Why the Buy & Hold Forever Strategy May NOT Be Best for Retirement

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As we continue talkin’ about what many have learned as more or less the “commandments” of real estate investing for retirement, this one has caused more than its fair share of regret. Though its premise looks great on paper, more often than not, its execution fails to deliver. What’s worse is that since the results it delivers come at retirement, dodging most of the damage is easier said than done.

Let’s take a look.

Let’s first examine what results the investor expects from this approach.

  • The generation of impressive retirement cash flow.
  • The growth of an exceptionally large net worth due to random cycles of value increases.
  • The ability to refi once or even two or three times over the years for the purpose of increasing the portfolio.

I’ve heard proponents detail many more benefits, both real and hoped for, but those are the big three.

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Generating Impressive Retirement Cash Flow

Having worked exclusively in San Diego’s investment market from late 1976 through mid-2003, I found countless enthusiasts employing this investment strategy. They often talked about it as if had been found on the third tablet Moses dropped on the way down the mountain. 🙂 The last chapter of that book falls sorely short of what could’ve very easily been a retirement cash flow and net worth 50-200% larger. I’ve seen it firsthand the last 40 years.

Here’s the thing about real life — it’s, you know, real and stuff.

Let’s take a 30-year-old married couple who starts investing in real estate for retirement. They plan to retire at 65 with 15 free ‘n clear rental homes. We’re gonna have ’em buy these homes in average areas, as most investors base most of their decisions on price. They compromise on location, quality of construction, and age at purchase (another post altogether). They began in 1980 with a small home inherited from his grandfather and retired last year as planned. How’d they end up? Is their retirement income impressive? What’s their portfolio like on a day-to-day basis?

Remember, their strategy is to buy, hold forever, and retire with 15 debt-free homes. They’ll all be in San Diego, as they’re never leaving. (Who would, right?)

The homes have an average monthly rent of about $2,500. Let’s use the 50% rule, which I abhor, but for comparison purposes it’ll serve us well here. That’s $18,750 a month in retirement income, certainly nothing to scoff at.

retirement_not_secure

But (There Seems to Always Be a “But”…)

In retirement the average age of their 15 rentals is around 50 with many over 60-80 years old. This doesn’t bode well for little things like, say, operating expenses. But that’s merely the tip of the iceberg.

Then there’s all the functional obsolescence built into their rentals. Floor plans reminiscent of Grandma’s house. Wall heaters in some units. Small living rooms and bedrooms.

Related: Why Your “Realistic” Retirement Goals May End Up Woefully Inadequate

The homes bought from 1976 through 1995 are either totally without any remaining tax shelter (depreciation) at retirement or with precious few years left. Even then, the sparse annual depreciation left on the most recently acquired rentals won’t shelter much more than a third of that income — and then only for a few short years. Beginning around the fifth to the seventh year of retirement, every dime of cash from from their 15 rentals will be naked to the tax man every year.

Since they bought based upon price mostly, nearly always compromising location quality, they’re now in many neighborhoods once populated by hard working blue collar families, but now attracting, um, less desirable tenants. I can name several San Diego County locations fitting this bill. This happens all over the country. Can’t tell ya how many investors call me with portfolios in neighborhoods in which they bought due to low price who now regret the choice.

What if They Did This Instead?

In a parallel universe, another investor couple began on the same day with the same agenda — retirement income. However, they took advantage of upward market moves to improve their portfolio. They took the first home, inherited free ‘n clear, and worth around $90,000, and held it. The after tax cash flow allowed them to bank around $20,000 by the time 1984 rolled around. Between historically high interest rates and the devastating 1981 recession, that choice was easy. They then decided it was time to trade up and ended up with a fourplex, closing in the first quarter of ’84.

What they didn’t realize was that the next five years were gonna put real estate values through the roof. In late spring of 1986, they traded up again. Their net equity was able to get them three fourplexes. Prices didn’t stop rampin’ up at all.

Over a few months in 1989, they traded up again. This time, they ended up with seven four-plexes and a 2 on 1 (2 homes on 1 lot). This was a pattern back then for many. In the ’80s, I had several clients who literally traded up three times in a little over six years. Such was the power of market appreciation back then. At this point, it’s almost 1990, 15 years before the scheduled retirement.

Taking the cash flow from all the properties each month, plus the monthly savings they’d normally used to accumulate investment capital, they put the BawldGuy Domino Strategy into play. Beginning with the smallest loan, the 2 on 1, they began eliminating loans, one by one. Once that one was done, they went after the lowest balance fourplex loan. For the most part, each loan was paid off in roughly equal time — or more likely more quickly than the last one. This process finished off the last remaining loan in the spring of 2015, just in time to retire in August.

retirement_income_net_worth

Their Retirement Income From Income Property

Gross scheduled rents add up to $61,000 a month. Invoking the 50% rule brings that to a net operating income of $30,500 monthly.

$30,500 – $18,750 = $11,750

So that’s $11,750 a month more than the first couple who simply bought and held. Our second couple generated around 63% more income by doing a few simple tax deferred exchanges along the way. Nothing fancy, just took advantage when opportunities presented themselves. For the record, I purposefully played the second couple’s scenario very conservatively. Bottom line is they will get around $140,000 a year more in retirement income, before taxes.

The Takeaway

Both couples will share one negative aspect of their success: little if any tax shelter at retirement and older properties with all the downsides that comes with them. I haven’t used this approach for quite some time, as there are other strategies available to the investor that can and will yield far better results than even my second couple experienced. I’ll go much farther. This approach is antiquated, even the second couple’s approach.

Related: Don’t Count on Social Security: Why It’s Crucial to Take Control of Your Retirement NOW

Don’t do it. Yeah, my way totally eclipsed the “accepted” wisdom of buy, keep, never sell, pay off, retire. What I really wanted the reader to see is that just buying a bunch of houses over the years, then payin’ ’em off AIN’T the best way to go, not even close. In fact, it’s like buying a car with a carburetor instead of fuel injection. Unless you’re collecting old cars, it makes no sense whatsoever. In other words, my old car slaughtered their old car. 🙂

Let’s Compare Net Worth in Retirement

Our couple with the 15 homes will have roughly $7,500,00 in net worth, which is certainly impressive. Our second couple has roughly the same, even with seven fewer properties, around $7,000,000 for the fourplexes, and $500,000 or so for the 2 on 1. Yet look at the gaping difference between portfolio NOI at retirement!

