Gross rents for 2013 yielding 50%

Tax statements are starting to roll in. This year should be much simpler than last year, since my CPA won’t have to do as much work.

What I was thrilled at getting was a 1099 from my property manager that is handling our rentals. It lists how much gross rent we have received. It’s roughly half of the money we put down to buy these units. You could call that 50% yield on the money we invested. Is your 401K plan showing that much improvement?

Of course, it’s more complicated then that, because we used the money to secure financing that has to be serviced. But at the core of things, it’s a good sign that my portfolio is yielding rock solid cash. And the concept that it will keep yielding that same cash flow year after year is something you just don’t see when you invest in the appreciation of mutual funds.

Another nice tidbit is that this rental income is completely tax sheltered. The depreciation of the property exceeds the gross rent by a significant amount. By design. In the eyes of the IRS, we lost money this year. And because I can’t apply any of this loss to my ordinary income, we will carry the loss forward into next year. And so on and so forth, until sometime in the future (such as when we sell a unit) we can apply all the accumulated losses. That should nicely offset the capital gains taxes.

To top it off, I got news that one of our tenants is having to vacate his unit due to military reassignment. In case you didn’t know, military personnel can break a lease with no penalties when they receive orders to move to another base. I have no quarrel with that. Within five minutes, I had called up my leasing agent that finds new tenants and asked what rents we can charge. This is an opportunity to raise the rents. She happily noted that we can go up $25/month and will probably have it rented before these people move out. That is what it means to have the right experts on your team.

Plastic isn’t ceramic, and don’t you forget it

The title of this post might seem a bit cryptic. It came to me as I was loading the dishwasher. I am the pro dish washer loader in the household, and prefer to not be disturbed while doing it. That’s because I’ve learned several tactics to essentially fit as many dishes as possible and thus save myself from washing anything by hand.

A key facet of loading the dishwasher is to avoid letting dishes hit each other. This isn’t good and can break your ceramic crockery. But this principal doesn’t apply to plastic ware. Things like plastic bowls, kid’s cups & bowls, and cooking spoons can certainly touch. Hence, I always try and load the frail items first, ensuring they don’t touch. Then I start eyeballing where I slip in “big” plastic items, and finally, layering in the smallest things. I use plastic’s innate lack of a brittle nature to my extreme advantage.

And I realized this is the same thing I do with my wealth building plan. There is a debate that won’t die over at BiggerPockets.com (the most popular real estate investment website). This subject keeps appearing in new blog postings and forum discussions: stocks vs. real estate. Check out these titles:

You can keep going back and finding more. But they often cite different aspects, and reach a conclusion of which one is better at building wealth. Several cited factors in the various articles include: liquidity, leverage, and efficiency of the market (or lack thereof).

Liquidity: good or bad?

Let’s examine some of these. For starters, stocks are highly liquid; real estate is not. You can get in and out of a stock in seconds. Can’t say the same for real estate. Is that a plus or minus? And here comes the proverbial…it depends. Warren Buffett has said, “Our favorite holding period is forever” and “Only buy something that you’d be perfectly happy to hold if the market shut down for ten years”.

This may say that you should only buy stocks if you are highly confident that you’ll be happy with the purchase for ten years or your entire lifetime. But stocks offer an escape hatch that real estate doesn’t. If something goes wrong, such as a dividend cut to your high paying company, you can sell it and move on to the next item on your short list. Real estate requires much more careful thought. When I had a boon of money dropped in my lap from the sale of my previous home, facilitated by the HELOC on my current house, I immediately lunged at the chance to buy a big position in VNR. I knew the dividend payment rate (8.6% at the time) would trump my HELOC’s 4% rate. I quickly computed that with no dividend increase and no interest rate increase, I could pay off the HELOC in 8 1/2 years and then pocket the difference from there on forevah!

Since then I’ve contemplated whether I should have taken all that money and simply bought another rental property, with the intention of using extra rent to pay off the HELOC. I quickly dismissed it on the grounds that my rental wasn’t liquid enough to deal with unforeseen issues with the HELOC.

However, on another note, I have a stock option with my current company. When it goes public, I’ll get a chunk of change. There won’t be any debt connected to it, so it will be a perfect opportunity to ring up Jeff Brown and pick up another unit or two. The liquidity won’t be needed to hedge a risk in that situation. So once again, whether or not to put a pile of money into an illiquid asset like a rental vs. a highly liquid investment such a stock depends on what risk your are mitigating. And hence the reason I often tell people, “Why pick one over the other?” Stocks AND real estate can be good wealth building vehicles.

Leverage

Here’s a good one that people usually slam out of the park. Real estate leverage usually trumps stock leverage. It’s possible to buy stocks on the margin, but the rules are all different.

If the value of your stock position goes down, your broker will be on the phone hitting you up for more cash. This is the famous margin call, and something you don’t want to ever experience. It sounds too analogous to someone upping the ante in a poker game and then asking to either up your own position, or fold.

