So long Murphy…until we meet again

As I received April’s invoices, I knew it would only be a couple more days and I would finally get paid…for all four rental units.

I bought these units last Fall, and have been waiting for a tenant for months. It has been tough. I called the agent they hired to find tenants twice.

This is part of the price for buying brand spanking new rental units. They aren’t occupied. Duh! Hopefully, this was the relative startup cost. My gut tells me that units with tenants may tend to attract future tenants because it shows that someone has decided the place was good enough to live.

It’s not ‘if’ but ‘when’ Murphy decides to visit

Whether or not I’m right about future tenants, this exercise has definitely put me through Murphy Training 101. When the property manager sent me my first batch of invoices back in September along with rental agreements, I was nervous when I noticed that only three of my four units had leases. But I knew we had set things up real good. And then the first check came in. After paying that month’s mortgage payment, I had plenty of left-over cash. Whew!

While that was good, I knew in the long run, we needed to be fully occupied, so I watched slowly, month-by-month. I was feeling a strong emotional desire to cut the rent rate and get someone into the unit. But my wealth building nature quickly interrupted that train of thought. I knew that would probably impact all future rents for the life of the property. It took me little effort to visualize how bad a $300 drop in monthly rent times 20 years would be.

You see, even if you raise the rents down the road, a drop up front would establish a lower overall baseline and take out a sizable chunk of total wealth. It would also impact the future sales price of the units as well. I understood this concept, but I lacked the real world, boots-on-the-ground experience to solve the problem.

So, when January rolled around, and we still had no tenant for the fourth unit, I called Jeff Brown. He quickly confirmed my assumptions about the negative impacts of cutting the rent. He explained how he had done a rent calculation and our mortgage broker had done his own, and they had both reached the same conclusion. To tie things up with a bow, he told me they had already a top notch pro to get those units rented. They had already rented several in that neighborhood, and the evidence was already rolling in that their rent rates were right on target.

Good things come to those who wait

There are some upfront fees. For one thing, they pay the agent who found the tenant out of the first month of rent. The property manager has also been paying to keep the lights on for several months, so that has to be paid as well. Finally, they had been keeping the lawn mowed. So I’m only getting about 35% of the total rent in April. In the Land of Investing Based on Fees, that is tragic and a ripoff. Such costs would never be tolerated. Instead, the recommendation would be to sell everything and put it into a low cost index fund.

But for those in the Wealth Building Society, this is fantastic. That’s because I’m leveraged about 3.5-to-1, we have our tenants building the equity of our investment, we don’t have to deal with much in repairs, and are smoothly cash flow positive with a nice cushion of cash. Next month, with all the one-time costs for a new tenant out of the way, should be even better.

Can your wealth building plan still net a good profit even if only 3/4 of it is in operation? Imagine that your mutual fund investments had taken a 25% hit. You would need 33% growth to recover from that. That isn’t our case. We have a fixed mortgage meaning despite the shortage of rent for the past six months, our loans have been paid off consistently and the estimated values of the units have continued to rise. Not bad for my first run in with Murphy after diving head first into rental property. But remain ever vigilant. Murphy will strike again. We must be prepared.

The power of liquidity

Earlier this month, my family moved to a new house. This time, we had much more control over the entire process. We bought our new house, took the appliances and other things that we wanted, fixed up the old house, and then put it up for sale. This was all thanks to our liquidity.

Cash empowers you to make a better deal

We were not in a crunch to negotiate on the new house with any contingency clauses. Asking for a contingency clause on the sale of your existing home can make it harder to get the best deal, because the seller knows you may be tight. Remove the need for that clause, and you remove the “cost” of that convenience.

We also took what we wanted from the old house. This included the refrigerator, the window treatments, the TV & mount up on the wall, and some other things. Basically, with them removed from the property before a single potential buyer saw it, there was no need to negotiate $2000 here for window treatments, or $1000 there on the house price over a $400 appliance.

With everything gone, the house looks way bigger. It’s already a big house, but removal of all furniture makes it even more appetizing to prospective buyers.

My father-in-law and I were able to fix the handful of issues before even talking to a home inspector, propping up the quality of the house. This removes the things the buyer can complain about and start negotiating over. It doesn’t mean there will be no negotiations, just that there will be less on the table to argue over, allowing us to get to the real selling price much faster.

What made it possible? The fact that I had a big chunk of cash in the bank. With that, I’m able to carry the cost of two mortgages long enough to find the right deal.

Cash is just the first requirement

Of course, this requires having a fantastic selling agent (which I do) as well as a solid neighborhood. Since they finished every house in this subdivision over a year ago and finally finished the roads, things are ripe for the taking. Given that the comps on the house were noticeably higher than the original purchase price, and the past three years of mortgage payments had knocked out a chunk of debt, we were poised for a good sale.

But don’t forget: cash is the first requirement. Without a lot of set aside cash, many of these options simply don’t exist.

With enough cash, we can take our time, get a good price on it, collect our equity, and replenish the bank accounts. If we didn’t have such liquidity, we probably wouldn’t even have done this deal, and had to pass on this fantastic new house.

The gap between fund performance and investor performance

One tool I have looked at a lot is Dalbar’s Quantitative Analysis of Investor Behavior, known by many as simply the Dalbar Report. It is a study that looks at the last 20 years of data. They have been doing this study for over 10 years. It a rolling study in that each year, they add the latest year and drop the oldest year. Then they look at how investors are doing that invest in mutual funds.