Furthermore, if the second couple came to me now, they’d easily end up with well over $50,000 a month in retirement income at the very least. They’d add notes and be doing fun things with there Roth accounts and the like. Here’s some food for positive thought. It’s been my experience, say, over half the time that mosts folks with whom I talk are far better off than they believe. They can generate far more retirement income than they projected. Best of all? Over half the time, they’re able to retire 5-15 years earlier than they believed. And the process to get there isn’t rocket science, which I suspect is the best news. 🙂

Have a plan. Execute it on purpose. Be flexible. Do the happy dance.

Investors: What do YOU think? What’s your retirement strategy of choice?

Leave your comments below!

About Author

Jeff Brown

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

104 Comments

  1. I just saw the opportunity in 2009, I was already retired. When the homes in my neighborhood, were going into foreclosure at half the price, payed a few years earlier, it was hard to resist.
    I am paying more taxes now, than ever in my life as a full time RN. I have had to hire a Prop Management Co. who can speak the foreign language of my tenants,. That takes a big bite out of the profit.
    My partner says SELL.
    I do not know an agent experienced in 1031. Can I use First american Title to escort me through it?
    I am thinking of gifting my rentals to my adult children.
    Thanks for listening, I painted myself into this corner. ..all by myself.

    • Jeff Brown

      Hey Lin — Don’t do anything now. Contact me. You’re more likely than not in better position than you might realize. Do NOT let a title company ‘guide’ you through a 1031, as the very thought just sent shivers through me. 🙂

    • Jeff Brown

      Hey Zachary — Trading up is slang in the industry for exchanging your equity, usually tax deferred, up to more units/buildings. You do sell your existing property, but then you ‘turn it into’ an exchange. It’s NOT for beginners to do themselves. Get some pro advice and help. Good luck!

  2. William Morrison

    Great subject. Having lived on west and east coast I know many on the east coast don’t realize that when you talk San Diego you are talking the equivalent of a state on the east coast in size and changes in neighborhood across San Diego county.
    I have property there but it’s commercial, class A if you will. It’s hard to get a decent return on real estate rental in a good neighborhood. One metric is schools that are 5, close to 7 or 8 or better on a 1 to 10 scale. And then a looking for a 1% return on asset value. I think you’re closer to 0.5 or 0.6. The same thing is true in Montgomery County Maryland.
    A 1.0% return in a nice neighborhood is easier in say Charlotte, NC or maybe Fresno, CA.
    It’s still hard to go get that return when you have to now work in an area you are not familiar with.

    The average age of you portfolio is important as you said as well. I just bought a new house as a rental to raise my average age 20 or 26 years from now.

    It not as easy to leverage your rentals when your debt to income ratio changes in retirement. Mortgage Brokers don’t adjust the numbers for tax free income well. $700 tax free could easily be $1,000 or $1,100 but its’ hard to get them to adjust. That could be 30 or 40% of your income you’re not getting credit for when trying to do a 1031 exchange after retirement.

    You also have to have a plan for how your properties will be handled as you loose that sharp mental ability you think you have . A property manager wont fix that. Think how many time you have to interact with them.

    Another thing how old is your property manager? I’m assuming the person makes the firm. It’s like your doctor and dentist, do you want them to be retiring when you do?

    You should have a plan that works into your 90’s or more.

  3. Thanks for the post, Jeff.

    Does part of the success of the second scenario (where the buyers traded up) depend on the fact that properties at that time grew in value so much over a relatively short period of time?

    I’m 49 and I’m trying to buy my first rental property in the Los Angeles area — I’m considering Burbank, Pasadena, Montrose, Glendale, La Crescenta. My husband insists we invest locally. I’m trying to buy in decent neighborhoods and everything is so expensive. It seems hard to imagine these properties increasing so much in value like they did in the 80s and 90s.

    Do you have any brief suggestions (I know you’re busy!) for me? I have about $200,000 – $300,000 to invest and have been approved by the bank for a $700,000 loan at around 4,8% (not yet fixed since I don’t have a property at the moment).

    Also, do you recommend setting up a LLC or just having umbrella insurance?

    Also, do you think a lower interest rate is possible?

    Thanks —

    • Jeff Brown

      Hey Rachel — I’ll answer your questions in order.

      1. Does part of the success of the second scenario (where the buyers traded up) depend on the fact that properties at that time grew in value so much over a relatively short period of time?

      BOTH couples bought in the same market during the same period of time, so they were both subject to whatever the market did from 1980-2015. They both benefitted from the two run ups in values in the 80s and early 2000s.

      2. Do you have any brief suggestions (I know you’re busy!) for me? I have about $200,000 – $300,000 to invest and have been approved by the bank for a $700,000 loan at around 4,8% (not yet fixed since I don’t have a property at the moment).

      I’m officially beggin’ you to email me, Rachel. 🙂 You and your husband can absolutely kill it in a positive way, just not anywhere near where you live. You’re in FAR better shape starting out than you might believe. When you email me, please say you’re ‘Rachel from BP’.

    • Jean-Thierry Aleman

      Rachel, I won’t pretend to have any answers for you as I’m a new investor. (we just bought our first rental property 2 months ago) I only want to respond to your question about LLC vs Umbrella insurance. Don’t let these things prevent you from buying. There is no need to do anything like that first although an LLC will be great to have. I highly highly reccomend listening to bigger pockets podcast #109. You wil find it very interesting based on your question. The guest speaker is an asset protection lawyer. He addresses LLC’s and how to best protectect and insulate yourself from lawsuits. Again… podcast #109 is awesome!!!

      • William Morrison

        JEAN-THIERRY when asking the LLC question or collecting your answers be sure to separate Single Member LLC answers from multi-member LLC.

        There is also the California answer based on annual costs vs some other states for LLCs.

        Also ask your lender if you plan to leverage your real estate if they allow it and are the rates different.
        If you use some advise about transferring the rental after obtaining the loan to an LLC that you may receive, ask the what the lender would do with due on sale clause if they are include in a law suit.

        • Jean-Thierry Aleman

          Great points William,
          Again as a newbie, my knowledge and experience is limited, but always ready to grow. My understanding is that due on sale clause is rarely if ever acted upon as long as the bank still regards it as a performing investment being paid on time.