With real estate and fixed debt, no one will be calling you up if the value of your property drops. As long as rent is rolling in such that you can make payments, there is nothing to worry about. 
Simply put, I own stocks without leverage. I own real estate with leverage. I don’t foresee how my wealth building would be adequate with a stock-only approach. History has shown that the rich invest in real estate and it has also been a strong wealth builder for the middle class.

Efficiency of the market

There is a popular theory out there called the Efficient Market Hypothesis. It says that everything about the stock you need to know is factored into the current price. It also says that you can’t “beat the market” because you don’t have an edge. The EMH is highly controversial and has many supporters and critics. I don’t totally agree with it because all you have to do it point out that Warren Buffett has beaten the market by wide margins for over forty years.

Something not directly stated but that seems to get tied into the EMH is that the market is always rational. Essentially, the price of stocks includes all risk, rewards, and other factors embedded in the price. This one I find hard to swallow. British Petroleum (BP) took a big hit three years ago when their stock price fell 33% from the mid 60s down to the low 40s. This was because people were concerned that BP was going to have to payout tons of money in claims amongst other concerns. Today, most of the claims have been paid. On top of that, BP still has a strong balance sheet with much capital, supplies, and is producing as much oil as ever. And yet the price still hovers around $46/share.

In the first article link up above, the author describes EMH to mean that there is no opportunity to go and buy someone’s stock at a huge discount. There is no way to find someone in distress, buy their shares at a low price, fix them up, and then re-sell them at fair market value. This simply doesn’t exist in the stock market, and hence you can’t make the same profits as real estate. He goes on to point out that real estate is incredible inefficient based on the process it take to complete a transaction, thus making it possible for people to create good value.

But again I look at stocks like BP. Other stocks have similar things happen all the time. Some event happens, people panic & sell, and others buy at a relative discount. Then things recover. From a 10,000 foot perspective, this sounds very similar. And it also sounds a lot like what Warren Buffett has been doing for years.

Whereas I might disagree with the author about the definitions about the EMH, there is a nugget of value in all this. A real estate transaction can cost thousands of dollars. A stock transaction is probably less than $10. That alone can make a difference on slowing down the pace of real estate, allowing one to make much bigger gains. Sometimes for better and sometimes for worse. When the value of your rental drops in value, you aren’t as likely to panic and sell. You realize it will cost thousands to sell it and acquire another. So you are driven to do a more careful analysis of the situation. Sometimes slowing things down can help you not panic, a phenomenon many in the investment industry say causes common people to not do well with investment products.

But being able to drop your stock in a heartbeat because a company stopped paying dividends may be just what the doctor ordered.

If you head is starting to hurt, because efficiency, leverage, and liquidity seem to be different sides of a coin (three-sided?), then you’re right. We are simply comparing the dynamics of each vehicle and seeing that they operate a little differently. But dropping one for some foolish rule of thumb can impair our ability to build wealth.

End result

I like having spare cash from my cheap HELOC put towards growing wealth instead of simply residing within the walls of my home. People seem to relish the value of their primary residence except you can’t eat your home. You would have to sell it to harvest the equity.  I prefer doing that now while I still have time on my side.

But I also like the monthly cash flow from my leveraged real estate. Both of these approaches work together in a synergistic fashion and are making it possible to build a better retirement wealth than shelling out 2-4%/year to a mutual fund house.

All metaphors break down, which is why I can’t say that real estate is ceramic or stocks are plastic ware. They each have their pluses and minuses. For example, ceramic may be more fragile to contact, but it’s more resilient to hot water. Plastic can bump against other things, but tomato-based foods need to be rinsed out before hand.  The important aspect is handle each part of your investment portfolio properly and be sure to guard against the risky things as well as take full advantage of their benefits.

Real estate vs. stocks vs. EIULs

I’ve written many articles about real estate, stocks, and EIULs. You may be wondering if I value one over the other.

The truth is, they all have their purpose. A lot of investment sites tend to prefer one over the other. For example, a lot of investor websites talk about mutual funds. Some even focus specifically on index funds. To find a site that suggests using multiple tools is, in my humble opinion, a bit rare.

I might have given the wrong impression with some of my articles that I value some vehicles more than others, given the number of times I mention my primary stock, Vanguard Natural Resources. I like VNR, and it provides a good medium to discuss different wealth building options, but it’s not my primary asset.

The way I track my wealth involves adding a new row to my spreadsheet every month for every asset and every liability. But I also have a secondary worksheet where I track groupings of various assets. This lets me observe how my portfolio is distributed.