The results? Not good! At the end of 2010, the 20 year average of the S&P 500 was 9.14% while investors in mutual funds averaged 3.27%. Yikes! So does the report say WHY there is such a big gap between the index itself and investors? They claim it is investor behavior and basically their fault for only holding a given mutual fund for less than three years.

You see, Dalbar sells the report mainly to financial advisers telling them that not only must they help their clients pick good mutual funds, but they need to do a little bit of hand holding and have them stay the course when they pick a mutual fund.

I investigated criticisms of the Dalbar Report a bit, curious what members of the financial community thought of this. After all, how often have you heard these damning statistics against mutual funds? Did your HR department send this information out in an annual notice along with other news about 401K options? Didn’t think so.

It appears there is one big concern with Dalbar’s methodology. What I read was wordy, but could be summarized simply as, the first ten years were during the Great Bull Market, while the last ten years were during the Lost Decade. Strangely, this criticism seemed to attack the explanation of the gap, meaning it wasn’t 100% the investor’s fault, and that comparing these two figures was like comparing apples to oranges.

The Great Bull Market was a highly unusual time period. It stretched from 1980-2000. The equities markets grew strong during this whole period. If you had a lot of money in the markets at this point in time, you would have done well. But when 2000-2001 hit, we got a major market correction. What made things much worse, was that another correction hit in 2008. In my personal research of looking at S&P 500 data going back to the 1950s, it appears that we encounter a market correction about every 10 years, so missing one for 20 years almost demands this double correction.

But at the end of the day, what does it matter WHY there is such a gap. What is critical in putting together a wealth building plan is to look at investor performance and realize that mutual funds don’t work. This fact of there being ten good years followed by 10 flat years just proves the existence of sequence of return risk and how insidious it can be. To solve this problem, we don’t need to debate whether or not investors are to blame for their actions over the past 20 years. Instead, we need to build a plan that assumes this behavior will continue, as it has each year since Dalbar began their studies.

We need a combination of tools that will help us build wealth without causing us to panic during down years, like rent producing real estate. Buying a handful of stocks that not only have a solid history over decades, but also involve products we fully understand would also be helpful. Finally, putting a chunk of our accumulated wealth into a EIUL, a vehicle that was designed to avoid losses as well hedge against inflation and future taxes. All of these tactics, when used together can provide a much more effective approach to building wealth. No longer are we betting on the appreciation of mutual funds, but instead accumulating assets that will yield cash for us in retirement with protection from the tax man.

Throwing out old advice that didn’t build much wealth

We recently moved. My family needed a bigger house, and we looked for some time before finding the perfect place. In the process of packing for the move, I came across an old book. I had bought it just a couple years after finishing college and entering corporate America.

At the time, I was into the full blown, set aside the max 15% in your 401K deferred savings plan. In fact, I had increased it to 18% and was reaching the max annual set aside.

Advice I read years ago

I had read this book to learn all about stocks, bonds, mutual funds, futures, options, REITs, gold and real estate. As I was now sifting through all my books and deciding which ones to throw out for this up-and-coming move, I leafed through it, remembering when I had first read it.

I quickly scanned the section on investment real estate. I was shocked out of my mind! It never mentioned rental property. Instead, it covered the idea of buying real estate with the idea that it will appreciate over time, and then eventually selling it. Not one iota talked about rent, cash flow, landlording, the famous 1%-rule, 50%-rule, etc. I felt the book was really lacking. Essentially, it said that buying a piece of property and waiting for it to appreciate was risky, not very diverse, and pretty much a no-go.

They quickly moved on to REITs, which are a type of stock holding where they invest in real estate and distribute earnings to the share holders. It quickly pointed out how this was much less risky, didn’t tie up your investment capital for years, and let you avoid the expense of closing costs if you had bought the property yourself.

Costs again?

The focus on costs is nothing new. Some people drop the idea of real estate in a heartbeat simply due to the closing costs. That is sad, because real estate is one of the biggest ways that the rich become rich. Things like REITs and MLPs are regulated to pay out 90% or more of their earnings in order to maintain their tax advantaged status. That’s nice, but at the end of the day, they are just stocks. Unless you are buying on margin, you can’t get the same leverage as you can with real estate. When you consider that real estate grows at around 5%, that doesn’t seem like much. But if you purchase rental property with 25% down, then you’re cash-on-cash growth rate become more like 20%. Show me a REIT or MLP that beats that.

Another important thing to know when comparing real estate and REITs is that just because you own a REIT, doesn’t mean you escaped closing costs. You might not have to show up at a closing with a check in hand, but who do you think pays the REIT’s closing costs? They are part of the bottom line in earnings, so you are still paying for them.

By dodging the closing costs, the property really isn’t yours, and you don’t get the direct rent or cash-on-cash return of buying the property yourself. You didn’t take the risk so you don’t get the profit. Instead, you get what’s left after the REIT pays its manager, staff, promotional materials, managerial fees, and a dozen other things needed to maintain their structure. You are, as they say, at the bottom of the food chain. You receive a fragment of what’s left. If you invest $25,000 in a rental vs. $25,000 in the REIT, the outcome will be very different.

Talking about investment property without rent is incomplete

To have a section where all they talk about is appreciation is only half of a conversation. It would have been fine to mention that rent may bring in money, but there is the risk/cost of landlording. That would have been better. But that was completely left out.

I really appreciated how the book had a running theme of mentioning risk. For example, in the chapter about futures, they clearly describe how you can make money. But they are quick to point out that it’s very risky and is one of the things you really can lose your shirt. In the section on margin trading, that is also risky. It is the sort of thing where you may start with putting in $10,000, but it’s not hard to get a call from your broker indicating you have to either pony up another $30,000 or lose your original investment.