          Would love to hear of your experiences with this as I will likely transfer my property from my name to an LLC in the coming year. As I am already looking for my next property, I am hoping to better protect myself.

          –JT Aleman

        • William Morrison

          JT, I suggested you ask the question of your lender based on a law suit, not prompt payment. I know the going idea is the lender will not call the loan based on due on sale clause if payments are made on time. And this is probably true.

          I happened sit down with a lawyer who is in the business and only takes non frivolous cases. I was working a different issue with him but he allowed me to ask some questions about LLCs and insurance.
          During his due diligence or investigative time frame he likes to know how much the landlord owes, how much insurance he has, does he have any loans or lines of credit setup only to hide assets, etc. Because hiding assets (vs protecting assets) via a shell game may or may not be legal based on how its done, it’s one of the areas he attacks. He includes the lender in the suit. Two things happen here. The lender is included for knowingly not enforcing the due on sale clause and becomes part of the suit which would at this point include the LLC, lender and the individual owner. Or the lender was not notified with the assumption as you stated or implied no big deal if the payments are made on time. At this point the lender knows (notified by the lawyer) and immediately calls the loan to avoid being a party to the suit and may add a suit for not being notified as required by the loan docs.

          You don’t see much discussion about actual law suits here. And I hope that’s because there aren’t many.

          By the way I have a combination of insurance and blanket insurance on rentals owned in my name. My lenders told me they would enforce it if they know. They don’t do any LLC loans. I have some LLC involvement but the leverage is at commercial loan rates (interest) and terms (years). If I could find a lender that would give me the going 30 year rate with 20 or 30% down inside an LLC I’d use it. I also have a straight partnership in California but that was based on California’s tax till they bleed idea if it was an LLC, Grin

    • Jeff Brown

      Hey Jerry — A crucial question for sure, though it has a kinda sorta false premise.

      We must look at how they chose locations. They were price driven for the most part, so they sacrificed location quality to that end. Most of the locations still aren’t ‘bad’. However, many in so-called average areas are now a cut below that grade. Blue chip quality locations rarely go downhill over time. Average locations tend to age and go down in perceived quality in the eyes of buyers. Sometimes average areas actually improve due to surrounding development, though public perception usually goes down when viewing what used to be average 30 years before.

      I’m not sure why you’d think areas would naturally get better over time. If you were referring to increasing values, ALL of SD county went up tremendously over the time period used in the post. Demand for those areas, and therefore current perceive property values and rents also dropped.

  4. I was under the impression that you’re supposed to gut every unit every 20 years. I’ve never owned a property younger than 60, and my eldest was 120. SOP for me was to pay cash, replace pretty much everything, then work to get rent. I chose bad neighborhoods and worse contractors, though. I’m ready to talk, Jeff, if you’re willing to work with a relatively broke guy such as myself.

  5. Daniel Mills

    Awesome post! I am just trying to figure out how to apply it to my situation. I live in japan, so even if I do a tax deferred exchange with my properties in the US, I will have to pay capital gains here in Japan. I am also wondering about the attractiveness of multi-family homes in the future. I have heard that more people are renting because they want the flexibility to move for work, but they are looking for single family rentals because they don’t want to “take a step back”. What are your thoughts on that?

  6. Great post you mentioned “other strategies available to the investor that can and will yield far better results than even my second couple experienced” could you point me in the right direction for further reading? Thanks

    • Jeff Brown

      I’ve written roughly 300-350,000 words here on the BP main blog, Richard. Simply go to the search box, type in my name, then click on Biggerpockets Blog on the left. I think I’m over 250 posts at this point. There are well over 100 videos/podcasts on my own website, not to mention another gazillion written words. 🙂

      Better yet? Email me and I’ll give you a blow by blow description of what I was talking about. 🙂

      • Lora H.

        Mr. Brown,
        I had the same question as Richard! Would you mind killing two birds and include me in the same email convo?
        Richard’s Post:
        Great post you mentioned “other strategies available to the investor that can and will yield far better results than even my second couple experienced” could you point me in the right direction for further reading? Thanks

        Greatly appreciated!
        lora

  7. Good article, Jeff. I guess the premise of your article is true if you stick to the narrowly defined parameters in your piece: buying homes in average areas, compromise on quality of construction and age at purchase, buy and hold forever. These absolutes yield tremendous support to your argument. However, a more general question is, can the buy and hold strategy of real estate investing satisfy your retirement needs? The answer is unequivocally yes.

    My career kept me on the road five days a week over a 20-year period, so it was challenging to build any type of real estate portfolio. I did, however, start buying real estate in my early 30s in a well-known tourist destination off the coast of Florida – basically one road in, one road out. I started in 1993 with the purchase of two condominiums on the beach. This was back in the day when condo’s actually cash flowed. This town, like many others, experienced a volatile ride in terms of real estate market valuations. I traded up several times over this period and eventually sold everything in 2007 (unrealistic and artificially inflated valuations). In 2013 I started buying REO’s in high-end markets with a buy and hold strategy. Long story short (I know, too late), I’m now in my 50s living solely on passive income generated from these properties. The rental market is phenomenal, my tenants are stable, and the cash flow has funded my savings and retirement accounts. Could I have done better? Maybe, but I’m satisfied with the results.

    I’m not on trains, planes, buses and automobiles five days a week. I’m not eating crappy food through a window every day. My passive income takes care of my living expenses and future retirement needs, so all in all, I’m happy with the results. That is not to say that I won’t face challenges moving forward (e.g., taxes, etc.), but I’m happy with the outcome. Buy and hold investing can work if done correctly.

    • Jeff Brown

      First of all, Randy, let me applaud you, good job. Allow me some observations on your thinking, and your method, as you pose excellent questions.

      “Premise of the article and parameters used” — Both couples shared two basic parameters. They were investing in the San Diego market, and did so during the same exact time period.

      “Can buy ‘n hold forever satisfy your retirement needs?” Heck, even in the post the ‘loser’ couple ended up with over $18,000 in monthly retirement income. So yeah, it can ‘satisfy’ retirement needs for most. However, I can’t resist the temptation to quote ‘Papa’ Rockefeller, who when asked by a financial reporter how much was enough money/income for the average person, replied, “Just a little bit more.” My question is, “What would you do with an additional $11,000 MONTHLY income in retirement?

