2010. This allows everyone to check the numbers in their particular market to see how it woulda turned out where they live. I’ll be using San Diego’s market cuz that’s where I’ve lived since I was 15.
Here’s how the comparison will go:
1. I’ll assume the B&H and “never ever sell” approach will benefit by the overall rise in values/rents of the time, just as everyone else’s properties did.
2. Ultimate retirement cash flow for the two approaches won’t be computed equally. The 10 homes will calculate cash flow by taking the GSI (gross scheduled income) and taking 100% of it as before tax cash flow. Yep, we’re gonna make these rental homes magical to make the point crystal clear. 🙂
3. The ultimate retirement cash flow for my “client” will be computed on two levels: a) Real estate, which will be subject to Murphy’s Spreadsheet math. That is, we’ll simply take the total GSI and divide it by 2 to arrive at before-tax retirement cash flow, and b) Since my clients will be movin’ n’ grovin’ whenever opportunity and the market allows, they’ll have more income sources than will their buy ‘n hold forever competition. Two of those sources will not be real estate.
4. However, fear not, as their ultimate before tax cash flow from real estate will annihilate the other investor’s strategy.
5. Both investors begin with the same household income, get the same raises/bonuses, and have the same lifestyle expenses. The only thing different will be the investment strategy(s) used to generate retirement income.
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1975-2010 — Buy ‘n Hold
B&H sets their plan in motion by acquiring a rental property sometime in 1975.
It took ’em five years to save the down payment. By today’s standards, it’s laughably cheap, under $30,000. As was their plan, they continued buyin’ home after home. The acquisition period ended some time in the mid to late 1980s. At that point, they’d acquired the 10 houses set out in their plan. The next part was to pay ’em all off by retirement, which they did.
Both of these investors were born in 1945, so planned on retiring at 65, which is 2010.
They benefitted by three incredible periods of appreciation, 1976-’80; 1986-’90; and 2001-’06. ‘Course, their strategy dictated they both remain calm through the downturns and also not alter their strategy during the wild upturns. They remained admirably disciplined. B&H’s 10 homes in 2010 on the day they retired were worth roughly $3-3.5 million. Today, they’re likely worth $4-4.5 million.
What Was Their Before-Tax Cash Flow at Retirement?
The average rent is about $2,000. That’s GSI of $240,000 a year.
When we apply the aforementioned expense factor… um, wait, never mind. We said they’d retire with 10 magical rental homes with no vacancies or expenses. Therefore, their gross rents would be their before-tax cash flow. Voila! They retired at age 65 with $20,000 of monthly before tax cash flow.
Great job, guys!!
How Did Our More Flexible Investor Do With Their Strategies?
They began with the same exact house their buddies bought, for the same price/terms, on the same day in 1975, with the same exact floor plan, across the street. That start equal enough? 🙂
By sometime in ’77, nearly three years later, that home was worth roughly $50,000. Their equity at that point was around $26k, net of loan/sales costs. Those doing the math will come up with a slightly lower net equity figure. This investor, following my advice, added an extra $100 a month to the loan payment, which goosed the net equity. Pretty boring stuff.
NOTE: We’re definitely NOT gonna go through the painful minutia of numbers details for every transaction over 30 years. I’m doin’ it for the first property to show how I arrived at net equity, which was to apply sales costs of 8%. From here on out, it’s nothin’ but broad brushstrokes. Those who prefer all the numbers ad nauseum? I suggest an HP 12C. 🙂
They were advised at the time of sale to examine whether or not it was better to sell and pay the taxes or to defer taxes in an exchange. They chose to pay the taxes, which amounted to around $4,000, some of which came outta their Levi’s, but well worth it. They then took the after tax cash, approximately $25,000 and acquired a local fourplex for $110,000.
Update: They now own four doors instead of one, and it’s barely three years.
They make another move in the spring of ’79. They acquire a couple duplexes and a triplex on separate but contiguous lots from one owner. They got rid of the fourplex to do so.
Update: It’s now summer of 1979, and they own seven doors broken up into three properties.
As it happens, Grandma passes away during the early winter of late ’79. She didn’t have much to pass on, but both our investors received around a $20,000 inheritance. Our B&H investor put a huge smile on his wife’s face by giving their kitchen a complete makeover.