Back then, I liked learning more how those markets work, but I always appreciate that they said these more “exotic” investments were only for experts. Now, after having read “Where are the customer’s yachts?”, I have sincere doubt that there are any experts in these exotic investments. They are rare and hard to find. Ben Graham and Warren Buffett are the exception, not the norm. So whenever I read stock news, I take it ALL with a grain of salt. The only advice I read closely is from those who have made millions and billions over the decades

Time to throw it out

Since this was about packing, the question in my mind was, “Will I ever read this book again?” Seeing that this book was written for people that are worried about market risk and want to avoid exotic investments, I could tell I had outgrown it. Anyone who read it would be steered towards mutual funds and tax deferred savings plans. I wouldn’t recommend it to my dearest friends. I think reading many of the columns by Jeff Brown would be more constructive and lead to better wealth building. Hence, I threw it out instead of packing it up.

HOW and WHEN to invest in real estate

In many previous columns, I have discussed the benefits of real estate, but maybe you felt like something was missing. I have keenly mentioned the WHYs of real estate investing.

  • It has some of the best tax laws on the books (depreciation anyone?)
  • Prudent usage of leverage makes it top stocks
  • Adequate cash reserves can mitigate the risk involved
  • Everyone needs a place to sleep at night meaning there will always be renters
WHY we do something isn’t the only question we should ask when thinking about a plan. We should also investigate HOW and WHEN. These are very critical to a successful retirement plan.
WHY gives us the reason to pursue something. But once we decide it’s a good idea, we have to discover HOW to do it and sometimes more importantly WHEN to jump in.
These second two questions we ask ourselves can be the different between success and failure. Many people that decided to get into real estate learn lessons the hard way. Learning lessons in RE can be expensive. Can I give you an idea of how much? 
Do you know HOW, or should you find someone that does?

Let’s say you buy an investment duplex and manage to sign up some tenants. A year from now, one of them loses their job and decided to stop paying rent. Do you know HOW to handle that? 
If you decided to save a little money and manage it yourself, you have to decide on whether or not to evict the person, or let them live in your duplex rent free. The mortgage payments aren’t going to stop, so you are effectively paying them to live in your unit. Let’s say you decide to evict them. Do you know the state laws regarding due process? County laws? If you don’t follow the right process, your tenant may get extensions and be able to stay much longer than your expected, all of it potentially at your expense.
I don’t think I would make a good landlord and I also have a full time career and family that I focus on. That is why I have a property management company to handle all this. They do the background checks, handle the leases, collect the rent, and if needed, evict the tenants. That is HOW I hire a good expert to serve my needs.
HOW do you even find good property to invest in? There are lots of units for sale. I almost bought one not far from where I live. We visited the unit, walked through it, and got a feel for the place. I thought it looked alright. Then when I talked to Jeff Brown on the phone, he asked me why the place had been on the market for SIX MONTHS. If this place was a good deal in a good location, why had no other investor in the area scooped it up?
I knew then and there that this place WASN’T good, so I let it by. Later on, I got the properties in Texas I have written about before. And they have done great. We have 75% occupancy and are still widely cash flow positive. I’m just hoping in the next month or two, we can find a tenant for the fourth unit. In fact, Jeff Brown hired someone specifically for that task; to find tenants for the units in that subdivision not already rented.
That is why I have experts like Jeff Brown and my property management agency. They are hand picked to help me complete the HOW of real estate investing.
WHEN should you invest in real estate?
This question is very important as well. I would generally say, the sooner the better. Many people suffer because they wait until everyone around them is doing something before they feel it’s safe to “get into the water”. That is usually the worst time. No one buys a mutual fund BEFORE it has sprung into value. Sadly, that is the time it needs to be bought. Once people discover its value, its price will start to rise. Those that wait until everyone else is onboard have probably missed the major upswing. And then when its bubble pops, they may be the last ones to sell, losing much.
To get into real estate I could have waited until my 401K money had recovered more, but who knows how long it would have taken to actually get back to my original value. Instead, it was better to eat whatever losses I had, and get moving on things. So my first decision was to call up that financial institution and start the withdrawal process.
But the next step, WHEN to buy a rental duplex, is trickier. Again, that’s why I have people like Jeff Brown that have been doing this for over forty years. He knows the market, and I’m counting on him to help tell me WHEN to sell, WHEN to move, and WHEN to use other arrows in my quiver of real estate investing.
That is they key reason to finding the right expert. They know the HOWs and the WHENs of what you are trying to do. The right expert may have higher fees, but its usually because they will generate more profits for you! If you do this the other way around, and look for the cheapest option, you will undoubtably have far less success.
Sorry if you were looking for a column that told you in no uncertain terms HOW and WHEN to invest in real estate, but the truth is, there is no single rule for that. Instead, its based on how much capital you have, where you can get in, what your needs are, how much extra you can save every month, and whole host of other factors. That is why we need top notch experts that understand all this to help form a plan, instead of just throwing money into some deferred savings plan and hoping it will work.

Is your net worth built to survive inflation?

Two big factors that can impact your net worth are taxes and inflation. In this posting, I want to discuss inflation.

Essentially, the government pumps out a certain amount of money periodically. The Big Idea behind this is to smooth things out by having a steady increase in money supply. You can debate whether this works or not in some other forum. I only want to discuss how this impacts your net worth.