  • 51.3% of my holdings are rental property
  • 31.7% is personal property (personal home and vacation home)
  • 6.3% Vanguard Natural Resources stock
  • 1.1% other stocks
  • 3.4% Roth IRA and 401K
  • 3.2% exercisable stock options
  • 1.5% cash
  • 0.9% EIUL

That may not add up to 100%, but it’s pretty close. One thing I’ve seen mentioned by others is to not invest too heavily in your own home. A tip was to have no more than 25%. This breakdown doesn’t account for liabilities such as mortgages, so it doesn’t track the fact that I have HELOC-based cash invested in VNR. It simply has the value of my properties and my stock holdings grouped together, divided by the total value of my assets.

The point of this article isn’t to steer you towards a certain asset allocation. And it isn’t to tell you that you must also put half of your assets into real estate. Frankly, it’s the way my portfolio has come together. When I withdrew my 401K holdings, I plowed them into rental properties, and bought what I could. The left over cash was put into reserves to back my play. I have used some of that cash to buy some stock positions, and I have also used HELOC cash to increase my position in VNR. The EIUL was set up so that I could fund it with the same money I was using to fund my 401K.

Essentially, I didn’t start with a top-down plan to spread my money into percentages. Instead, I built things from the bottom-up, picking opportunities as I saw them. I just put together this spreadsheet so I could keep a bird’s eye view on things. And ever since I put this in motion, I’ve seen 89% total growth. This says I’ve already made back the money I lost in early withdrawal penalties. I’m cautious to throw that out there because part of it is tied to estimated value of my rental properties. But I can tell my wealth building plan is doing much better than before with the monthly cash flows I am now receiving.

Building passive income with real estate

Passive income is a curious beast. Essentially it involves money that you don’t “directly” earn. If you show up at your office or at the factory, put in the hours, and do your job, then you get paid a certain amount of money for your time.

Even in lame court TV shows, you see people successfully suing to get reimbursed for earned income when they prove they put in the hours. This is “ordinary” income. And the government taxes this type of income on the basis that you are more likely to show up on a daily basis, put in your hours, and get your pay check. There is relatively little risk to you not getting paid and hence little risk of Uncle Sam not getting to collect their cut.

But real estate rental income is different. You get paid because you own the property. There may be fees, but in general you don’t have to lift a finger to collect your rental income. It doesn’t mean it’s easy. But it doesn’t require you to put in a certain number of hours to earn the income.

The trade off is that you take on the risk of not collecting. The tenant may not pay. You can go to court to collect past rent. But the property could also be vacant. And if your tenant is behind and you evict him or her, you will be losing money until you find a new tenant.

This is passive income. The government looks at it as riskier income and not as likely to bear fruit. So they cut you a break and charge lower rates. And there are different options in tax deductions. There are even barriers between sharing tax deductions between ordinary income and passive income.

This means that investing in real estate can produce a lot of income with better tax rates, but it has risks. It is one reason to seek top quality properties, because that is how you attract top quality tenants. That hedges the risk that comes if you lease junky units.

What’s another reason to get into real estate? Because when you accumulate enough, you can stop your busy day job and stop “putting in the hours.” Retiring and living off passive income is a boon.

Real estate also comes with added benefits. It allows you to use prudent leverage, which is one of the greatest wealth building tools available to the middle class.

P.S. By no means am I a CPA or tax expert. Please contact your tax advisor and start firing questions about passive vs. ordinary income. If they stare blankly, it might be a clue that aren’t right for you. In fact, ask them if they know how to handle a K-1 form as well as an 83(b). If they don’t have a clue what those might be, or don’t ask you questions to glean if your qualified, its another sign they might not serve your needs.

Active management vs. passive income

I recently wrote an introductory article where I listed a slew of tactics for building wealth. In this article, I want to dive into what is a crucial aspect of making those strategies work: active management.

For some example of active management consider this: to engage in leveraged real estate you can’t simply “set it and forget it”. The same goes for buying stocks or over funding an EIUL. If you take a passive approach to managing your wealth, you will miss important things and possibly wreck any chances.

Real estate

Let’s look a little deeper at each of these. When it comes to real estate, the most important thing is having tenants in your rental properties. Empty units = no cash. If you have setup your mortgages to get automatically paid, this will drain your coffers quickly. In the area where my rentals are located, I have someone that I can pick up the phone and quickly get cracking on finding new tenants. She also can tell me what the going rate of rent is in the area. She gets a cut of the first month’s rent, but it’s worth it to ensure I’m getting the best rental income while also staying occupied.

I could try to let my property management company cover this task, but they are driven by one thing: occupancy. If they can spend less effort and get it occupied for a little less rent, they’ll do it. My tenant-finding agent doesn’t have the same motivations and so I can count on her to do her job of researching market rates and betting me the best deal. But to engage her services, I need to stay on top of things.

I have a good property manager that sends me emails when tenants are approaching the end of their lease. I also get notices when monthly payments come in. I don’t have to worry about this on a daily basis. But once a month, I need to ensure that everything is working properly and all my people are doing their jobs. This is different than the attitude of throwing money into your 401K plan and maybe looking at once-a-year. It is very different than assuming it’s going to turn in to a fistful of cash in ten years.

