“Volatility is far from synonymous with risk… If the investor fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.” — Warren Buffett
Those of us who’ve been around longer than an economic cycle or two can attest to the overall ups and down of pretty much any long term investment vehicle. The go-to has usually been stocks/bonds, but real estate and debt instruments — a high-falutin’ way of saying notes secured by real estate — are subject to the same market factors as everything else. Still, the fact that they at times seem volatile doesn’t alter the reality that over the last several decades, real estate and notes have so far outpaced the stock market, it always baffles me as to why they even volunteer to suffer the results of honest comparison.
That isn’t to imply or even induce an inference that many investors, though part of a small minority, don’t do exceptionally well over the very long term in stocks and bonds. They absolutely do. And to that tiny batch of folks, I offer my profound respect and admiration. But what’s the other side to that coin?
It’s retirement income.
If your stock investor buddy across the street retires with $2 million in stock/bond “equity,” what will their income be? The same pros who got them there will also tell ’em, and rightly so, that preserving their principal is primary. To that end, risk will be fittingly avoided, though not totally, as that’s only a pipe dream. A four to five percent return is what they’re expecting of the couple million amassed so painstakingly by retirement. If we give them 5%, their pretax retirement income will be $100,000 yearly. Not bad, eh? Considering how badly most Boomers are retiring these days, that is IF they can retire at all, that is truly a very impressive retirement income.
However, when compared to what was possible, an alternative set of options, the after tax retirement income from that $100,000 very well coulda been looked upon as mere pocket money.
Let me illustrate with a real person.
The Case Study
“Rod” is a 39 year old immigrant, married with a new baby. His wife, Beck, is an accountant with her own small business, while he’s a software programmer/developer. She’s backed off a lot since their baby was born, so her income has dropped precipitously. Between ’em, they now make around $165-180k/yr. They live in a high tax state in the Northeast. At this point they own a house with a mortgage, a small rental in the Midwest without a mortgage, and have around $80,000 in cash. His 401k is less than $50,000, a figure with which he’s less than impressed. They save around $4,000 monthly, give or take, post baby.
If he retires in 20 years, just months before he turns 60, what are the possibilities for potential retirement income?
First, let’s list the initial actions they might consider taking:
- Beck starts a Solo 401k — contributing all capital AFTER tax on the Roth “side.”
- Once their little girl goes to school, she can ramp her business up again, if she likes.
- Her Solo buys discounted first position notes from now ’til she turns 59.5, another 23 years or so.
- Rod sets up a self-directed Roth IRA for the same purpose.
- They put the equity in the midwest rental into Texas, buying a duplex.
- They buy a second Texas duplex with money they’ll have at the end of this year.
- They start an EIUL, committing $1k/month premium, indexed to inflation, for 20 years.
- When possible, they start second note portfolio with personal money.
That list isn’t all-inclusive by any means. Nor does it include the various investment strategies they’ll be employing, many of them synergistically. We’ll assume, based on my experience, that they’ll be able to put away an average of $15-20k/yr combined in the Roth Solo and Roth IRA for the next 20 years. The average of that over a couple decades is roughly $350,000. The last 18 years will see them investing their combined annual note payments into new notes every year. As the notes pay off — completely randomly — they take the untaxed profits and buy more notes, etc., etc.
- Their payments are buying notes every year beginning the third year. Each year they can buy more than the last.
- Though it’s unpredictable, current data tells us the typical 30 year note pays off in full in roughly 6-9 years.
- Bottom line? If they don’t have $6-10k/month or more in tax free note income in 20 years, somebody screwed up.
But What About Their Real Estate?
There’s no tellin’ where they’ll end up in 20 years. Nevertheless, they have a distinct and measurable advantage over most investors in that they can strategically leverage the tax code’s stance on depreciation. They’re barred from using any leftover depreciation against their own ordinary income due to their household income, which exceeds $150,000 a year. Oversimplifying to the max, this allows them to pay off an investment property’s loan in about five years, while generating a next tax liability of very little to nothing. This is done, short version, by using “stored,” unused depreciation to offset any capital gains and/or depreciation recapture tax incurred by a sale. The bottom line result is that very little, if any, “net” tax liability is left standing. The tax savings on the personal income tax side mostly, if not totally, offsets the tax liabilities generated by the sale of the investment real estate.
It’s at that point things get pretty amusing in the best way.
In Rod ‘n Beck’s case, it means they’ll have around $300,000 +/- after tax in the bank to do with as they please. Who knows what that’ll be five years from now, right? I know I don’t, that’s for sure. But let’s play with it a bit. If the interest rates and/or real estate market hasn’t gone totally insane by then, they’d have the option to buy a couple more duplexes, with half the money while investing the other half in discounted first position notes. The after tax income from those notes — held personally, so taxable — will serve several purposes.
- It’ll add appreciable velocity to the termination of the next loan(s), which will allow them to pay off two loans instead of just one. They’ll trade velocity for more debt elimination in the same five years.
