Investing Architect

Author: Erion Shehaj

  • Regret > Loss

    Regret > Loss

    The current strategy most Americans use to save and invest for retirement is fundamentally flawed. In order to evaluate the effectiveness of any strategy in an empirical way let’s look at the final results.  Then let’s compare them to the results you employed the strategy to achieve.

    We will go through that very process using two well known and often quoted studies.

    First, a 2007 study performed by the Employee Benefit Research institute found that the average Baby Boomer had an average balance of $75,000 in their retirement account at retirement age. The same study performed recently, found that average balance has risen to  $127,000 following the bull market of recent years.

    Second, a 2009 study performed by the US Census found that the average college graduate (undergraduate) earns a little over $2M in their lifetime. Graduates with higher level degrees earned $2.5M (masters) and $3.5M (doctoral). But let’s stick with the undergraduate figure for the purposes of this article.

    The math here is shocking and unforgiving! After 40+ years of working, earning, saving and investing the average “retiree” ends up with a little less than 2 years salary  in their nest egg?! After four decades of tax-deferred 401K contributions, employer matches, double digit average market returns you arrive to find an account with 6% of your lifetime earnings?!

    Depositphotos_2414091_l-2015 (1)

    I know, I know. Yes, many boomers invested when the market was at the peak and pulled their money out at the bottom because they were fearful. Yes, they may have neglected to invest during the early years because they weren’t thinking about retirement then. Yes, their portfolios were probably not as diversified as they should have been. And finally, yes, they could have had much more money at retirement if they had the discipline of a robot and were completely unfazed by a 30-40% drop in the market.

    All that considered, some pesky questions remain. Is this the outcome Baby Boomers signed up for when they invested their hard earned money? If given a do-over, would they do it again?

    Of course not.

    Sadly, for most retirement age folks in this predicament the only remaining option is to work much much longer than they had anticipated. But what about future retirees who are 15, 20, 30 years from retirement? After seeing the sad ending to this movie, do you follow the same path on purpose or do you shift strategy, direction and ultimately destination?

    America has been called the “land of opportunity” and nowhere is this more evident than the above example. Unlike most countries around the world, an average college graduate earns a couple of million dollars in their lifetime. Think about that.  Not the outstanding, exceptional college graduate – the average.

    If this average graduate simply saved a dime out of every dollar she earned and never invested it at all, she would end up with 2-3 times more in their retirement account than the average retirement-age Boomers. How’s that for pathetic results?

    When you first consider investing in real estate long term, fear of loss promptly ensues. After all, there are many unknown variables:

    1. How do you know if it’s the right property?
    2. What if the tenants are a major hassle?
    3. What if it doesn’t rent quickly?
    4. What if there’s a major repair?

    I wrote this article to make one simple yet crucial point: Regret > Loss.

    When you live in a country where the average college graduate makes over $2M in earnings in their lifetime, that’s a major opportunity. If you squander the opportunity to make something beautiful, to become financially independent and built wealth, the regret will be way more painful than any temporary fear of loss. If all you have to show for millions in earnings is 40 years of expenses, that will be a shame.

    —

    References:

    http://www.census.gov/prod/2002pubs/p23-210.pdf

    http://www.usnews.com/education/best-colleges/articles/2011/08/05/how-higher-education-affects-lifetime-salary

    http://www.fool.com/retirement/general/2015/01/10/the-typical-american-has-this-much-in-retirement-s.aspx

  • Why did oil prices drop in 2014

    Why did oil prices drop in 2014

    Last year, on the morning of June 12, the market price for a barrel of West Texas Intermediate Crude Oil was $107.12. When the ball dropped to announce the arrival of 2015, the price of oil did a spot-on impression and dropped 51% (to $53.45). As I write this article, the price sits even lower at $44.80.

    As you read through those numbers, you are probably asking yourself two critical questions:

    1. Why did oil prices drop in 2014?
    2. How will the drop in oil prices impact the real estate market in Houston and across Texas?

    If you own investment real estate in Texas (and especially Houston) you might be substantially more interested in the answer to the latter question vs. the former. However, in order to understand the impact that a significant change in market conditions can have on real estate demand and prices, you must first have a clear understanding of the causes behind the drop in oil prices as the two are deeply interconnected.

    Over the last month or so, I’ve been answering those questions almost on a daily basis in one-on-one conversations with clients and long term real estate investors. In this article I will share the answer to the first question backed by empirical data in Greater Houston Partnership’s annual report.