Stocks

When I invest some of my capital in dividend paying stocks like Chevron (CVX) and Vanguard Natural Resources (VNR), I need to monitor their dividend reports. Are these stocks continuing to pay the same or more in dividends? Dividend Growth Investor has a hard rule: when a company cuts dividends or stops paying altogether, abandon ship. Move your money somewhere else. His opinion is that this is one of the first actions taken by companies steering into risky waters. I haven’t adopted that rule wholeheartedly, but it probably makes sense to make such a decision now, because I get put into such a stressful circumstance. It means I need to ensure the dividend payments happen on schedule. There are usually press releases indicating scheduled payments or the lack thereof, so it’s not hard to keep up with. This is especially important considering I’m using the cash distributions from VNR to pay off my HELOC.

I need to NOT get sucked into the daily news about the fluctuations in stock price. In fact, Warren Buffett warns against being too plugged in as well. Instead, seeing quarterly dividend reports is the best indicator of success. The Conservative Investor actually goes so far as getting some classic stock issued shares to hang on your wall, a six pack of Coke (if you own KO), and even framing a dividend check to see everyday as a reminder that holding the stock is paying you money on a regular basis. Anything to remove you from the abstract concept of minute-by-minute price fluctuations, and instead focusing on quality of business and it’s flow of dividends into your pockets. Unless you’re prepared to think in this mindset, stocks can ruin you. If you see a 50% drop in price and it drives you panic, you will not succeed. But if you have thoroughly researched a list of companies and instead see these drops as mere opportunities caused by other irrational investor, then you can do very well.

EIULs

Finally, I have my EIUL funding setup on automatic. It makes things easier. This one truly is long term. If you cut out before twenty years, it would be for naught. One of the pieces of this plan is to increase monthly contributions by 4% every May. I’ve already done that once. It’s a task I do in order to emulate cost of living increases. I have more money, so why not put more money into my regular contributions. It creates a very strong improvement in the total build up of cash value.

Summary

Something that might have confused you is where I wrote “active management” in the title, and yet we are talking about things that are considered “passive income” according to the IRS. Active management is required to make sure everything is performing as expected. The style of investing where you throw money into some index funds and don’t track their historical performance, and even avoid the statements when you know the market is down can be referred to as “passive management.”

If something shifts out of alignment, it is up to me to respond properly. But most of my focus is on building passive streams of income so that when I get to retirement I no longer have to “actively” work to earn money for my day-to-day expenses. If you adopt a passive strategy, you might not realize your rental properties are either vacant, or one of your tenants is five months behind. You might not realize that one of your stocks is no longer paying you the dividends you planned on. And you might not be upping your contributions to your cash value life insurance policy.

How to build retirement wealth

If you are a new reader here, perhaps it’s time for an introduction. I like sharing my opinions on how I am building retirement wealth. I also like to document how my own investments are doing. Some of these ideas might sound outrageous or in contradiction to what you’ve heard from your financial planner, financial adviser, or some popular radio hosts.

But the concepts I lay out in my articles are backed up by historical evidence. In fact, I look at history to try and determine the best ways to build wealth. Do you know how you always hear “past returns are no guarantee of future returns”? While true that there is no guarantee, trying to shirk the past and it’s strong evidence is reckless and frankly won’t lead to a good retirement.

So what are the investment vehicles I employ?

  • No mutual funds.
  • No 401K or IRA wrappers.
  • Direct ownership of stocks (not mutual funds).
  • Leveraged real estate
  • Over funded cash value life insurance (also known as permanent life insurance)
  • Build wealth using various forms of arbitrage

These may the types of vehicles I use, but it also includes the concept of actively managed wealth building. Some of these vehicles may be considered passive forms of income, but it takes an active approach to do it right. The concept of simply dumping money into a mutual fund inside your 401K and assuming it will grow to serve you in retirement just doesn’t work.

No mutual funds

The Dalbar report has been monitoring mutual funds and tax deferred savings plans for 20 years. According to the 2013 report, mutual fund investors have significantly underperformed the S&P 500 over the past 3, 5, 10 and 20 years. In 2012, they reported the average performance of investors in equity funds was 4.25%. They further indicate that this is mostly tied to investor behavior rather than fund performance.

The performance numbers are clear: people investing in mutual funds average poorly. Dalbar goes on to make a judgment that it’s the consumer’s fault. This might or might not be a valid judgment. But is that relevant? If people don’t do well, and haven’t been for 20 years, do I really want to plan my retirement under the assumption that I can beat the average? I’m sure it’s what most others think. Dave Ramsey is happy to quote the FDIC in saying that 97.3% of people don’t follow through on their promise to pay off a 30-year mortgage in just 15 years with extra payments.