- By utilizing this combining of strategies, a quite intended consequence will be another stand-alone source of retirement income, discounted notes.
- Over 20 years that will grow nicely, thank you. In the end it’ll likely hit $5-10,000 monthly before taxes. That’s due to their ability to rinse ‘n repeat using the above mentioned combined strategies of unused depreciation/debt elimination/note income.
- The fourth and last time they use that fusion of multiple strategies, they’ll likely be simultaneously paying off 3-4 loans in the same five year period. This will result in ownership of approximately $1.5-2 million in free ‘n clear property. The income from those properties, assuming today’s current NOI never goes up, would be around $100-150,000 annually, much of it tax sheltered.
Let’s tally their retirement income, shall we?
First, their real estate will be no less than $100,000 a year, much of it sheltered. It could just as easily reach $140,000 a year. Another option available to them after the last go-around with their now favorite buncha strategies will be to refi some or all of their properties to the point where they continue to cash flow pleasantly, but not much, relatively speaking. They’d then take the $1 million or more tax free dollars to acquire an additional and almost immediate $10-14,000 of monthly income or more, depending on their luck in the note market at that point. It’d be a raise of over 20% compared to not refinancing the units at about 70% LTV. The long term advantage of this approach is that the notes then pay off randomly, allowing them to reinvest the after tax proceeds in more notes with higher payments into infinity. They like the sound of that. 🙂
Personally held note income will be — if we compromise below the halfway mark of the range of $6-10,000 monthly — $90,000 annually, pretax. However, if they opt for the “refi for more notes” agenda on their last go-around with real estate, that note income would go up by the aforementioned range of $10-14,000 monthly, or $120-170,000 a year.
Note income from their various Roth retirement accounts will be generated 100% by notes. This will result in an income range — ALL of it tax free by tax code definition — of $90-140,000. We’ll compromise on the low side and call it $100,000 tax free note income.
Note: Whatever it turns out to be will be the lowest it’ll ever be. Why? Pretty simple — even when we retire, notes keep randomly payin’ off, allowing our couple to buy notes with bigger payments each time it happens. Retirement income raises into infinity — the name of my new band. 🙂
Oh yeah, what about that EIUL they’ve paid for the last 240 months? What about that income?
Full disclosure: I didn’t have enough lead time to get a reliable scenario run by my expert on the subject, David Shafer. After many years of reading those spreadsheets, I’m gonna make an educated guess at the outcome. However, I will definitely put the actual income straight from Dave’s computer to mine in the comments section when I get it from him.
I strongly suspect the income from Beck’s EIUL after a couple decades of $1,000/mo. premium indexed to inflation will be approximately $70-100,000 a year, tax free ’til their likely around 90 years old or so. We’ll use the lower number to be safe, $70,000.
Bottom Line Retirement Income
Bottom line retirement income is:
- $70,000 yearly EIUL income, all of which is tax free by tax code definition.
- $100-140,000 a year from income property, depending upon what options they choose along the way.
- $90-170,000 a year in personally held note income, again completely dependent upon whether they opted to refi properties just before retiring or not.
- $90-140,000 a year from their Roth retirement accounts, all of which derive from notes.
So, tax free income after 20 years would be in the range of $160-210,000 annually. We’ll use the lowest number.
Taxable income, even if only partially so, will be approximately $190-310,000 in combined real estate and note cash flow.
The total of all income at retirement would be in the range of $350-520,000 a year.
Note: If they do refi after the last round just before retirement, the income from their real estate portfolio would fall to as a result of the newly acquired debt service. They wouldn’t do it if it wasn’t a no-brainer, Captain Obvious decision at the time.
If we take the lowest figures for everything, their retirement cash flow would be $350,000, $160,000 of which would be tax free.
Or, put another less generous way, they could afford to gift their stock investor neighbor $100,000 a year out of the goodness of their hearts and still have more after tax income then their neighbor would be grossing, including the $100,000 yearly gift. 🙂
Warren Buffett’s point is that over the very long haul, volatility isn’t equal to risk, and that his experience shows it in spades. The same is true with real estate, notes, and various other vehicles. The duplex selling today at $300-600,000 depending on the market, sold for significantly less than $50,000 in 1975. Yet we all know the horror stories generated by the random but inevitable downturns in our economy as it relates to real estate — which begs the question, what’s the difference between the average investor and the highly successful investor?
Again, the answer appears to be tellingly simple. The successful investor didn’t conclude they were as knowledgable as an experienced professional. Put in the vernacular, they intuitively avoided coming to a succession of gunfights with rubber knives. The volatility of various markets isn’t where the risk resides. In fact the risk is literally magnified by the lack of knowledge, experience and expertise of the average investor. In the end, volatility has very little to do with it.
Investors: Weigh in! What are your thoughts on my assessment?
Leave your comments below!