    Why did oil prices drop in 2014? Too much of a good thing

    Have you ever heard politicians of both sides of the isle talk about “reducing our dependency to foreign oil” during presidential election campaigns? They might disagree on exactly how to do it (more exploration/production vs green/renewable energy), but the idea of reducing our dependency is as bi-partisan as they come.

    Oil derrick in sea

    Did you know that we’ve been significantly reducing our dependency on foreign oil since 2008? Courtesy of innovations in oil exploration and extraction (i.e. hydraulic fracturing or “fracking”), domestic oil production has gone from 5M to 9.1M barrels/day since 2008. The result: In 2005 imported oil accounted for over 60% of U.S oil consumption – ten years later, that figure is expected to be lower than 20%.

    Wait a second – you thought reducing our dependency on foreign oil was a good thing. It is… however, oil is a commodity and as such it is governed by supply and demand. While the U.S increased its domestic production, other oil producing countries (read: OPEC) didn’t stop or taper their production. So if we weren’t importing 40% of our oil consumption anymore, what happened to those millions of barrels? They either got directed elsewhere (see: growing economies of China and India) or got stored. In fact, OPEC’s surplus in 2015 is expected to be 2.7M barrels/day!

    In a nutshell, we have too much supply and not enough demand to absorb it. So what happens to price when supply is excessive? Second half of 2014 happens.

    But what about demand? Well, demand for fossil fuels rises when there’s economic growth. The U.S economy has shown signs of solid growth during the last three quarters but that’s the exception to the rule these days. The Eurozone has fallen prey of their austerity measures that have stifled growth while China’s growth is gradually falling with the latest annual growth at 7.7%.

    Therefore, the fall in oil prices is primarily due to a glut in supply as a result of increased production without increased demand.

    Who controls Supply?

    Unlike supply-demand dynamics in a free market, oil supply is controlled by a handful of nations – with Saudi Arabia as the headliner. In the past, OPEC (Oil Producing and Exporting Countries) have cut production as a way to shore up oil prices pretty much immediately.

    However, this time it’s different. If OPEC cuts production while U.S producers keep their supply steady, prices would rise but OPEC would lose market share. They have a very different idea on how to cut supply. Saudi Arabia would like to see U.S production reduced rather than their own. But how can they do that? The Saudis know that the very innovations that we’ve employed to increase our production (i.e. hydraulic fracturing and shale oil) carry with them a higher cost of production. Namely, if the Saudis can extract oil at a cost of $10/barrel (making essentially any oil price profitable), wells that utilize some of the new technology have breakeven points at $50-$65/barrel.

    Source: Wikipedia
    Source: Wikipedia

    Therefore, their plan goes something like this: Let’s keep prices low for an extended period of time and U.S production will blink first because their cost structure is so disadvantageous. While that might prove effective, low prices come with a high price to the majority of OPEC members. In fact 9 out of 12 member countries need oil prices to be between $70-$120/barrel to balance their oil revenue dependent budgets.

    Deja Vu of 2008?

    “But wait a second” – some of you might say – “haven’t we seen this movie before, not too long ago? In 2008 oil prices dropped in similar fashion from a peak of $145 in July to a low of $30/barrel. Then a year later, prices were back up to $89/barrel in 2009 and hit $100/barrel again in 2011.

    There’s a fundamental difference between 2008 and 2014. The former drop came as a result of a substantial drop in demand due to a global economic crisis. When the economic conditions improved, so did demand and the price of oil rebounded. Last years drop came as a result of too much supply. The only way to re-establish balance between supply and demand in such an environment is to taper supply until glut is absorbed or for demand to rise sharply due to economic growth.

    Impact on Economy and Employment

    A sixty percent drop in oil prices will have a substantial impact despite the fact that the local Houston economy is much more diversified now than it was in the woeful 80s. According to the GHP annual report, “broadly defined, Energy accounted for 38.1% of Houston’s GDP in 2013. Of which, Oil and Gas Extraction (mining) accounted for 19.8% and Other sectors that are typically identified as part of the energy industry (chemicals, refining, oil field equipment manufacturing, fabricated metal products, pipelines and engineering) contribute another $83.9B or 18.3% of total”.