So why would we expect people to follow through on their attempt to not buy when things rise and sell when a market correction hits? I prefer to build my wealth building plans using the averages.

No 401K or IRA wrappers

401K and other government wrappers come with an incredible entanglement of regulations, restrictions, and other tricks to basically keep your hands off the money. The concept is to get you to put away money and keep your hands off of it until you reach retirement age. But many investment houses take advantage of this situation in the sense that mutual funds and other vehicles available tend to have the highest expense ratios.

People will eagerly point out things like IRAs as giving you more control, but the government has strong limits on how much you can put into an IRA. Suffice it to say, the limits on IRAs aren’t enough to build a retirement plan.

And do you really think the government designed the 401K to help you set aside money and save on taxes? The government wants you to put away money today without paying any taxes, so that you will grow the money into something bigger, and then start paying full blown income taxes when you reach retirement. Yikes!

It’s true that I have a Roth IRA and a 401K, but that is money I put in before I realized it wasn’t working. As you’ll see below, most of that money has been re-applied and is already making way more than what it used to. The only money I have left is trapped in my current company’s 401K and I can’t get to it. The Roth IRA I have is small as well and would serve little benefit if I extracted it.

Direct ownership of stocks

This one really stuns some people that I meet. I don’t like the dismal performance of mutual funds combined with their fees. Instead, I prefer owning stocks directly. If you look at all the studies done over the years, there is one stock market strategy that has proved fruitful: buying and holding dividend-paying stocks.

If you look at people like Warren Buffett, they have created billions by acquiring strong companies when they were on sale. Warren Buffett has also bought cash flowing stocks and companies, and reinvested their proceeds in other strong companies. This has created a compounding affect that has let him beat the S&P500 for years by great margins. The book value of Berkshire Hathaway has averaged it’s growth by 28% during the boom years, and by as much as 18% during bad recessionary times.

It’s not hard to find solid companies. In fact, there are many blog sites dedicated to this, such as Dividend Mantra and Dividend Growth Investor. The companies they invest in are not fly-by-night shady outfits. Instead, they mention thinks like Coca-Cola (KO), Walmart (WMT), and other names you’ll recognize. Companies like Coca-Cola have created millionaires for decades. You can find a list of companies that have paid consistent dividends, increasing them year after year, for over 25 years. It’s not that hard. It turns out, these are some of the best investments regarding inflation. A company that has managed to increase payouts to its shareholders through thick and thin is pretty solid.

Leveraged real estate

After the 2008 housing melt down, many people won’t entertain investing in real estate. The problem is that newspapers were reporting the worst scenarios regarding foreclosures. The truth is, 99% of mortgages are current and paid for. The number of people that suffered rate hikes on risky loans while having insufficient money to keep up were a fraction of a percent.

Real estate has shown a more consistent growth rate than mutual funds. And real estate is one of the easiest investments for middle class people to get into. Using prudent leverage, an average 4-5% growth can turn into 20-25% growth in your investment capital. That certainly beats the 4.25% average growth of mutual funds. Again, this is what happens if you use the averages. You can make more and take on riskier, higher paying options, but why take a risk? You’re already ahead of what mutual funds in 401K wrappers have to offer.

Since real estate was a no brainer, I cashed out my 13-year-old 401K from my old company, paid 37% in taxes and penalties that year, and used it to buy two duplexes with 20% and 25% down. I couldn’t be happier.

The rentals I own are paying me a nice monthly profit as the tenants pay off the mortgages for me. I keep a fair amount of cash in reserve to handle vacancies. And seeing my property yield monthly cash helps me to focus on that instead of pure growth in value.

Over funded cash value life insurance

This is one that stirs a lot of discussion. People have been preached to that cash value life insurance is a rip off and to never, ever, ever buy it! Phrases like “buy term and invest the difference” as well as “don’t mix insurance with investments” flies all over the place.

The thing is, many of the people that preach this opinion have an incomplete knowledge of how it works and how it was designed to function.

To be clear, I’m talking about EIULs, or equity indexed universal life insurance. And the critical component is over funding the policy to the limit set by the IRS. Essentially, buy a policy where you get the minimum amount of death benefit for a given amount of money. That causes your cash value to build faster. If you get the maximum amount of death benefit, then your cash value grows very slowly and it becomes an ineffective tool in storing wealth.

EIULs that are over funded give you the option down the road to borrow from the cash value. Essentially, you borrow money (without paying it back) and when you die, the loan is paid off with the death benefit. Whatever is left over is passed on to your beneficiaries.

EIULs have the benefit on not investing in the stock market, but instead in European options on the market. This is how they institute caps such that your principle is guaranteed to growth somewhere between 0% and 15% of the index it is linked to. If the index goes negative, your cash value stays the same. But if the market goes positive, so does your cash value.

