Rebalancing my portfolio – part 3: rental property

My units have a very nice exterior that reduces wear-n-tear.

In several previous posts, I have gone over key changes I have made to my retirement portfolio since I got highly active a year ago. I describe it as rebalancing my portfolio. When most people engage in rebalancing their portfolio, they are talking about selling badly performing stocks and mutual funds, and instead buying better performing ones. It also refers to adjusting future investments so that you target better funds for future investment. I have expanded the concept to a much wider scope of financial instruments.

So far, I have:

My final step?

  • Invest in rental property aimed at capital growth.

To pour a strong foundation in rental property, I have found every spare nickel of investment capital and acquired two rental duplexes in Austin, Texas. You can see pictures of one of them  throughout this blog post. Now let’s examine the risks and rewards this final (and most important) part of my plan offers.

Isn’t rental property risky?

Short answer: Yes. And that’s the point!

Anything which carries a return also has risk. It is important to realize this, and learn how to mitigate such risk rather than hide in fear by taking little to no risk by investing in ineffective index funds. An investment plan that tries to avoid risk rather than make plans to deal with it is doomed to fail.

So how does one mitigate the risk of rental property? Cash reserves. Some of the biggest risks you must prepare for include: vacancy, repairs, and property damage. A good insurance policy will help cover property damage. An umbrella policy can provide extra liability protection. For the rest, you need cash reserves ready to cover you when your property is vacant or needs repairs. (Notice the “is”, and the lack of “if”!) Another risk mitigator? Top quality property. The older your property is, the more repairs you will be paying for. The bigger the discount you pay for it? Probably an indicator of the increased rate your location will slide into chaos. Plan appropriately, and you will be able to handle these bumps in the road.

What about the rewards?

Well, we discussed the reality that real estate has risks. But let’s talk about the reason we are entertaining the purchase of real estate. Exactly what makes rental property a top quality wealth builder? Rental property has some of the best tax laws. You get to take a paper loss every year known as depreciation. Properly structured, it can shield all if not most of your net rental income. With the right circumstances, you might even be able to store up enough extra depreciation to shield capital gains at the time you sell. The more money you get to keep from the tax man, the more you have to reinvest and grow your rental portfolio.

Let’s not forget that everyone needs a place to live. This is the reason people have been buying real estate for centuries. Real estate has been growing in value for a long time. It is true that it can slow down and even fall, as witnessed in the past decade. But real estate really does recover. You may also think you have to be rich to enter this market, but you don’t. Which leads me to our next point.

Real estate is also good because it is one of those investments that is easy to leverage. By putting 20% down on the properties, I get 5x the growth of any combination of appreciation and equity payoff. This is one of the reasons people in the middle class can get into rental property. If it required all cash, then I really would have to wait until I was rich to get started. Leverage not only opens the door to investing in rental property, but it also increases the rate at which I can grow my capital.

Do da’ math: Imagine I had bought a $100,000 rental with only $20,000 of my own money (ignoring closing costs for now). If it grew by a conservative 4% to $104,000, my own equity would have gone from $20,000 to $24,000, a 20% return on investment. Who could turn that down?

Location, location, location

Each side of my duplexes has a two car garage.

Now show me a mutual fund or 401K investment that is returning that well!

Slow down there partner!

How do you find the right deal? Well, it’s true that a critical factor in real estate investing is to look for good property and not end up buying worthless swamp land in Florida. Duh!

That is the reason I hired Jeff Brown, aka The Bawld Guy. He is a real estate broker focused on designing long term real estate investment plans. He has helped me find great options. He has been doing this for 40 years and knows the business inside and out. By business, I mean investment property for the middle class, not just rich millionaires. By 40 years, I mean he has been mentored by many pros on everything from 1031 exchanges, note investing, partial transfers, hypothecated notes, and even selling homes in a buyer’s market without resorting to steep discounting! There is no one like him out there. Trust me when I say, the agent that sold you your current home doesn’t hold a candle to this guy. Read some of his blog entries. It took me six months of reading, talking to others, and investigating him through multiple channels before I called him up. But I’m sure glad I did.

It doesn’t stop there either. After buying property, there is a tiny task known as property management that involves collecting rents, making repairs, as well as finding good tenants and evicting bad ones. All these things can be very stressful. That is why I sought a property management company to handle this task for an acceptable fee. This is, again, where Jeff chips in. He has scoped out all the builders and property management companies in many parts of the country and built teams. When you hire Jeff, you hire an A-list of people to do the job, making your investment plan work.

I mentioned risk, right? Instead of hoping it doesn’t hit us, it is better to assume Murphy will pay us a visit. To prepare for this, it is critical that we set aside enough cash to handle big issues. I put enough cash in the bank to handle 6 months of 100% vacancy. That would be an incredibly big bump, but I have to be able to sleep at night, right? If anything significant happens, like repairs, eviction court fees, or other unforeseen issues, I can write a check and deal with it. Because the properties are cash flow positive, the minute I am clear of these issues, I can let the cash flow replenish my reserve account. That is also the side benefit of living off the salary from my day job. Once the reserves are back up to my safe level, I can resume pouring all the extra income towards knocking out one mortgage at a time.