    The energy sectors that will be impacted the hardest from the drop in oil prices are new exploration, oil field services and oil field equipment manufacturing. And that makes sense: Once the investment has been made to find out whether or not there’s oil in a particular area, the cost to drill and extract crude oil from the ground is very low. So existing wells will continue to  produce at max capacity as their cost per barrel still affords a handsome profit even at $40/barrel oil. If instead an oil company has to invest money into new exploration that increases the break even cost for that new well 20-30 fold. Therefore it would no longer be feasible for the company to make that investment. That’s why you have probably heard news of capital expenditure budget cuts across the board from all the major oil companies.

    But let’s not get it confused. Integrated big oil companies (Exxon, Shell, Chevron, Conoco etc) will be least impacted by the current economic conditions. They sit on impressive piles of cash (always handy in a situation like this) and have hedges in place to weather longer term storms. In fact, 2015 will be somewhat of a Black Friday Sale for big oil companies as they look to pick up struggling smaller outfits on the cheap.

    Since budgets for new exploration will be cut and unfeasible rigs will be shut down, oil field services and equipment will bear the brunt of it. As a matter of fact, some of the big players like Schlumberger and Baker Hughes have already announced layoffs. In 2015, there will be job losses coming from this subsector. In addition, smaller companies with unsustainable debt levels will have to merge or fold – in either case, that will result in layoffs.

    However, the GHP expects net employment in the area to rise by 69,500 jobs in 2015 with the bulk of growth coming from sectors outside energy: Construction, health care, retail, professional services, public eduction etc.

    Materials:

    Employment-Forecast – Source: Greater Houston Partnership

    Economy_at_a_Glance – Source: Greater Houston Partnership

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    Next Up: We will take a look at the impact of this climate of lower oil prices on the real estate markets in Houston and across Texas. Stay tuned.

     

  • How to avoid “getting married” to a rate of return and a pyramid scheme story

    How to avoid “getting married” to a rate of return and a pyramid scheme story

    The year was 1997 and the country was on the brink of civil war.

    Just under two years prior, several “investment” firms had appeared offering a very enticing opportunity: Invest a sum of money and in 90 days receive three times the amount. People could smell that something wasn’t right but they felt drawn to the easy profit nevertheless. So they started investing small amounts: $100 at first that became $300 in three months time. And the word started to spread as more and more people decided to dip their toes in cautiously (at first).

    Then came the rise. Emboldened by the capital that kept coming, many of the firms started making public investments, sponsoring sports teams and the arts, and in one occasion even became an official sponsor of Formula 1. By now the phenomenon had gone national. Only a few “stubborn skeptics” remained out of the “investment of the century” and they were under constant pressure from friends and family members to join in. For a brief six month period, a poor, previously communist country experienced what it was like to live in an affluent society. Everyone had money, jobs were plentiful and the good times had smiled upon us again.

    The missing piece from that story is that while euforia overcame common sense, people’s comfort zone had expanded to the point that many were selling their homes and investing their life savings in these companies. Of course, none of it was real. The companies tried to reduce the amounts they paid out per quarter at first to 15% and finally to 8% but there were simply no people left to feed the pyramid. It was all a facade – all of it. Even the large and public investments were simply a show to lend credibility to a pure and simple Ponzi scheme.

    Unlike most Ponzi schemes that typically unravel after 6 months, Albania’s pyramid firms lasted 18 months fueled by large across the board participation as well as large sums of laundered illicit money.

    When it was all said and done, widespread devastation drove the country to the brink of civil war.

    I told you that extreme story from my teenage years to make this, more understated but equally crucial point.

    Every asset class has its own “normal” level of performance in relation to the quality of the asset. Well diversified blue chip stocks usually rise 6-8% over the long term with heavy cyclical volatility in between. High quality real estate investments usually offer cap rates of 5.0-8.5% depending on the asset in addition to conservative long term appreciation of 4-5%. Add to that the fact that debt is being paid off using rents and owners of real estate enjoy exclusive tax benefits not available to investors in other asset classes.

    Now, there are times when “the elements” come together just right and real estate investors are able to obtain higher cap rates, appreciation and debt paydown than normal. This usually happens at the bottom of a recession, after a correction in values, when the economy is in distress and interest rates are low. That’s what happened between 2008-2012.

    If you had the courage to overcome the negative mood of the country and the widespread fear that the world was going to hell in a handbasket by next Thursday, you could purchase high quality real estate investments with 20-25% down, borrowing money at rates as ridiculous as 3.75% and enjoying cash on cash yields of 15-20%. But let’s be clear about one thing. The principal reason why courageous investors were able to get those type of returns was because of risk. Values were depressed because most people were fearful – they were staying away from the market, in squirrel mode stashing away as much cash as possible to last them through the impending Apocalypse. Now that we know how the movie turned out, their risk taking was vindicated. But let’s not forget that instead of the path of Houston, your market could have also taken the path of Detroit, too. And the risk would have cleaned out most investors under that scenario.