If your money is invested in fixed instruments like treasury bonds, CDs, or fixed interest bank accounts, then inflation can be very hard on your net worth. A pile of cash can lose its purchasing power when it grows at 1% (or less) while inflation grows at 3-4%. Inflation is a complicated concept. There are a couple of ways to look it up. One is the base rate that the Federal Reserve lends money to banks. Since banks make money by adding a little profit on top of this, all other interest rates are above this. Given that you can borrow money today at rates like 3.5%, you can imagine how low the Federal Reserve rate is.

Another is called the Consumer Price Index (CPI). The CPI is essentially a basket of goods whose purchase price is tracked periodically. As the prices rise, an estimated rate of increase is derived, i.e. inflation. But going back 20-30 years, we find that this basket of goods has been altered on multiple occasions. For example, in recent years, beef and oil have been removed from the CPI. Official inflation metrics may report somewhere in the neighborhood of 4%, but the price of beef has risen much faster than that in recent years.

Suffice it to say, the subject of inflation can be talked about to death. But it’s real and here to stay. Which means we must deal with it when it comes to retirement investments. Take a real example. Imagine you own a home and need to replace the roof. If you do it right now, there is a certain cost. What if you need replace the roof again 25 years from now when you are retired? The price will have certainly risen. Other home maintenance costs will slowly rise as well. Fixed income instruments don’t lend themselves well to handling this rise in home repair costs. Other things that increase in cost is groceries, medicine, and gasoline. All these things are good you will need in the future when you are retired. Simply paying off your home mortgage won’t shield you adequately from needing to deal with this.

Assets that weather the storms of inflation

Some tools we use for investment purposes are ravaged by inflation while other things tend to compensate. One asset that can handle inflation is rental property. In times of inflation, rents tend to rise along with the value of the property itself. They may not grow at the same rate, but generally, rents rise. Now in past articles, I have presented numbers on the value of real estate based on NO rent increases. That was to make sure things were sound without depending on these increases. Sometimes rent doesn’t increase when inflation grows. Or at least it might not rise immediately. But in the long run, and real estate is a long term investment, rents rise and that’s a good thing.

Do you know what else weathers inflation pretty well? Dividend aristocrats. These are long term companies that have been paying increasing dividends over decades, some more than 50 years. These are from companies that are producing quality goods that are able to raise the prices of their goods in line with inflation. By owning positions in some of these companies, you can keep receiving increasing dividend payments that tend to compensate for inflation.

The strategy to building up an inflation-proof plan

Okay, that headline is misleading. Nothing is inflation-proof. Maybe inflation-resistant. Every time this country has suffered high levels of inflation, the reasons have varied. Some people think we are poised to enter a high level of inflation, or even hyperinflation. I’m not sure I agree with that. Those opinions have to be counterbalanced by whether the ones making the boldest predictions are selling.

To get this conversation on track, the question should be, what strategy must I use to handle future inflation?

  1. Develop a good reserve fund. This is where I agree with the many pundits who are talking about building up a 6-12 month reserve of liquid cash, like in a savings account. 
  2. Eventually, owning a home with a fixed-rate loan is a good thing. While property taxes and homeowner’s insurance may rise, a fixed payment of debt will tend to shrink as inflation grows. This also helps you avoid rising cost of rents. It’s no reason to buy a home RIGHT NOW before having your cash reserve built up, but eventually, a fixed house payment will help reduce the risk of being on the wrong side of rising rents (your own rent!)
  3. Start acquiring cash flowing rental properties and dividend paying stocks. As dividend payments come in, reinvest them periodically, and as extra rent comes in, use it to pay off investment debt.
  4. Plan to increase your inputs in various investing vehicles each year to compensate for lost power of the dollar.
This list, while seemingly detailed, is very non-specific on when to do each, or how much time it should take, etc. That’s because everyone is different. You can send me a note if you want to chat a la email, skype or on the phone to talk about things in more detail. There are no promises to be made when it comes to dealing with inflation, but certain approaches are better than others. The bottom line is that investing in real estate and cash yielding stocks are good tools that have a long history of helping to compensate for inflation. Both of these things are better than gambling on mutual funds being able to match or exceed inflation through the pure appreciation of mutual funds.

Building net worth using rules of thumb

We’ve been discussing net worth from many different angles lately. I wanted to visit the subject of real estate, and how several of the popular “rules of thumb” would work towards growing our net worth.

You just found a half of a duplex for sale. It’s new, meaning there aren’t many big items of deferred maintenance sneaking up on you. It is listed for $100,000 in a great section of town. After sizing things up, you pull out Thumb Rule #1: Rent it for 1% of the purchase price per month. That would mean we can fetch $1000 a month. Local research shows that similar units from the same builder are fetching that much rent, so you should be able to find a tenant. So, is $1000/month going to work?

After I dig up one of those handy online mortgage calculators, I punch in $100,000 value. Let’s assume I already have hit the four mortgage limit, meaning I will have to put down 25%. This means I will get a mortgage of $75,000. After getting off the phone with my favorite mortgage broker, he says he can probably lock us in with a 30-year fixed, 4.5% loan. This mortgage calculator happens to have a place to enter property taxes and PMI, but not insurance. I zero out the PMI, but decide to bump up the property taxes to 1.5% to represent taxes and insurance. It spits out a required monthly payment of $505 and change.

Time to check Thumb Rule #2: Does the rent equal or exceed PITI? PITI is what real estate investors use to refer to Principal + Interest + Taxes + Insurance, i.e. the total amount needed to keep the bank happy. In this case, the answer is a clear yes. In fact, our rent is almost double the mortgage payment. In highly complex investor-speak, this is cash flow positive.