Finding investment capital to buy real estate

So where did I get the money to buy two duplexes in the Austin, Texas area? I liquidated the 401K I have been putting money into for the past 15 years.

Yup, you heard that right. I nuked my 401K.

Holy tax penalties, Batman!

Yes, there is a cost to doing that. Essentially all that money must be reported as income in the year it is withdrawn. That will cost at least 28% if it doesn’t push me into the 33% tax bracket. But it doesn’t stop there. By taking out an unqualified distribution (i.e. before turning 59 1/2), there is an additional 10% penalty taken off the top. My running estimate is that I have lost 50% of the money stored in my 401K.

I don’t want to gloss over this point. The cost for ditching a badly performing 401K is enormous. You should realize, Wall Street setup the 401K to hit you right between the eyes like that so that you would never, ever, ever think of doing something like this! The government, realizing all the taxable income they would gather in your retirement years, went along with it. But continue reading to see why taking that big hit was a no-brainer for me.

First of all, if it had been closer to the end of the year when I made this decision, it would have been better take out half now and half at the beginning of the following year. That would have spread the taxes and penalties across two years and possibly kept me out of a higher tax bracket. Unfortunately, it wasn’t until April of this year that I made the choice, and given this was an election year, I couldn’t gamble on waiting until January to see if my 401K would soar or nose dive. Elections, regardless of their outcomes, can have big, emotional impacts on the markets.

So let’s break down this analysis into two options, one where I keep my existing 401K, and the other where I cash it out for essentially $0.50 on the dollar.

Option 1: Keep the money in the 401K. The value of mine still hasn’t recovered to pre-2008 levels, despite putting more money into it over the last four years. Part of the reason is because I got married four years ago and now have two kids, forcing me to reduce the amount of money I could save that way. I used to set aside 15% of my paycheck, but with new family expenses, I had to scale back to 6%. Did your financial advisor put in such a factor when putting together your plan? At the beginning of this year, my 401K was still about 20% down from the pre-2008 peak I used to have. Another big factor is that losses are hard to recover from. When your portfolio drops 20%, it has to recover 25% to break even. A 50% loss requires 100% recovery. Get the point? If it takes another six years to get back to where I was four years ago, then that is an entire decade gone. Poof! See why 2000-2010 has been dubbed as the lost decade? To put one more nail in the coffin of the 401K qualified plan, The Dalbar Report shows that investors using mutual funds average less than 4% average growth per year. Does your 401K offer anything other than mutual funds? I didn’t think so. It is possible to manage your own 401K and invest in things other than mutual funds, but the huge mass of people I meet have never setup their own plans, and instead use the corporate one with little to no interaction. Top it off with the incredibly high fees found inside 401K plans, and you can understand why I flat out don’t like them.

Summary: Draw a line starting at your current 401K value and extend it with a slope of 4%. Not good enough! Now let’s look at our alternative.

Option 2: Crash the 401K, taking every nickel you can get. Assume 50% survives the carnage and aftermath. Shed some tears. Now face an even bigger task: tell your spouse. Telling my wife was the hardest part! I wish I could have skipped that part, but we both needed to be onboard, 100% percent committed. Next step, buy top quality, premium rental property. My units are brand spanking new, checked out by a licensed home inspector, and I even walked through them myself. Now, assume only half the rent money makes it into your pocket after paying for repairs, property management fees, insurance, and vacancies. Use that money to pay for principal and interest on the mortgage. My loans at 4.75% & 4.125% (30-year fixed) still leave me with cash flow positive. After paying the minimums on each mortgage, pour all extra rent money into one loan to knock it out as fast as possible. Throw in enough depreciation to shield all that net rent money from taxes, and you now have a nicely performing set of assets! What rate of growth did we pick earlier? Oh yeah, 4%. Only now it is leveraged 4-to-1. That results in a tasty 20% return on investment.

Summary: Draw a line at half of your 401K value with a slope of 20%. Painful at the start, but in the long run, much better!

Look at the graph below, where we assume you started with $100,000 in your qualified plan, and ran both Option 1 and Option 2. Which option would you pick? That is how I came to realize it was a no-brainer, and sprang to take back as much of the money I’ve been saving over the last 15 years as I could.

Bottom line: it was a huge cost to get my hands on this highly needed capital. Some of you reading this probably can’t comprehend doing such a thing. Have you even heard of someone crashing their 401K like that? But the end result is MUCH better than I would have ever gotten with mutual funds.

My estimate is that within five years, the penalties I suffered will have been paid off. I realize the chart above says six years, but that only assumes some conservative appreciation. It doesn’t include paying down the loans and growing the equity position.

If you want to swap things around and instead assume no appreciation, but still paying half the rent towards expenses, my properties still yield 6% annually. That is more than we assumed when drawing the chart up above.

To top it off, my investment capital is now growing at 5x the rate it grew at before hand. I have a big chunk of cash sitting in the bank to back my play and handle bumps in the road. My relief of no longer sweating the dips in the Dow and the S&P 500 is incredible.