You may not be aware, but that facet is incredibly powerful when it comes to wealth preservation. So many people have seen huge booms in their mutual fund holdings, but the overall performance is knocked back to that Dalbar average of 4.25% due to losses. If your account shrinks by 30% in one year, and then grows by 30% the following year, are back to where you started? Nope. $10,000 would drop to $7,000 and then grow back to $9,100. But if you had an EIUL, that $10,000 would stay put, and then grow to $11,500 (0% loss followed by a 15% gain based on the caps).

EIULs are very expensive for the first ten years; a fact many people like to point out such as Suze Orman and Dave Ramsey. But after ten years, the fees drop to almost nothing. After twenty years, the fees will probably average between 0.5-1.5%/year. Sure beats the 2-4% average cost of mutual funds. And then you get to start taking out tax free loans (compared to mutual fund payments at income tax rates), there is even less to fret about in retirement.

Once I understood the entire picture of what EIULs could and couldn’t do, it was a simple decision to stop investing money in my company 401K and reroute that money into an EIUL.

Build wealth using various forms of arbitrage

Something people are unaware of is how banks make money. Banks borrow money from the Federal Reserve at rates like 3.25% and then turn around and lend it out at 4.25%, pocketing the 1% difference. You can use the same concept.

I took out a HELOC against my home for (PRIME-0.25%) with a floor of 4%, so right now, it costs me 4% to get this money. Then I bought a position in Vanguard Natural Resources, an MLP that has been paying 9% distributions on a monthly basis. As I pay off the HELOC, I am essentially pocketing the 5% difference.

This is also referred to as equity harvesting. All that equity in my house was earning 0%. I am getting the cheapest form of money available, a mortgage, and using it to collect cash flowing assets. After I pay off the HELOC, I can redirect the money towards paying off investment mortgages, buying other dividend aristocrat stocks for even more passive income cash flows, or increase my position in Vanguard Natural Resources. And at that point, I can also renew the HELOC to get more investment capital.

When people ask “would you take out a $50,000 loan on your house and invest it?” my answer is a resounding “yes!”

Stay tuned

I hope you enjoyed this introduction to the concepts of build wealth at the Wealth Building Society. Wealth building isn’t hard, but when you boil things down to sound bites used by radio entertainers, some of the worst advice gets out there. Are the people that are telling you to only take out 15 year mortgages and pay them off as fast possible retiring on mutual funds? Are these people maxing out 401K and IRAs, or are they building wealth through writing books, running TV and radio shows, and piping their business equity pay offs into rental property?

Investment Property – Classic Way vs. My Way

A couple nights ago, I was watching one of my favorite shows – Investment Property. I always enjoy seeing the renovations combined with putting new landlords into business.

But this time, I couldn’t help but view everything through a wealth building lens. I kept asking, “Would I do that?” And the answer was a clear “No!”

Classic way

So what was the deal? The investors picked a two story, three bedroom house that was going to cost $750,000 after purchase and renovations. The rent was estimated to be $2700/month, with $100/month profit after mortgage and expenses. The house was in their area. They could drive by it everyday, and they could even manage it themselves to avoid paying any property management fees.

That is the classic way. Look for a duplex or other property in your area, perhaps that one you drive by every day. Get it at a discount. Invest a little sweat equity so you can find quality tenants, and then hope it will grow in value down the road.

My way

I bought a Texas duplex last year for $270,000. It brings in $2650/month with about $1000/month after the mortgage and expenses. In case you didn’t spot that, I spent 1/3 of the money for the same rent, and thanks to a smaller mortgage payment, I pocket more profit.

To top if off, my duplex was brand new and didn’t require ripping out smoke filled carpet and tar covered wall paper. If I had the same money as those investors, I’d buy three of these duplexes and be pocketing $3000/month. Sadly, I only had enough to buy two duplexes.

Why invest in Texas? For one thing, Texas has shown bigger job growth in the past couple years than all other states combined. People are flocking there. Those people need a place to sleep. New construction is on the rise and the sheer volume is keeping the prices in check. Many people are ready to rent. By picking top quality units, I have attracted top quality tenants. And my property manager is ensuring there are proper background checks.

Finding experts to help guide you

On the TV show, they have Scott McGillivray. He is a contractor and income investment expert. That is the expert the people on the show use. He seems to know what he is talking about. Frankly, I would like to trade notes with him. I wonder if he is constrained by the nature of the show. If I was his client, there wouldn’t be so much TV-worthy material. I didn’t have any renovations to deal with. I wonder if he helps people that don’t invest in their own market.

It can be tricky to navigate a new market not in your backyard. That’s when I pick up the phone and call my expert, Jeff Brown. He is someone who does this type of research on a daily basis, nationwide. He looks for quality, affordability, and does rent analyses on multiple markets. If you call him, ask him how many of the past one hundred deals were investment ones. His answer will be “One hundred.” That is the mark of someone who isn’t doing investment real estate as a hobby. The man has been doing it since the 1970s.