Our more flexible investor spent all $20,000 on a 2nd position note sportin’ a loan balance of $29,000. The payments were monthly, totaling $2,900 annually. A modest start in the note arena, but a start nonetheless. It was at 10%, interest only payments, all due and payable in five years. He used the after-tax monthly payments to add even more velocity to debt elimination.
The note paid off as agreed in January of 1985 — $29,000.
At that point, they rinsed ‘n repeated the process, using the after-tax payoff cash of around $27,000. Found a $42,000 note for sale that made sense. Another 2nd position note secured by a local triplex. This one was a 10% loan, which had started out as a 10 year loan back in 1980. Payments were interest-only monthly, all due and payable in early 1990. The payments added to $4,200 yearly, which netted out to around $3,000 or so after tax. As usual, the monthly amount was dutifully added to the targeted loan of one of his properties.
From that summer ’til around spring of 1984, they don’t do squat. They begin to wonder if “normal” would ever return to real estate investing. I know at that time I sure did. 🙂 By then, the median house price in the San Diego home market, even post recession, is over $100,000. They poke their heads up, but decide to stand put a while longer. They’re not enamored with interest rates.
Both investors have been doin’ well at work, getting promotions and raises.
During the downturn, the “flexible” investor was advised by his RE investment broker to apply more money to the pay down of his loans. So, for the almost six years since the last move in 1979, they’d been applying around $400/mo to one of the duplex loans PLUS the newly acquired note payment. Doesn’t sound like much these days, but that much back then could make a real dent.
What with much pay down on one of the duplexes and normal debt attrition on the other two properties, they happily jump into the 1985 market. Well, happily except for the never-ending hangover of high rates. They opt for the newly available adjustable rate loans, which don’t have any negative ammo. For the record, that was a pretty salient call, as the index used, the 11th District Cost of Funds, went steadily down for many consecutive years.
They acquired three fourplexes in 1985. Again, they used adjustable rate loans. Both times they began with precious little cash flow, though that quickly gave way to ever increasing cash flow due to the rents tracking the demand-created rents (inflation at its best), which never seemed to stop headin’ northward. This wasn’t unique to SoCal, just more pronounced than most markets around the country.
Update: They now own 12 doors 2 (20%) more than their investor counter parts ever will.
Let’s Skip to the Last Inning
From 1986, at which time they’d gone from a lonely rental home to 12 doors in three fourplexes, they made a large move in 1989 that allowed them to end up the proud owners of 22 doors. This was made possible by the use of the then very much increased net equity of the three fourplexes they’d acquired in 1985. Inflation and value appreciation is a fine thing, isn’t it? Crashing those loan balances downward didn’t hurt either. 😉
In early 1990, the note bought in 1985 paid off with a check for $42,000. They just kept the ball rolling by acquiring junior position notes each time, which they did ’95, 2000, and ’05. In ’10, they changed their note approach slightly, buying only 1st position notes. ‘Course, they’ll actually never stop that part of their plan, even after retirement, right? Who doesn’t want raises after retirement?
Real estate-wise, they went fishin’ again from their last move in ’89 until about 1998. Why? The whole S&L Crisis thingamajig put a crick in pretty much everyone’s neck. 🙂 On the silver lining side, using all their cash flow, spendable cash from their family budget, and after tax note payments, they literally paid off one of their fourplexes. They then set out with serious intent to move up once more.
NOTE: Here’s where massive appreciation for consecutive years makes the avoidance of 1031 exchanges more difficult. Cost segregation up to that point was still a rather contentious topic with the IRS. That precluded any real planning for future cap gains/recapture tax reductions. I’m a lotta things, but a bleeding edge pioneer ain’t one of ’em. 🙂
By early 1999 the smoke had cleared on the turnover of their entire real estate portfolio. This took many months to accomplish. Duh. The result was they ended up with a buncha duplexes, triplexes, and fourplexes, totaling 47 doors. Total value of the acquired property was just over $4.4 million.
Meanwhile, Back at NoteRanch…
By 2010, their note portfolio had grown to just over $200,000.
This was helped along by having one of their notes pay off way early, which happens every now ‘n then. The payments on these notes were, as usual, interest only. The interest rate had declined slightly to an average “note rate” of 8.5%, resulting in an annual before-tax income of $17,000.