When I started thinking about this plan, it took me six months to overcome the psychological shock of losing all that money. But after realizing the long running history of real estate vs. mutual funds and no longer being told to keep my hands off that money (401K rules), I was able to look at the Big Picture and get ready to eat that “stupid tax” in order to jump ship from my lousy 401K.

Key piece of wealth building: getting over the pschological hurdles set up by Wall Street and the government. They don’t want you pulling your money out of a 401K, so they have erected big barriers. They also make it appear as your best and only option, by offering the huge tax deferral options. But does the person at your company who advised you about 401K options mention real estate? Do you think they even know a lick about rental income and depreciation? Probably not.

Making money with rental property

The floors have tile, which also extends life of the unit.

Nothing is free. There are closing costs, property management fees, and a fee to the broker that found me these top notch properties. I have also hired a CPA who is also a real estate investor, and knows every tool in the book to get the most tax efficient plan going. That will cost a tad more than TurboTax software.

The properties themselves aren’t exactly at discount price. Usually there is a reason something is at “discount.” If the property is junky or in such a terrible location that you wouldn’t put your own mother there to live, then it probably won’t yield the high rent thou dost seeketh. These properties are different. They are top-of-the-line and I definitely would put my own mother there. Finding the right people to help dig up top notch real estate takes work. If you get stuck on paying the lowest fees, it isn’t going to work. The performance of your assets will suffer, because you didn’t buy the right units and didn’t hire the right people.

Assuming you can dig through all that and find some good rental property, you will learn that there are incredible benefits to owning real estate instead of mutual funds. With real estate, you only have to sell when the market makes it a no brainer. No more panicing when the market falls and you are either dumping your mutual funds, or suffering from your holdings in a particular fund getting transitioned because everyone else abandoned it. Instead, let your tentants keep building your equity. Not depending on appreciation, but instead taking in the solid yield of monthly rent is much better. And prudent usage of leverage puts the icing on the cake.

By the way, I absolutely advocate taking on debt to do this instead of buying everything 100% in cash. In the early years, it increases the cash-on-cash returns. But again, this requires buying top quality real estate, not dumpy stuff that is only going down hill. This is good debt! Evil debt is taking out a loan to buy a toy you can’t afford. Using debt to buy cash flowing, appreciating assets is what helps us attain wealth.

Another key task is to grow as much as possible. Pour all excess rent money into paying off one loan at a time. If you have extra money you can save from your day job, see if you can add some more. Why do that? So you can sell it when that no-brainer opportunity arises and then buy more property, re-leveraging your new capital. Every dollar you throw into your real estate portfolio will grow multiple times. Give yourself 20-25 years, and that should help build a sizeable nest egg. But it cuts both ways. If you tap the rent money for other things, it will cost you similarly.

Retiring on rental property

The final benefit in this plan? When it’s time to retire, I can stop working on growth and instead shift to cash flow. If you were planning to withdraw from your 401K, every nickel will be taxed as regular income. Ouch! That can get pretty steep, considering we don’t know what the rates will be 25 years from now. But if I take all the capital built up in my real estate portfolio over a 20-25 year period and essentially buy all-cash properties so they are heavily cash flow positive, much if not all of that passive rental income will be shielded for the next 27.5 years by depreciation.

Shielded by some of the best tax laws on the books, and the fact that things won’t be tied directly to the stock market, this makes for a much better long term investment strategy. THIS is building wealth. And when the time comes, after building a portfolio of lots of rentals properties, I can sell one or two and buy another EIUL to stuff away yet more money for tax free withdrawals during retirement.

Considering I also plan to start withdrawing tax free money from the other EIUL I mentioned earlier as well as receiving dividends from my stocks, it all adds up to a sweet, low tax retirement plan. And to me, that makes it a no-brainer.

5 thoughts on “Rebalancing my portfolio – part 3: rental property”

  1. Rental property has been very, very good to me. Mitigate your risk by getting great tenants. Great tenants always pay, even if they leave to buy a house after a couple of years. That is much better than having a tenant for 5 years, that you eventually have to do a 100% remodel as the place is destroyed. Or after 6 months evicting someone.

  2. Bro, Why didnt you just save up the money and keep your 401K? It might have taken some time, but at least you could have had your cake and eaten it too.

    1. James,

      Several favors. 401(k)s have shown a dismal history of performance. According to dalbar report, investors that buy mutual funds (the primary thing sold inside 401k wrappers), rate of return has been around 4% annually. They may have big booms, but the busts ruin the long term more than most people realize.

      Another factor was that it took me 15 years saving at rates of 18% of my gross paycheck to accumulate this capital. Now that I’m married with kids, I just can’t save at the same rate. It would take me at least 15 years to take in the same pile of dough, and doubtful at that.

      With leveraged real estate offering the chance to grow my portfolio and not suffer the same crashes as 2001 and 2008, when people referred to retirement funds as 201k funds, I could see that take a 50% hit up front (which has actually become only a 37%), the way forward was clear.

  3. I am new to your blog. Are you in Texas? I was trying to figure out if you believe in rental properties out of state or do you prefer renting in local markets?

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