      When buying in your local market, cuz, you know, you absolutely MUST be able to drive by your entire real estate investment portfolio, you’re hostage to what’s available — and what’s not available. In San Diego old is the norm. Poor construction? Not really, just dated construction, massive functional obsolescence, and the deadly combo of decreasing share of the quality tenant pie while experiencing increasing operating expenses. I turned my life upside down for quite some time in the spring of 2003 when I left San Diego’s income property market forever. Why? It’s because I can take clients outa state for a duplex costing 65-75% of a SD duplex, and it’s also 30-75 years younger, has more beds/baths, and each one has an attached 2-car garage big enough to house 2 Hummers. Furthermore, the quality of location is superior. The GSI is the same as SD’s duplex. Wanna start investing in SD now? A 30 year old duplex/4-plex is considered merely ‘broken in’.

      You’ve done well, Randy. Could you have done better? Big time. Given you’re living he life you clearly enjoy, you’ve done better than 90% of those in your generation by a mile.

      • Jeff, what areas out of state (Calif.) do you recommend investing in? And do you have any advice on how to find a company to help with this? I live in Los Angeles and my husband wants to invest locally but I despair when I look at the property prices and rents. Thank you.

        • Jeff Brown

          I’ve told investors to stay away from anywhere in CA for the last 13 years. In fact, though I’ll list and sell CA properties, I have refused to sell CA properties to anyone, no exceptions since 2003. I couldn’t look ’em in the face while doing it. There’s nothing magical about being able to drive by your property, period. In fact, let me be a bit harsh. Amateur real estate investors for the most part, don’t know many of the pertinent questions to ask, much less the answers. They need truly professional help, or as often as not they end up causing real financial damage, damage that typically doesn’t come home to roost ’til they’re ready to retire. That is not the happy ending for which they planned.

      • James Bitakis

        Jeff, it sounds like you are minimizing the theory of “always buy locally”. Are you saying that if you can buy better (younger properties), in better areas; but they may not be local, for the same or cheaper than your local area; that is a better choice, correct? I gathered that from your, “When buying in your local market, cuz, you know, you absolutely MUST be able to drive by your entire real estate investment portfolio” comments.

        • Jeff Brown

          Hey James — You bet I minimize local investing. Most local markets are simply not worth the trouble. I’ve always wondered why so many think it’s better to have an inferior local RE investment portfolio vs a vastly superior outa state portfolio. It’s as if their ability to drive by ’em magically turns them into gems somehow. I abandoned my own market long ago due to it’s increasing relative inferiority.

  8. Curt Smith

    Thanks Randy for your success story!!

    Because my wife is a retired teacher she instinctively knew to buy in top high school districts, today I would say buy in great schools 6 or better, over fix with laminants, advertise the school names and great school score in the ad title, filter for young children dual income and poof: huge appreciation and zero turn over (is what we are seeing).

    Jeff I believe served the community well with his two scenarios, so thanks. And after the fact I believe the topic title even if misleading did hook me in to read. 🙂 I would have chosen a different title but it did work.

    • William Morrison

      Curt I have used that idea as well and like it. When looking at the three High School levels, i think the HS is most important. But I do like the other two to be 4 or 5 or better. If the neighborhood is mostly beginning families it may be more important.

      But I’ve also found if the area is expanding the newer houses will still cause the good older neighborhoods to decline but not necessarily become a bad neighborhood. We are talking buy and hold for retirement here. So 20 or 30 years is in the picture added to the age of the purchase. If your buying a 10 or 20 year old house then, it will be a 50 or so year old neighborhood later in retirement.

      Some areas the school are know to keep the rating because of the district or whatever the reason. Others not so much over long term.

  9. David Roberts

    Hi Jeff,

    I’d like to email you also and discuss the 1031 further and what I might be able to do with it. Would you be willing to discuss with me further? It may be easier to chat on the phone if you are willing. Thanks very much for writing this article.

    I’d also like to discuss further your better strategy for getting ahead!

  10. Adrian Stamer

    I know this is a real estate forum so I don’t like pointing this out, but with your first example due to huge appreciation in the San Diego area you would most likely get a better return if they just sold them and put the money in the stock market.
    Real estate isn’t a passive business so don’t treat it that way.

    • William Morrison

      Adrian, what Heresy. Many have the religious type views on this site that you can’t do both. The market is all losses and real estate is all gains.

      By the way this is not a shot at this author. Just some funny threads with supposed thought out pros and cons have appeared here.

    • Jeff Brown

      Hey Adrian — I’ve been taking clients to states with little if any appreciation as the norm for the last 13 years. Appreciation is merely a sweet bonus, not required. Still, your proposal is interesting to say the least. Let’s say they began in 1970 instead of 1980, and retired in 2005 instead of 2015. Furthermore, we’ll say they followed your advice, sold everything off and invested it into the stock market. 2008 rolls around. How’d that work out for ’em?

      • William Morrison

        Jeff you and I, I think would agree on a lot in the real estate would. But your stock market idea not so much. I do have the real numbers for the S&P500 in a retirement fund with dividends.
        Remember its not leveraged in a retirement account and you have a max of 50% leverage in a standard brokerage account which most do not utilize. Not the 70, 80 or 90% you can find in real estate.
        2005 up 5%
        2006 up 15.80%
        2007 up 5.5%
        2008 down 37% (these are year end numbers no highs and lows during the year)
        2009 up 26.7%
        2010 up 15.1%
        2011 up 2.1%
        2011 up 16.1%
        2013 up 32.5%
        2014 up 13.78%
        Go back to the 1890’s, the equivalent S&P500 basket has never been down more than 50% in a year and averages a 10 to 12% return. The numbers above include reinvested dividends. They come from an actual S&P500 retirement fund run by Blackrock. So the draw in % or fixed amount in retirement will determine where you are.
        Leveraged real estate without a reserve can be the same risk or more.
        What is probably more important is why more are not doing both.

        • Jeff Brown

          Hey William — Good stuff, thanks. First, and clearly most importantly, are you advising 50% leverage in the stock market to retirees?

          Secondly, investing into ANYTHING without a healthy cash reserve account is, to be gracious, foolish.

          Given your numbers, (thanks so much) it appears they’re relying on selling off periodically for living and recreational expenses, true? Dividends usually average 1-3% with anomalies both ways. Selling the real estate as you suggest would not only cost the investors roughly $500k in selling costs, but another $1 million, very possibly more in cap gains taxes.