But that’s not everything. Let’s assume we have a day time job that supports us, allowing us to invest any extra rent into the property. In order to do that, we need to hire a property manager. Hot tip: good property management ain’t free. Duh! But once found, they’re worth every nickel. You want to answer the call at 2:00am about fixing a stopped toilet? I sure don’t. Let’s assume we can find a property manager with good credentials that charges 10% of the gross rent each month, and gives us the rest + a nice emailed report once a month. After shaving $100 of the top, we get a nice automated deposit of $900 sent to our checkbook each month. Yum!

Still looking good, right? Dang, don’t say that! That would be like writing an engraved invitation for Murphy to show up and take pot shots. Now that I think about it, why don’t we factor Murphy into our plan? In fact, hoping you don’t into trouble is a terrible strategy in building any wealth plan, especially investment real estate. Time to deploy Thumb Rule #3: Assume 50% of rent is eaten up fees, taxes, insurance, and repairs. Is there still enough to pay the bank’s Principal + Interest? Considering we started with $1000, that would mean we only get to pocket $500. Uh oh! Our mortgage payment was $505?!?!

Not so fast! The mortgage payment stated above includes taxes and insurance, and we also had to pay $100 to the property manager. In other words, taxes, insurance and property management fees are all included in that $500 hit we took with Thumb Rule #3. If we go back to the mortgage calculator and zero out that property tax field, then we can get purely Principal + Interest. Crunching it yields $380, which is still less than the $500 we get to pocket from our renters.

This means we can still pay the mortgage and be cash flow positive with $120 to spare. But we’re not through yet.

Ever heard of O’Toole’s corollary? Murphy was an optimist. We have factored in a decent possibility of having extra expenses that are beyond our control into monthly rent. But this assumes we have rent. What if the unit is vacant? One thing positive: no fee for the property manager. We still have to send the bank monthly mortgage payments. So, let’s invent Thumb Rule #4: Set aside 12 months of mortgage payments. That adds up to $6000. Round it up to $10,000, and you should feel pretty good sleeping at night.

What does this add up to? Let’s fast forward five years. Mortgage calculator says that we should have gained about $7000 in equity. Remember how the 50% rule left us with $120/month of spare cash? Added up over five years, and we have another $7200, resulting in a total growth of over $14,000. Divide it by our original investment of $25,000 down, and we will see over 56% total growth of our net worth. Take the fifth root (five years), and we get an annualized growth of about 9.4%. Not bad for a highly conservative estimate that includes getting hit hard by Murphy.

If there is an ounce of appreciation, or if we invest that extra cash flow to pay off the mortgage, we will only do better. If rent increases at any point, I won’t complain. The trick is finding the right piece of property and having the discipline to set aside the cash to insulate us from issues. We must also not tap the cash flow. By plowing it back into the rental property, our success will be much stronger. For example, if we have 100% occupancy for all five years along with no repairs, but still no appreciation or rent increases, our annualized growth rate could soar to over 17%. Show me the mutual fund that works that well after factoring in the risk of Murphy taking shots at you.

Thumb rules work until they don’t

So far, we have examined a piece of property on paper using spreadsheet formulas. Spreadsheet-based investing can be risky and detrimental to your financial health. That is because too many people think that is where the analysis ends. Instead, this is where things begin. When a piece of property passes all these checks, it means it MIGHT be good enough, but requires more research.

Don’t shoot for a property SOLELY BASED on these rules of thumb.

There are lots of small factors that can shoot deals out of the water. Remember me mentioning at the beginning that this was half of a duplex? One of the first questions this should spur is whether or not each unit has its own utilities. Tenants that share utilities like water historically consume more because it doesn’t hit them directly. There is also a side effect that if a water main breaks, it doesn’t get fixed as fast, because the cost doesn’t get passed on to the tenant. Water is one of the most damaging things to housing. Delays in repairing broken water pipes can translate into longer term maintenance costs as well as less net rent in your pocket due to inability to increase rent to compensate. Hot tip: split or joint water meters don’t often appear on the MLS or any website. It requires boots-on-the-ground research to track down.

Another factor is the agent you use to find rental property. If you’re shopping in your local area, don’t bet on the agent you used to find your primary residence. They may get you in for showings, but they probably won’t have much insight into the investor side of real estate.

Simply put: if something appears too simple, then it probably is. Find a piece a property for sale that meets are the rules of thumb, but it’s been listed for six months? Why didn’t the other investors in your area already scoop it up??? Spreadsheets may be good for turning a long list of properties into a short list, but get on site, check out the area, and call up an expert in this area to double check things.

Real estate can build wealth

Emphasis on “can.” You can also buy a chunk of swampland, and spend all your money trying to drain it while fighting off the alligators. But that shouldn’t be your reason to skip real estate altogether. Read, read, and do more reading. Visit places like and learn as much as you can. Never stop. Real estate provides some of the best means to building long term, cash flowing wealth available combined with great tax laws such as depreciation. If you want to talk more, drop me a line.

Advice based on risk but not net worth doesn’t cut it

I was listening to a radio show recently, and the caller was debating with the host the fact that while he held mutual funds, he had also invested in stocks over the last 10 years. Given that I have been writing several articles about net worth lately, I felt particularly attuned to the lack of attention to net worth. When the host asked how much he had in savings, the caller answered $96,000. When he next asked how much he had in the stocks, the answer was $47,000.