I also talked to my father-in-law. He has owned rental properties for twenty years. He says he has usually done pretty good if he can make 1% of the purchase price each month. That’s know as the 1% Rule, and these people on the TV show were missing it by a long shot. For that much capital, they should be getting $7500/month. So instead of earning a cap rate of 12%, they instead are making about 4%.

With 100% occupancy recently achieved, I dialed up payments on my smallest loan by an extra $1000/month. I’m also replenishing my cash reserves by $1000/month. When the reserves gets back up to the level I want, I’ll increase monthly payments on the loan to an extra $2000/month. With an extra $12,000 in annual payments, we’re talking about knocking down a mortgage by $60,000 in five years. If I can step it up to $2000 in a year, the total in five years will be more like $108,000, which will have paid off the first mortgage.
 
Bottom line: By giving up the need to drive by my rentals, and finding the right experts to put things in motion, I got the same amount of rent and only had to put down 1/3 of the cash. And this includes total property management. It builds in a cushion where I can handle things if half my units are vacant. The results have been fantastic so far. I should be able to knock out the first mortgage in less than five years. The people on the TV show are going to take much longer to grow their portfolio.

The right way and the wrong way to invest in real estate

As I often do, I turned on the radio and listened to a popular anti-debt radio show. Someone called in because they were in the midst of a financial calamity.

  • They had lost their job in the past month or two
  • They had relocated to a new area
  • They owned two rentals. One was vacant and the other hadn’t seen a payment from the tenant for five months
  • The caller had filed for Chapter 7 bankruptcy ON THEIR OWN
  • All 401K funds were depleted, and this person was flat broke
  • This person had no attorney to assist with the bankruptcy, but for some reason did have an attorney involved with the real estate

I was a bit shocked at all this. As radio host said, Chapter 7 bankruptcy is the “atom bomb”. It’s where you nuke all debts and simultaneously give up all assets, except possibly your primary residency. The caller had just moved and was trying to rent out their previous residency, but was failing. The host informed the caller that everything, including their leased car was going bye-bye.

The caller tried to argue, and the host told them they were crazy for trying to do a bankruptcy without an attorney. One of his first questions was, “Why didn’t you sell the rentals?” Answer: “There was a tenant. I couldn’t do any showings.” That is the most ridiculous thing I ever heard! Let’s see if we can walk through all this and see what mistakes were made.

Rentals don’t have to be empty to be bought or sold

Rental owners buy and sell all the time. There is no requirement to empty the unit out to sell it. Perhaps the tenant was being belligerent and making it difficult if not impossible to conduct showings. This would certainly make sense if they were five months behind on rent payments. The tenant knows good and well that a new landlord would probably have them evicted with no questions asked.

Don’t allow a tenant to stay in your unit and miss five months of payments

It may seem obvious, but the caller appears to be doing the land lording themselves, and they are doing a terrible job. When someone is five months behind, it’s time to evict them. The chances of getting caught up and then being on time are near non-existent.

Maybe there is something else missing, like a tenant that knows the legal system and has managed to fight making payments as well as fight evictions. They’re out there, but they are few and far between. From everything I’ve read, tenants that get behind are usually taking advantage of the owners.

I highly doubt this person had decent cash reserves

One of the most critical aspects to owning rental property is having plenty of cash to handle vacancies, repairs, evictions, etc. Think 6-12 months of mortgage payments.

You must be ready to go through the rough patches where you aren’t collecting any rent. Without cash reserves, you will be forced to dig into other sources of liquidity like 401K or just about anything. And it will also drive you to panic and make rash judgments. Having adequate cash reserves can calm you down and allow you to weather Murphy storms.

For some things, you NEED the experts

I wouldn’t dream of entering bankrupcy without a highly competent attorney. This is an area you can really screw up. I don’t know the law and what all my options would be. I would prefer to avoid bankruptcy altogether, but if it happened, this is where avoiding legal bills can cost you a whole lot. This person instead of selling the rental unit, is essentially throwing away a valuable asset.

Another area where it pays to find top notch experts is property management. If they had a good manager, that tenant would probably be evicted and someone much better, more stable, and better qualified would be in the unit and paying rent. The rental asset would be growing in value, not becoming a nightmare.

Finally, finding someone to scout up a tenant for the other unit is a great place to invest cash reserves. I have used someone to ensure my final unit was rented, and if I get another vacancy, I wouldn’t hesitate to hire her again. This is outside my expertise and I very well don’t expect the property manager to serve my interests in that capacity.

The likely outcome

This caller is probably never going to THINK of buying real estate ever again. Debt is probably off the plate as well. That means the idea of finding quality property, renting it to well researched tenants, and having professionals manage it are non-existent.

The results? This person will probably do everything to clear out any remaining debt, and then focus on investing in index funds and other things. That means that they might build up some pile of cash to retire on, but they aren’t going to get that nice retirement. I doubt they will scrape together enough money to be enjoying big cruise trips, but instead, will probably have to get a supplementary job to make up for what they don’t have.