          On the other hand, just spitballing here, refinancing at say a safe 60% of value would net them about $450k tax free. The portfolio would still be cash flowing, though at a far lower amount. The $450k could then be invested into discounted notes which would, over time, completely eclipse anything the stock market would, without the risk. If a stock tanks you have two choices, to sell for a loss or hold on. If a note goes bad the retiree owns real estate debt free, a far better backup plan than plummeting stock values offers. A retiree cares about income far more than net worth, as they don’t spend net worth when at the grocery store.

          Over time, as the discounted notes pay off they pay only cap gains tax rates, rinse and repeat, and generate a higher note payment than the one before most of the time. In other words, random raises in retirement. I’ll freely cop to being massively biased against the stock market. However, I can empirically show how real estate and notes are safer, at least from my experience. Would love to hear your thoughts, and thanks again.

        • Jeff Brown

          Um, it’s too late in the day for math. 🙂 The refinance would net them $4.5 MILLION in tax free cash while allowing them to keep the real estate, which would still be generating cash flow. Man, I need more coffee.

      • Adrian Stamer

        Was simply referring to their returns with an outright owned portfolio. Due to the huge appreciation better just to liquidate

        Or just cash out refi to avoid taxes… I’m just saying sure if you have a RE portfolio and do nothing with it of course there will be problems over time

      • William Morrison

        Hey Jeff I’m convinced you and I would enjoy a cup of coffee Grin.
        Your response mixed a little of my post with a little of another.
        I was only saying the market did not do the damage some suggest or assume everyone thinks was fact.
        The sell and move left and right, ie timing the real estate market or the stock market is tough thing although there are some historical indicators in both that say “all in” has never failed but those don’t come around often.

        Just a note on leverage in the stock market, absolutely don’t recommend leveraging at 50% when investing in stocks. Although many don’t know what a conservative reserve for real estate rentals might be if made up of a mix of Dividend Aristocrats, a few REITS and some Low Book Value stocks. It can work well for your cash reserve that you’ve put aside for your roof and HVAC. Those dividends have been averaging closer to 4 to 6% or more the last five or more years and have a different history in down markets from the primary indexes. And if you can build a decent cash reserve you can borrow from yourself at a relatively low interest rate when you do need to replace that roof. And you just write yourself a check with many accounts.

        All said there is a place for both. I wasn’t the one suggesting selling the real estate and moving it to the market. I was in both through the 2008/2009 down turn. The market more than doubled my pre-2008 numbers with dividends and I’ve been buying real estate with it. Some real estate has come back some has not. There are still a lot of people under water. The good news, the tenants continue to pay down my debt and cover the expenses. And no I did not buy real estate in the couple years leading up to 2008. The numbers just didn’t work. As you know it’s hard to get rents that are 125% of known monthly expenses to cover vacancies and major repairs without larger and larger down payments as the market peaks.

        Dividend stock are paying much higher than 1 to 3% and don’t have the telephone calls from the property manager. Grin. The Dividend Aristocrats are S&P 500 constituents that have increased their dividend payouts for 20 consecutive years. That said, I am expecting more from my real estate and still play both sides.

        And your basic idea that buy and hold blindly may not be the best idea is right on.

        • Jeff Brown

          Yep, I’d love to chat with you sometime. You make some solid points, and do it well. Much appreciated. I think our conversation would yield dividends. (sorry)

    • Patty C.

      Yikes! A financial planner I saw encouraged cash out refi’s on my properties and put the money in the stock market…I ran for the hills. We obviously had a major difference of opinion.

      One of the luckiest things I did was borrow from my retirement account in 1999 to purchase a property. The tech bubble burst and the property appreciated nicely :-).

      Comparing the performance of my defined contribution plans and real estate, real estate has done better by far. (But that’s just me.)

  11. I am definitely looking at a 1031 exchange to a eventual live-in retirement opportunity. As I have 8 properties, plus my own, with little mortgage debt. (I have been buying my own notes from the bank…)

    I have a great cash flow with 25 renters, but need a good transition plan as I get more inclined to travel and do less maintenance.

  12. Ian Ippolito

    A very thought-provoking article, and I do agree with some of it. However, it makes a huge assumption that I completely disagree with. It’s great that the hypothetical 2nd couple (that started investing back in 1980) were able to take advantage of historically unusual high price appreciation on multi family and did so well. However, the majority of readers on BiggerPockets are starting their investing in 2016 in a completely different era and economic future. The odds of them enjoying the same velocity of price appreciation is extremely low. Just this week, reports of multi family peaking in several national markets, as vacancies rise and overbuilding continues.. Let alone enjoying the same luck for another 30 to 40 years until retirement.

    • Jeff Brown

      Hey Ian — Fair enough, but there’s a false premise in your thinking. BOTH couples bought in the same market, and BOTH started in 1980 and retired in the same year. So both couples has the same exact opportunity, the same options menu so to speak.

      The fact newbies would be starting now is a benefit compared to beginning in 1980 or so. Investor fixed rate interest with 30 year amortizations are, and have been less than 5% for quite some time now. I was in the business for 32 years before I saw an owner occupied rate (much less investor rate) less than 7%! Here’s the point: All things being equal, the second couple will always slaughter the first couple given the first couple’s vastly inferior strategy.

      Appreciation is a blessing, but believe me it’s not required to make things work. For Heaven’s sake I’ve been in TX now for going on 9 years, and they’ve been conditioned to believe a price increase of 5% is reason for dancing in the streets. Yet, using far more productive strategies, often in a synergistic manner, consistently results in solid success. It’s my policy my team members are banned from imputing ANY appreciation into any spreadsheet of any kind. If appreciation is required, something’s wrong with the investor’s approach.

      I agree wholeheartedly, Ian, appreciation shouldn’t matter. Those beginning now should always keep that in mind.

  13. Bruce Rexrode

    Hi Jeff! i appreciate all the time you take to answer fellow Bigger Pocket people. forgive me for playing on that generosity. I’m trying to get the straight story on capital gains taxes, both federal and Rhode Island (RI throws an extra 6% tax on you). We have been expecting to lease our RI house (it’s a 2 on 1) as we are moving to NC in July. However, I’ve gotten mixed information on whether you lose the $500,000 exclusion if I don’t sell before I move out of state, or if I have a 2-3 year window. Need to understand all the pros and cons asap. I could easily sell this property as it is in a great location and upgraded recently. If so I would have another approx. $400k to use in investing in the Durham/Chapel Hill area. Thots!