The host immediately went on the war path. He slammed the caller for having a broken risk meter. He asked the caller if he really thought he was going to “beat the odds.” He told him he was playing with fire. The fact that the caller had bought some tobacco stocks because people haven’t stopped smoking was dismissed as a frivolous strategy. The host indicated he probably knew more about stock investing than the caller, and that he flat out didn’t hold any single stocks. The call kind of ended there. I was a bit stunned!

Can you spot the rights and wrongs amidst all this?

First of all, the focus of the host was all about risk. The fact that the caller’s total net worth was just shy of $100,000 never entered the foray of discussion. The host chewed him out for buying stocks (making good on-the-air schtick), but didn’t get on his case for simply not saving enough. The Federal Reserve bulletin which comes out every three years shows that the average person in their mid 50s has around less than $60,000 in retirement savings (page 28), which is way low for building a retirement plan. The caller was a little better, but not much. Considering he had been investing in stocks for at least 10 years means the caller must at least be in his mid-30s. The fact that his net worth was way low for a good retirement was flat out not covered. The caller doesn’t seem to understand the truth about net worth and the reason we need to build up a portfolio of performing assets.

From there, the conversation went downhill. The host of the show berated his caller for basing stock buying decisions on what products are commonly used. The caller clearly knows that tobacco products aren’t going away anytime soon. In fact, the most successful investors of our day, including Warren Buffet and Ben Graham, preach that we should only buy companies we truly understand. If you look at all the products you use for your morning routine, you may spot things that millions of other people are using every morning as well. This leads to some potential stocks that deserve additional research and analysis to consider for purchase. While the host was correct that study after study shows people can’t beat the averages in day trading, buy-and-hold over the long term has been shown to succeed and build wealth, if you know what you are doing. As Warren Buffett says, “I buy on the assumption that they could close the market the next day and not reopen it for five years.”
The host said this guy had too much in stocks. That is something I agreed with. But the host implied that the answer was mutual funds. People buying mutual funds have a long term average performance of less than 4% annual growth. Not good enough! This caller needs something with a better, long term, double digit growth factor. The answer is investment real estate. It allows us to use safe amounts of leverage while taking advantage of some of the best tax laws on the books. Over the long run, real estate typically has a better appreciation rate than stocks. But don’t base your analysis of a piece of rental property on appreciation. Instead, base it on no appreciation and no increases in rent. If it’s in a good location and built with good quality, then you may be closing in on an opportunity. The less deferred and potential maintenance the better.
I’m sure if the caller had mentioned the idea of real estate backed by debt, the host would have shot that down in a heartbeat as risky and especially dumb when debt is brought into the picture. There definitely is risk involved, but that’s not reason to drop the whole idea. Instead, we need adequate cash reserves to mitigate this risk. There WILL be vacancies, repairs, and other costs to deal with, all which require a certain amount of easy-to-reach cash. Assuming Murphy will make an appearance and planning to deal with that will let you sleep at night.
The fact that the host was driven by risk and didn’t discuss net worth tells me he is imbuing his callers with a fear-based investment strategy. “Go for mutual funds. They are your best tradeoff because they let your money grow faster than CDs yet protect you from the total brunt of market corrections.” Okay, the host didn’t say that, but he might as well have. Fear isn’t enough to build a retirement plan. The diversity of mutual funds may protect you from certain losses, but even worse, they also protect you from recoveries even more.
In the math of losses and gains, you need gains bigger than your losses to get back to where you started. 20% loss requires 25% recovery to get back to where you started. 50% loss, 100% gain. We call that stacking the deck against you! Instead of wasting your time searching for the right mutual fund, find someone who is skilled at pursuing rental property and has a proven track record of building net worth for their clients. That is something that will, in wealth building lingo, cut it.

The truth about net worth

In this latest installment of my series of net worth articles, I dug up the Federal Reserve’s June 2012 bulletin where they pour over the results of the 2010 Survey of Consumer Finances. They conveniently include results from 2001, 2004, and 2007 as well, making it easier to compare certain statistics to check the trends. This document has a lot of detail and can make for a dry read when you try to read every detail, but my focus was on net worth. How much are people saving? In what ways are people saving money? What about debt? And what are the rich doing, compared to the rest of us? Anything we can learn to benefit our own wealth building

First, how is your own net worth stacking up?

Most of the tables in this report are broken down by either income, age, or ethnicity. To read the tables regarding income percentile, you need to first find out what income percentile you are in. If you look at the table below (from page 8), the first set of boxed income shows the median income rates for each percentile. Which bracket of income are you in?

Remember, median is half above, half below. For example, half of the people in the 60th percentile made above $71,700, and half made below.

Fed Reserve 2012 bulletin – Income by percentile and age

As a bonus, I also drew a box around income levels based on age. Where do you stack up? It appears that in general, as you get older, you make more money, until you reach retirement. It seems that people aren’t making as much in their retirement years. Is that a problem? Is it what you were expecting? If that isn’t in your plan, you may need to recheck things.

If you flip to page 17, there is a chart showing net worth based on both income and age. Using your income percentile you just figured out, check out the median net worth in thousands of dollars. Are you above or below the midpoint?

Federal Reserve 2012 bulletin – Net worth by income and age

Like the previous table, I also included net worth by age. Where you do rank in that? This makes me feel good, because I’m ahead of both. But that isn’t the final answer in this article.

The real question is: do I have enough to retire? I’m not there yet, but my plans should carry me there. What about you?

Another nugget of knowledge is how net worth has shifted since 2001. The table above lets us quickly look at previous years. Net worth for all families from 2001-2010 ranges $106100, $107200, $126400, and $77300. What do you think would account for a 17% increase in 2007 followed by a 39% drop?