The thing is, they won’t know what they’re missing. Sure they’ll have some peace of mind about having no debt, but they won’t exactly be living the high life either. It’s a form of survivorship bias, where you don’t know what you’re missing, and hence happy with what you got. If they are able to scrimp together $500,000 in index funds by retirement, they’ll probably be pulling $20,000/year before taxes. Could you live on that now? What about in 15 years? They’ll never never know what it means to be pulling $10,000/month+, tax sheltered because they got spooked from sloppy DIY practices.

Diminishing returns

I’ve previously written about how I took the proceeds from the sale of our old home and used it to buy a big position in VNR, an MLP stock that is yielding almost 9% spread out in monthly payments. I am using the monthly distributions to payoff my interest-only 4% HELOC and pocketing the difference.

So what do you do when the stock goes on sale? I bought my position at a relatively cheap price of $27.85/share. It’s a good deal, considering the stock has fluctuated all the way up to $30 in the past year. But in the past month, due to an SEC investigation of one of their competitors (not VNR itself), the entire MLP sector has shed lots of investors. I have seen it hit bottom $24.23. Buy more? After all, buying companies with solid business but suffering from some emotional panic on Wall Street is a key strategy employed by Warren Buffet.

Well…that depends. While that’s a great price, I have to look at it through the lens of my entire wealth building plan. Let’s see what we can figure out.

Is this too much exposure?

My plan (not necessarily your plan) is to have rental property as my #1 investment with quality, cash flowing stocks as #2, and liquid capital as #3 to hedge my plays. I have already built up a very nice position in VNR, so if I had the cash to buy a similarly sized increase, I have to ask myself if that cash would be better spent knocking out a rental loan.

Knocking out a rental loan doesn’t have the same immediate cash yielding benefit as buying more stock. But the sooner you pay down a loan, the sooner you can sell and releverage that property into more real estate. Using prudent leverage, that same amount of cash can probably produce a higher yield over the years in real estate than buying more VNR. Hence, buying too much VNR could hamper my real estate growth.

What about the other parts of my wealth building plan?

Any good real estate portfolio needs cash to hedge things. At certain times, it’s best to put extra cash into your cash reserves. Instead of investing in other things, it’s best to stuff it in the proverbial mattress. That’s why when new money comes along, we need to see where it fits best.

From time to time, our cash reserves can get depleted and we need to shore things up before taking on new investments.

What will be my net yield?

If it’s not a big chunk of cash, but instead something smaller like $100, $1000, or even $5000, then it’s probably not worth it. The rule of thumb is that I get $7/month for every $1000 of VNR I buy. Even $5000 more of VNR would only yield $35/month more. That’s not even a 10% increase in my current monthly yield, so I doubt this is the right place.

Conclusion

Bottom line, I have a good position in VNR that should provide a nice monthly cash for many years to come. I don’t need anymore. Instead, I’m going to check the other parts of my wealth building plan and decide where to apply the next chunk of change.

Reading the darndest things

While waiting in a doctor’s office, I couldn’t resist flipping through a copy of Money magazine and reading their title article “101 Ways to Build Wealth”.

I predicted it would be filled with classic advice, like investing mutual funds, maxing out your 401K & IRA, open a 529, and several other things that don’t have enough evidence to back them up. Essentially, things I would never use.

I was mostly right. But what startled me was item #75 buried towards the end. It indicated that now might be the time to get into real estate. I was pleasantly surprised to see Austin listed at the top in job creation, as you can see in the attached picture to the right. The tip nicely pointed out how job growth is a strong indicator of rental markets, a fact keenly mentioned in the middle of a podcast interview with Jeff Brown.

It was delightful to see references to stocks I had already learned about from the Dividend Growth Investor. I have used his website to help develop criteria for adding dividend aristocrats to my wealth building plan. The fact that I had already heard of them made me feel like I was ahead of the curve slightly in wealth building.

The tips about mutual funds were spread throughout the article. I saw a recurring pattern where they would synonymously refer to mutual funds and stocks both as equity holdings. In essence, when people talk about holding stocks, they really mean stock-based mutual funds. The commonly preached mantra is that stocks are way too risky, and mutual funds are simpler a safer way to hold the same thing. No attention is paid to overall buy-and-hold stock performances compared to buying mutual funds from the perspective of wealth building. They really aren’t the same thing, and mutual funds aren’t inherently safer. Instead, mutual funds mitigate away too much upside for the sake of not enough downside protection. Combined with terrible fees, they are a horrendous way to build wealth, and the historical evidence proves it.

Basically put, real estate is the biggest component in my wealth building plans, and this article nicely made reference to it. Stocks also play a key role in developing another basket of income. But not mutual funds. I was glad that they didn’t totally avoid the subject of these two.