Much of their ability to make trades sooner than some investors in the same market came directly from their ability to enter that market with more relative equity to trade. Even if they didn’t jump sooner than most, they were able to acquire one or two more properties due to the impressive debt reduction they’d created. Over the long haul, it can make a stunning difference in both end game capital growth and cash flow.
They continued the assault on their overall investment property debt. By then, they had 47 doors, so the cash flow, though measurably smaller per door than most other markets around the country, was still high. When combined with the four figure extra principal pay down each month, the impact on their growing equity was magnificent, to say the least.
And Then the Mother of All Bubbles Was Born
From 1999 to 2003, the overall value of their real estate investment portfolio went from around $4.4 million to roughly $5.7 million! They almost didn’t know how to act. Even though they’d moved into a new home, their payments barely rose ‘cuz the interest rates had gone down so much. Ah, the blind luck of timing sometimes.
For the record, our B&H investor was grinnin’ ear to ear, too, as he saw his 10 homes rise to almost $6 million by the end of 2006. ‘Course that smile adjusted itself by the time he retired in 2010, though considering his humble start, it was still bright.
To continue with our more flexible investor’s saga, the huge amounts they’d been adding to each month’s payments on successive loan payoffs had mounted up, and happily so. By late spring of 2003, they began to believe their real estate investment broker’s advice about gettin’ outta Dodge. So, they began the process, which took longer than they thought. They moved their whole portfolio, lock, stock ‘n barrel to a couple major markets in Texas. (Yeah, I know. Who knew, right?)
Here’s How it Played Out, More or Less
The total debt on their portfolio at that time was just under $1.5 million. The net equity using 8% for sales costs was approximately $3.5 million, being conservative. They acquired 50 Texas doors in a combination of brand new duplexes and fourplexes. Remember, no loan limit per investor back then. 🙂 That allowed for a monthly cash flow of around $13,000.
Add to that cash flow the $2,000 monthly from their family budget, and another $1,000 from notes. That means they were adding $16,000 monthly to the notes for seven years. Uh, oh. That means if they wanted to retire with all of ’em completely debt free, they’d hafta give a bit of a boost each month. Don’t ya just love these sorta logistical glitches? They decided to find the extra $258/mo. to end up debt free by 12/31/10.
So, What Was Their Retirement Income From Real Estate?
Bottom line, using Murphy’s Spreadsheet — divide GSI in half — their cash flow ended up being about $29,500 a month. In reality, the properties in Texas more likely cash flowed at about $35,000 monthly.
You’ll recall I agreed to compare the two strategies side by side, but with radically unfair methods to arrive at cash flow. Our B&H investor ended up with a retirement cash flow — at least in Fantasy Land — of $20,000 a month. This was based on having no vacancies or operating expenses once retired. 🙂
In other words, they have less gross collect rents per month than does Flexible Man, who had nearly 50% more cash flow while using half of his collected rents — on brand freakin’ new properties, mind you — to pay for vacancies and operating expenses.
Add the note income at retirement. Since the note paid off in late 2010 at $200,000, he decided to let it ride into more notes. Not a difficult decision. 😉 He pulled in his horns risk wise, opting for 1st position discounted notes. His first investments provided a 13% cash on cash yield of about $26,000 a year. So, as he entered into his first year of retirement on New Year’s Day, 2001, his investment generated income for that year was $380,000.
Let’s Revisit Our B&H True Believer
On his first day of retirement, the actual annual income was approximately $120-156,000, or $10-13,000 monthly. Woulda loved to hear those two’s first post retirement conversation, wouldn’t you? 🙂
B&H: “You’re makin’ how much?!!!”
If Flexible Dude wished to put a blanket 30 year fixed rate (portfolio) loan on all his units for roughly 70% LTV, then buy notes with the cash, his income would easily rocket up to well over $500,000 a year. Though I’m sure his good friend B&H would want in on that, I’m almost as sure the lenders in California wouldn’t give him a loan on 10 geographically spread out single family homes, especially since their ages range from 30-60 years old. He would be able to possibly refi 3-4 of ’em.
This is another example of why experienced investors don’t follow formulaic retirement plans.
Grab what the market gives us, when it gives it to us, and how it gives it to us. The rest is nothin’ but HappyTalk.
What do you think of this case study?
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