Rises and drops in net worth are based on where people have invested their money. The two biggest things people are investing in are 401K plans and primary homes. Those both took a big wallop in 2008, and people’s net worth suffered. My own net worth is still 20% down from where I was before the 2008 market correction. It’s part of the reason I realized I needed to get out and find something better.

These are good reasons to start tracking your net worth. How do you track with these trends? Could you handle a 39% drop in net worth if you were in retirement? If you are investing in the same things as everyone else, then that is what will happen! But if your net worth doesn’t suffer from these types of corrections, you may have developed some adequate financial insulation. No way to tell without tracking things yourself.

One of the reasons real estate does so well as a wealth building vehicle, is because even when the value of your property may take a hit, you will keep collecting rent. As an asset, it will keep yielding returns. You don’t have to sell when your property value drops 20%. If your money is in a mutual fund, enough other people may evacuate the fund when it takes a 20% hit that the manager closes it and moves your money to another fund anyway, even if you didn’t want to!

Hopefully this report will help you notice when you see an article from a finance magazine, or someone talking on TV or radio. Are they preaching how investing in our 401K tied in with the magic of compound interest will give us a huge savings? So, where are the people saving up huge chunks of retirement money in mutual funds? That last chart says that the median person in their 60s only has about $200,000 dollars in net worth. How much do you think is in accessible cash vs. home equity? I have been hearing this message for 15 years, so I figured this report would show it, but it flat out doesn’t.

When you hear your financial advisor saying he or she will help you build a portfolio worth over a $1 million, give him a double take and ask him if he really can place you close to the top 10% of people! That is what he is trying to sell you. The chart above proves it. The question is, are you buying? Ask him to show you proof that his other clients are doing this well. If he hems and haws, and tries to show you history of the market instead of history of his clients, run for the door. He is just trying to sell what’s on his shelf, not what’s best for you.

The report goes on to indicate that cash value life insurance is held in increasing amounts by wealthier people, but overall cash value life insurance assets declined from 2007 to 2010. In fact, all asset classes declined, probably due to people being able to save less and instead consume their income to deal with the economic downturn.
Page 42 has a very clear picture of assets held by people of a non-financial picture.

Federal Reserve 2012 bulletin – Value of non-financial assets

In 2010,

  • In first place, 47.4% of non-financial assets held by people was the equity in their primary residence. 
  • Business equity was in second place at 28.2%. 
  • In a distant third place is other residential property, which would extend to rental property at 11.2%. 

To sum it up, these non-financial assets (which also included vehicles) add up to 62.1% of the total assets people have! With this chart totaling roughly 2/3 of people’s assets, and primary homes being almost half of that, people are investing 1/3 of their money into something that doesn’t generate cash flow in retirement. You may say it keeps you from making a mortgage payment, but that only works if you are setting aside the same amount of money you used to pay on your mortgage into the other cash yielding investments. If you are sitting in your paid off home, and expecting to get by on the measly income from your 401K, you are in for a huge shell shock. Time to brush up on your Walmart greeting.

Looking for more information about rental property, the report says that 14.4% of families own some form of residential real estate, including second homes, time shares, 1-4 family rental properties, etc. Unfortunately, it is hard to break out which types of property are generating which types of cash flow. Second homes don’t yield cash flow. They may generate good family times (something to NEVER underestimate), but they won’t fund your retirement.

Sadly, for a report extending 80 pages, there is little found when actually searching for the word “rental.” It appears that few people have rental properties, compared with the grand scope of everyone, so there are few questions asked in the original survey to gather this type of information. In fact, this may indicate the lack of rental property. If lots of people owned rental property, it would probably become one of the key questions of the survey. I hope this changes, considering 1 out of 8 Americans is a real estate investor. If as many as 11% of people in this country are investing in rentals, the Federal Reserve should start getting more concrete data on this. It might shed more light on the success and validity of real estate.

The Rich own real estate and businesses

One thing is very clear. Looking at page 49, at the breakdown of non-financial assets across income percentiles, the rich have more real estate and business equity than anyone.

  • The top 10% hold a median value of $475,000 in primary homes, $320,000 in other residential property, $200,000 in non-residential property, and $455,000 in business equity. 
  • When looking at the next group (80-89.9% income earners), this drops off to $250,000 primary home, $120,000 other residential property, $58,000 non-residential property, and $82,400 in business equity.

I know that is a lot of numbers, but it speaks plainly. The rich own real estate and the rich own businesses. The rich keep doing what makes them rich, meaning they didn’t become rich through one mechanism and then suddenly switch to real estate and business. If that was true, we’d see another chunk of statistics reflecting the people that had become rich, but not moved their money into real estate and business. In other words, if you don’t invest in real estate or build your own business, you aren’t going to be rich.

The study also asks people that run one or more businesses, how many people work in them. The median point (half above and half below) for the number of employees per business was two, showing how half of the businesses in this country are comprised of 1-2 people. That should be a positive sign to all of us that we can indeed form a business. The report was clear that businesses with more than 2 people accounted for 79.5% of the value of all such businesses. But remember, the first step towards building a big company is to build a small one. No business started out big, already worth billions of dollars and with thousands of employees. But what’s more important is that no business must become that big for the founder to become relatively rich.


Looking at the liabilities section, mortgages against the primary residence is the biggest factor, accounting for 74.1% of all debt. This has dropped barely from 75.2% in 2001. An interesting nugget in the world of debt is on page 63, where it shows total amount of debt, broken down by percentile of income. The top 10% of income earners hold more debt in primary residence, other real estate, and other things. While they have more credit card debt, the median was $8,000, which isn’t a huge amount for such high income. The big difference is holding $180,000 in other residential real estate compared to the 80-89.9% which hold only $88,000. This is a sign of leverage, and the rich understand this. By taking out extra debt to buy rental property, second homes, and other types of real estate, they can add to their net worth.