    • Jeff Brown

      There are far too many unknown factors in your specific case for me to even attempt an answer, Bruce. But not to worry, as even a semi-competent accountant should be able to answer your questions in a few minutes. If you’d like to chat, contact me and we’ll make it happen. Frankly, I don’t think you have a problem.

  14. Matt Thompson

    This strategy won’t work in areas like the midwest where appreciation is low to non-existent. Real estate transaction costs would wipe out any gains.

    In some neighborhoods this strategy may still work, but from a national perspective, historically houses don’t appreciate much more than inflation over a long period of time.

  15. Tom Quist

    Thank you for all of your posts Jeff. Your insights and thoughts have really opened the eyes of I hope many who don’t have a purposeful plan to provide them and their family income at a time when they need it the most. Can you share with me why you abhor the 50% rule? That caught my eye when reading this and was hoping you could provide a further explanation. Thank you!

    • Jeff Brown

      Hey Tom — Good question. First, I’ll admit that for the most part I’ve learned the hard way that formulas often turn into traps. That is, the timeline for formulas is they work well ’til the day they don’t. 🙂

      Empirically though, think about the areas in likely 90% of the nation’s real estate markets where that’s even possible. My standard for location quality is likely in the distinct minority. I won’t put clients into locations in which I wouldn’t put my 85 year old mom to live alone. But let’s relax that standard for this discussion. Think of a casual lady friend who asks you whether or not she should rent a place found in a ‘2%’ neighborhood. Would you look her in the eye and tell her, “You bet. You’ll be safe, and the rents are lower than most other places.”

      I talk with 8-16 people a week, from all over the country, usually for 1-2 hours about their situation. One of the scenarios I put forth if they already own or want to own in those type areas is the following. It’s now 10-30 years down the road and you’re retiring. You want your retirement income to be reliant on income property most investors wouldn’t buy in a million years? Ask yourself why they wouldn’t buy it. Ask yourself why the cap rate was so phenomenally high. Why did it successfully fall into the 2% formula? Why was the price so low, especially when compared to the income?

      The answer to ALL those questions is that no semi-experienced investor would pay more, as there’s simply too much risk over time. You’ll also learn that most pro management firms avoid those areas, refusing to manage them at any price. They know what I’m talking about, Tom.

      Full disclosure: I’m really biased on the subject of location quality. And the congregation said, Duh!.

      • Tom Quist

        Thank you very much Jeff. I wholeheartedly agree with your thoughts and viewpoints on location and quality. Seems like common sense to me and the smart way to approach long term real estate investing as opposed to getting great cash flow and high cap rates with undesirable properties. Always appreciate your posts and look forward to the next one!

  16. Herb Mitchell

    I enjoyed your post. My plan is to use my Self Directed IRA account to purchase rentals. The bad news is I can not take advantage of the tax depreciation, the better news is that I will only pay taxes on the profits that I withdraw at my current tax rate. I also have budgeted at least 20% of the rent rooms to be preserved for vacancies and expenses. When I purchase properties, I always make any capital changes in the property before renting it, roofs, HVACs, etc. I avoid war zones and try to stay in lower blue collar areas. Any thoughts or suggestions?

    • Jeff Brown

      Hey Herb — As a rule I’m strongly against buying rentals inside a retirement plan. There are too many other strategies that will produce more cash flow, be more secure, and grow more predictably inside that entity. If you’d like to toss some ideas around with me I’d be more than happy to spend some time talking with you.

  17. Dan White

    Great thoughtful article Jeff, the retirement issues keep me thinking at night. I am about 5 years from semi-retirement; most of my portfolio was built with 1031 exchanges and leveraging early properties for new one. Having built my inventory to a comfortable size, 56 rentals, ,mostly SF with a few duplexes, I built a secondary business by lending hard money. The business is very profitable, however several realities have set in…
    My inventory is getting old, meaning difficult maintenance issues keep cropping up, I still have over 100k a year in depreciation but this is declining as I am no longer building the business, new inventory over the years keep my taxes down as I had early rehab expenses and a new depreciation schedule, I still carry debt about 40% of value, this is great as my average rate is around 4%, in about 10 years the oldest loans will fully amortize with more falling off thereafter as well as depreciation.
    What I have concluded:
    1) This will be a legacy business, tax basis of the properties is so low that taxes and transaction costs will destroy the wealth. by leaving this to my heirs they will get a step up in basis and earn a very handsome and tax deferred income, same for future generations. DO NOT GIFT THE PROPERTIES, your heir lose the step up in basis, this is huge. If your heirs are unlikely to operate the properties they can sell tax free upon inheritance
    2) I am teaching my kids the value of inherited wealth and their responsibility to manage it properly. At 13 & 15 they now own 2 rental properties of their own… held in my name until they are 18….
    3) Biggest obstacle is management as I get older. With ever increasing rents (my market increased 9% last year)
    I will have the income in future years to hire management and still have the lifestyle I want to enjoy, even though I have a low opinion of hired management, I am grooming my own team to do this.
    4) Hopefully one of my kids will be interested in the opportunity, take over the management, continue to work with me to add units this will moderate my taxes and leave a bigger legacy business.
    5) The reality is a mature real estate business will be highly taxed many years after you stop growing it, But then again we are talking about an income we could only dream about when we started.

      • Dan White

        When inheriting a property your heirs will establish a new basis based on the value of the property at the date of death, your spouse is also entitled to a step up also. Each time the property is passed on the basis of the property is adjusted to the value on the date of death.
        When gifting a property the recipient’s basis is the same as the donor’s, thus limited depreciation and large capital gain if sold.
        For a mature real estate portfolio the only logical exit strategy is inheritance to preserve the wealth you created and want to pass on. There is a lot more to the estate planning puzzle but these are the basics as it relates to real estate.

  18. I liked a lot of this, but kind of disagree with a few major points. First, the author ignores what is happening in most major urban areas like Chicago where I live: Foreclosures and continued hangover from the 2008 housing crisis has rental demand for “bread and butter” houses at an all time high. Thousands of houses have been abandoned and torn down and renters have been forced to double up. Rents in “working class” suburbs are increasing. Population is increasing and new construction is only being built in luxury areas. No one is building middle class housing in most major urban areas. I see rents being stable and increasing for years to come. I am not talking about the gang infested ghetto areas, I am talking about working class/section 8 starter housing in areas that decent people want. The prices are still low ( due to foreclosures) and the rents are strong.