Fed Reserve 2012 bulletin – Debt by category and income

It also makes sense that most people, even if they aren’t rich, take out a mortgage to buy a house. Mortgages are one of the best wealth building tools we have. It allows us to build up net worth with a limited set of resources. If we tried to save our way towards a 100% cash purchase of a primary home, we would lose so much opportunity, it would outweigh the interest cost of the mortgage. Considering prime, owner occupied 30-year mortgages are now being sold with 3.5% interest, there is no better time  to get one.

It is also a sign of confidence that this country isn’t full of people carrying around $100,000 in credit card/student loan debt, but instead a more temperate truth that most people carry a modest amount of consumer debt that can be tackled. Many people debate whether or not student loan debt should be considered as evil as consumer debt. With consumer debt, you are buying things you want, but arguably don’t need. Student loan debt is to purchase an education that it meant to be a stepping stone towards a long term career which will yield a cash flow. The trick is the cash flow part. If you get an expensive degree at a high price school that doesn’t produce a decent job, you may have picked the wrong path. Standard 4-year college isn’t the only answer either. Some schools will let you transfer credits from a 2-year community college, allowing you to effectively discount part of your education. Another different path are vocational/trade schools. They also can produce careers. College isn’t for everyone.

Bottom line, we shouldn’t fear debt. After all, the rich use good debt to growth their net worth. With a proper view of bad debt (consumer) and good debt (investment/leverage), and a focus on developing cash flowing opportunities and assets, you have the means to build a business and real estate portfolio to grow your own wealth over time.

What is your net worth?

You probably know what is in your checkbook. Most people I run into have some idea how much money they have. I know a handful of people that don’t, but they are few and far between. Face it, it’s natural to track it, since we need to know if there is enough to use our debit card.

But the balance of your checkbook isn’t an important metric for building retirement wealth. To see if you are succeeding or failing on that front, you need to be able to calculate your net worth.

  1. First, biggest step is to quickly and easily tabulate all your bank accounts (do you have more than one?). 
  2. Next, add up your big assets. This includes things like the value of your home. Other real estate. Some people throw in cars. Me? I don’t count cars, because the valuation is always dropping, it’s never worth that much the day you sell it, and in the end, WHEN I plan to sell it, the value has dropped too low to contribute much to my net worth. 
  3. Finally, add up all your debts and liabilities. Basically, to whom do you owe money? Numero uno should be the mortgage on your home. Throw in credit card debt. Auto loans. Me? I have a gigantic liability that I’m going to have to pay the IRS next year at tax time: the rest of the penalties for cashing in my 401K to buy cash flowing rental properties. My estimate is that I will owe 50%. 20% was withheld, so I cranked out what the other 30% was, and penciled that into another column of my spreadsheet. 

Sounds like a lot of work, right? If you have online banking, see if they let you enter other accounts. Mine does. They integrate with lots of 3rd party systems, effectively logging in and finding credit card balances as well as mortgage balances from other lenders. My bank also lets you enter in a street address to a piece of property and then looks up its estimated value from Zillow. Finally, for those accounts they can’t look up, I can manually enter the amount. A rough estimate, I know, but useful in glancing at my bank’s pre-built “Net Worth” report. I have found that this report is pretty handy, and gives me a good readout on exactly what my net worth is.

But the real question here is: WHY do I need to know my net worth? The answer: to tell if your investment plan is succeeding! My net worth includes entries for my 401K plan. Did I mention that I couldn’t make an early withdrawal on my current company plan, so I still have some money there? But there is no way to succeed at tracking net worth, unless you start logging it periodically in a spreadsheet, say once a month. This allows you start plotting the course your finances are taking. If your net worth can be tracked in less than 20 columns of dollars, then you can easily spend 10 minutes a month to grab the numbers and punch them into a spreadsheet.

Add up all the assets. Add up all the liabilities. Subtract one from the other, and you have your net worth. Divide it by the first entry, and you have your total growth. Don’t forget to include the date you gathered this set of numbers. The piece de resistance? Subtract the current entry from the first (spreadsheets convert this into days), and divide it into 365. This generates a nice fraction. Now take your total growth and apply this fraction as an exponent => (total growth) ^ (365/total days). That is your annualized growth rate of your net worth, the “average” rate your net worth is growing at.

Start tracking it. Even if you don’t do anything else I suggest on this blog such as dumping your 401K to buy real estate. Start tracking your net worth. When the next market crash hits, don’t be afraid to either read next 401K and punch it into your spreadsheet. When the market takes a hit, I can bet you that so will your funds. Well, we know that, because the Wall Street financial advisors are telling us that. But more importantly, we will see that their advice about “stay the course” isn’t good enough, and will slowly but surely kill our long term growth rate.

I honestly wish I had built such a spreadsheet dating back to 1999. Then I could really see the graphic carnage that the 2001 and 2008 market corrections did to my net worth. But I didn’t want to. I thought I was doing fine, following everyone else. Maybe if I had been really been paying better attention, I wouldn’t have waited so long to make my own correction to my retirement plan. The reason we tend to “go with the flow” of using 401K-wrapped mutual funds, is because everyone else is doing it, we aren’t aware of anything better, and we aren’t aware of how rough it is to our net worth annualized growth rate over time.