    Guess What: you should plan to replace your roof every 25 years and your furnace every 20 years. Hot water tank 15 years, etc. Your foundation is likely not going anywhere. Your yard is not going anywhere. Your garage is not going anywhere. Plan on repairs and keeping your house nice and you will find the best tenants and the best return. That is no reason not to buy an older property.

    Second, trading up to 4 plexes is not a trade up. They are much more difficult to manage and much more difficult to ultimately sell. I would much rather own 4 decent single family houses than a 4 plex. Single Family Houses rent in a heartbeat and they can be sold to investors, the renter, or Joe the buyer. A 4 plex is more than likely going to be sold to an investor and you have to worry about interest rates, etc. down the road. 4 Plexes and 2 flats attract renters that cannot afford or cannot qualify for a single family house.

    I own properties free and clear in my IRA and I like the idea of 1031 exchanges for my properties with mortgages. I like the author’s premise of buying and holding long term. But I am not buying the story that older working class houses are a bad investment. Unless you have a lot of time or are willing to pay for a management company, only buy 4 plexes if you really know what you are doing.

    • Dan White

      Amen, 4 plexes are not worth the management time, the only multi-units I have are single level duplexes, 80% of my inventory are SFH. My units are in working class areas that renters want to live in and can afford. Keeping up your homes well maintained is the only way to successfully operate a rental business.

    • Gary,

      You hit the nail on the head. I can not agree more. I have been an investor for over 25 years and your points are right on. I would rather hand over SFHs to my heirs then a bunch of 4 plexes. What an albatross to hand off to your heirs, especially if they have no rental property experience.

    • Jeff Brown

      Hey Gary — Thanks for your viewpoint. The point of the post wasn’t to discuss every market in the country, but to compare a couple strategies. Some of your ‘concrete’ statements are, shall we say, not quite accurate in the generic sense.

      “Second, trading up to 4 plexes is not a trade up. They are much more difficult to manage and much more difficult to ultimately sell.”

      The post clearly shows an increase of $141,000/yr in retirement income generated from moving single family homes into 4-plexes. Did I make that up? Is my experience doing it countless times since the mid-1970s happen in my imagination? I’ll bet the average investor would figure out how to manage, or duh, hire pro management and give up a small percentage of that 5-figure monthly income increase.

      The math is the math. I’ve demonstrated the superiority of this approach in several states to the tune of 8 figures in volume. We all have our preferences, but we should all do what works. Maybe your Chicago market is anomalous?

    • Scott Wang

      These were exactly my thoughts while I was reading the article. What’s wrong with an old house? I have a couple houses over 100 years old that are fine. When I buy them I make sure the “bones” are updated (electric, plumbing, roof, HVAC, etc). As long as the foundation is in good shape there’s nothing wrong with an aging house.

      And I also agree about the single-family houses. Easier to rent out (less vacancy and management) and much higher rental prices.

  19. Ed Lee

    I’m having a little bit of trouble with the math. When price appreciation/inflation occurs and your $90,000 homes suddenly becomes worth $200,000 it doesn’t just happen in a vacuum.

    Unless you buy in a lower cost market or just so happen to time a bubble just right I don’t see how someone could sell their appreciated property for $200,000 and buy 3 newer properties with the same funds in the same market.

    I suppose person #2 is using more leverage to buy more property which is great as long as things always go according to plan and we continue to have rapid inflation and price appreciation as was experienced in the past.

    • Jeff Brown

      Great point, Ed. The price appreciation in San Diego, where both couples invested, was crazy in both the mid-late 70s and 80s. That’s the only reason the second couple was able to do what they did. Still, trading a home purchased for 90k for a price of 200k EASILY allows for a trade up to a 4 unit property. I know, cuz I’ve seen me do it dozens of times. 🙂 Make sense?

      • Scott Wang

        I’m still hung up on that issue too. If the single-family house is worth $200,000 how on earth are you going to buy a 4-plex for that same $200,000? Shouldn’t the 4-plex at that time be worth over $600k?

        If the answer is that they use the $200k as a down payment and borrow the rest, why couldn’t the couple in situation #1 just refinance to take out that equity and use it as a down payment to buy more hold-forever houses? They would still be growing their portfolio using the appreciation they gained without having to sell a house that’s producing good cash flow.

        • Jeff Brown

          Hey Scott — I’m wondering where in the post it says the 4 unit properties cost the same as the SFRs? There’s no way they paid the same for a 4-plex as a home.

          As to what #1 could/might do, you’re right about refinancing or a few other choices. Thing is, my experience with dyed in the wool buy/hold folks is that they don’t wanna hear about ‘new fangled’ strategies. That’s one of the central points of the post. The buy ‘n hold/never sell school of thought is almost always intransigent in their thinking. Numbers mean nothing to many of ’em. I will say though, that in the last year or so I’ve begun to observe a mild trend toward at least listening to alternative thinking.

        • Scott Wang

          You just said it in your comment. You wrote “Still, trading a home purchased for 90k for a price of 200k EASILY allows for a trade up to a 4 unit property.”.

          This means the 4plex is being purchased for 200k, or you’re borrowing money to buy the 4plex (which you could have done without selling the single-family house).

          This article has me perplexed because I’m starting my career in rentals and my plan was to buy-and-hold. I’m in central Wisconsin where there’s little-to-no appreciation but if we did hit a point in the market where my properties doubled in value, I would rather refinance and use that money to buy more instead of selling the money-makers I’ve been managing. Am I wrong in this thinking?

        • Jeff Brown

          OK, Scott, I see the problem now. Here’s indeed what I wrote: “Still, trading a home purchased for 90k for a price of 200k EASILY allows for a trade up to a 4 unit property.”.

          I traded a home ORIGINALLY purchased for 90k for a value of 200k. In other words, the net equity was close to 200k after costs of selling, which easily made it possible for them to put a down payment on the much more expensive 4-plex. The 4-plex did cost 200k, that’s what the home sold for. Make sense? I’ll take the hit for this as my syntax could’ve been structured way mo betta. 🙂

  20. Lenore C.

    Hi Jeff,
    Thanks for the article. Very helpful. I am currently in the process of trying develop and investment plan to generate income for retirement. Our timeline is 7 – 10 years, and I am trying to sort out the best approach, whether it be cash flow properties, or other vehicles. If it is possible, I would love to have an opportunity to talk with you, or meet (we live in north San Diego county (Cardiff)). I sent an email through your website also.

  21. Doug Compton

    Jeff:

    I am relatively new to BP (and to REI) but as I browse the site many of your articles seem to pop to the top. This is another article that contains a solid strategy. I am also listening to the latest BPP show 169 with David Greene where he talks about a similar strategy you have him doing with notes instead of the trade up strategy.

    My question for you is this, I am in my early 50’s and getting started in this REI game quite late. I’d like to retire in 10 years (wife is older) so is there an accelerated strategy that I can employ over the next 10 years?

    Thanks, Doug

    • Jeff Brown

      I’d have to know much more about you and your wife, Doug, before I could even begin to answer your question. Suffice to say you can probably speed things up, but how, and by how much we’d have to talk. 10 years can be enough, or way too short, depending on several factors. Go to my site, bawldguy.com, and email me about it. We’ll figure how to sync our schedules and talk. 🙂

  22. Deanna Opgenort

    The trade-ups for couple 2 in this example were done with hind-sight – DURING a fall it’s a lot harder to tell when to move— is 2009 the right time to trade up? or 2010…market still falling, not a soul is writing loans, so hard to sell current properties in order to “trade up” unless I have a good job, but will I HAVE a job in 2 months? or will I have over-extended myself and lose it all (as many people did).

    Face it, if we could go back in time we could all just buy Microsoft & Apple at the beginning & live like the multi-millionaires we’d be, and without dealing with the hassle of real estate.

    • Jeff Brown

      Hey Deanna — I get your point, and it’s well taken. However, the post’s second couple was taken from my closed client files, not hindsight. 🙂 This post had nothin’, nada, zip to do with 20/20 hindsight. I don’t do that.

  23. Henry R.

    @Jeff Brown great post! I had to laugh at myself, I made an offer on a property that was built in 1890 or so. Most of the buildings back in NYS are 100yrs old. I don’t have the cash for new and have been looking for at least a 3 unit for 2 yrs. That cash flows. They are not easy to find in my area. It has been rehabbed and I will do all of the inspections before it’s a done deal. The offer did get accepted so I will find out soon.

    Thanks for sharing.

  24. Mark Gaines

    Thank you Jeff, I wholeheartedly agree with you. I wanted to have five to ten houses paid off in retirement. I switched over to commercial real estate and have never looked back. I exchanged two single family homes for a government leased building. Luckily the residential market crashed shortly thereafter but my commercial property rose in value and within a few years was able to increase the lease from 20,000 a month to 30,000. You can imagine how many homes that would be and how much managing it would take. I still have depreciation, capital appreciation, tax advantages, and a multiplying effect each time the lease increases.

    • Jeff Brown

      Hey Mark — First off, good for you! Now please allow me to play a bit of the Devil’s Advocate, ok?

      The reason I’ve steered clear of commercial investment properties, i.e., office/retail etc. is how they perform during general economic downturns. Now, in your case the cash flow so far has proven to be very good, and your tenant exceptionally reliable. I hope it stays that way. But even gov’t changes course, and leaves.

      Here’s how it’s played out over the last 40 years I’ve watched. We all know they kick major booty when times are good. But when there’s an economic downturn it quickly becomes evident the landlord of an office/retail property could literally give their failing tenants a dime a foot to stay and they’d STILL be outa business. Hello 20-50% vacancy rate. Meanwhile the now unemployed workers who’re now out of a job, go home to my residential income property, and work 12 hours a day to find another job. Why? Simple, they don’t wanna live in their Toyota.

      It’s a personal bias for sure, Mark. But it’s origin is watching dozens of investors I knew personally go through that cycle and become disillusioned. This is especially true when they’re approaching retirement or already retired. Just food for thought.

  25. Ndy Onyido

    Hi Jeff,
    This is an excellent piece and very timely for me. Just this week I have been scouring the sites of API-a company involved in asset protection and exchanges, just trying to make some sense out of 1031…
    Your post has been extremely helpful but I will need more information….
    1. Does this rule also apply to non US residents who invest and pay their taxes in the US?
    2. Will it ONLY be done via LLC or/also an individual?

    If you don’t mind, I can send you PM for more questions and how to get started.

    Thanks again,
    Ndy

  26. Patty C.

    Hi Jeff:

    I wanna do the “Happy dance”! 🙂

    Enjoyed your humor along with your shared experience. After witnessing someone close to me investing in marginal areas, it was clear that was not my forte. I didn’t consider what I was doing as investing because properties were purchased with life’s intentions (limiting commute, best place to raise children, where to retire, reducing income tax, where grandchildren would want to visit us, etc). We purchased each one as owner occupied: As it became obvious that the properties were rarely used, we decided to rent them out, but it was fun getting them fixed up and playing with them for a while.

    Now that my husband is retired and I have the option to retire next summer, we are thinking about our options with one of our properties and how best to reconfigure our small portfolio. Of course, generating more cash flow is also a goal.

    Our best performer, surprisingly, is a one bedroom condo that we purchased as O/O. We are thinking thinking about turning it into our primary residence for at least two years before selling it to maximize the tax-free capital gains for a married couple and replace it with a primary residence to utilize proposition 90 in one of the magnificent 7 areas (of which San Diego is last time I check ;-)). The benefit is carrying over the tax base of the relinquished property. Some of the areas we can exchange into has a housing cost arbitrage that is to our favor.

    We also need to look into the portion of the property that would not qualify under IRS pub 523 to see if there are monies that we can 1031 exchange (or if this amount is going to be seen as ordinary income). Have you worked with a situation where people have utilized prop 60/90, IRS pub 523, and 1031 exchange?

    I am currently looking into if and how the three strategies can be put together. We already have a property in one of the magnificent 7 areas, but the tax is so high that we are thinking that we can buy a replacement property in the same area (or just sell the condo and trade up into another well located property that I can manage…met interesting and nice people so enjoy managing). I must admit that I love our little condo and the building is in much better shape than when it was first built. For many reason it is hard to even think of letting it go, but for other reasons, it may be prudent.

    What are your thoughts?

    A PM has been sent to you since it may be better to talk off-line if you’d be interested in exploring this further with me. Thanks, Jeff!

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