    Now, all is well in our world (as for the rest of the world, that’s another matter). The fear is gone and hey, look at all this money we stashed away. Time to put it to work. So demand rises as do rents and eventually prices. And before you know it, returns are back to their “normal” levels as a reflection of greatly reduced risk. But now, we might miss those double digit returns to the point that we doubt the strength of current investments.

    Just like we will wish we had invested back when rates were under 5% for investment properties when rates will rise in the following years.

    The fact is we can’t control the elements. Prices, rates, economy, overall confidence aren’t up to us.

    However, what we can control is this: We can control our strategy and we can make sure it contains clear standards for the assets we acquire. We can control our discipline and execute our strategy. We can reach our financial goals regardless of the element mix.

    What we should never do is “get married” to and feel entitled to a certain level of return and in that process compromise our property standards to fit “minimum” returns we feel we must get. That’s where most investors go on the wrong path.

    You will never hear the story of the investor that went broke when he only got 8% cash on cash return on high quality real estate investments (instead of 12%) because it just doesn’t happen. Instead, you are far more likely to hear the story of someone chasing too good to be true returns and ending up burned.

    Play the hand you are dealt with a consistent, well thought out strategy and it’s a matter of time before your financial goals become your financial accomplishments.

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    If you are interested in developing a consistent, well thought out strategy that starts with your income goals and shows you an empirical way to accomplish them, please email me or if you’re reading this from your email just hit reply

  • The curious case of the Houston real estate bubble – An empirical analysis

    The curious case of the Houston real estate bubble – An empirical analysis

    The Houston real estate market has been on fire over the past 18 months. Since the start Q2 of 2013, we have experienced double digit increases in sales as well as rising prices and rents fueled by low inventories and high demand.

    The gallop has felt incessant. Just when you might expect that the market will take a breather for seasonal reasons or otherwise, it keeps sprinting forward. So, in this market climate, it’s no wonder that the hypothesis of a Houston real estate bubble has arisen reinforced by anecdotal “evidence” and largely unrelated 1980s oil crash references.

    However, a couple of weeks ago, Trulia released its Bubble Watch report. Mainstream newspapers like the Houston Business Journal and the Houston Chronicle regurgitated the findings without much scrutiny and that seemingly lent some “empirical” credibility to the story.

    Here’s where I got involved.

    I usually dismiss market studies from companies that are best known for data inaccuracies without a second thought. After all, how much credibility can you assign to a study that finds real estate markets like Las Vegas and Chicago to be undervalued?! But I started receiving calls and forwarded links to articles from concerned clients so I decided to take an in-depth empirical look and share the findings with you here.

    It’s hard to argue with anecdotes and I won’t try. I’m sorry to break it bubble proponents but the fact that your cousin’s neighbor’s house sold in 18 hours, 10% over list price to the highest bidder of 15 offers does not constitute evidence for a real estate bubble. Therefore, let’s begin by defining what a bubble is and look at some symptoms that may serve as indication for an overvalued market.

    Depositphotos_4561353_m

    Definitions

    In a 2004 Fed letter, Fed economist John Krainer and researcher Chishen Wei wrote:

    We borrow from the finance literature to take a different approach. The finance paradigm holds that an asset has a fundamental value that equals the sum of its future payoffs, each discounted back to the present by investors using rates that reflect their preferences. For stocks, the payoffs requiring discounting are the expected dividends. This approach can extend to housing by recognizing that a house yields a dividend in the form of the roof over the head of the occupant. The fundamental value of a house is the present value of the future housing service flows that it provides to the marginal buyer. In a well-functioning market, the value of the housing service flow should be approximated by the rental value of the house.

    A bubble occurs—in either the stock market or the housing market—when the current price of an asset deviates from its fundamental value. Right away we see that bubbles are difficult to detect because fundamental value is fundamentally unobservable. No one knows for sure what future dividends are going to be, or what discount rates investors will require on assets. Despite this obstacle, analysts still find it helpful to construct measures of fundamental value for comparison to actual valuations. One popular measure is the price-dividend ratio, which corresponds to a price-rent ratio for houses.

    Wikipedia states that “in their late stages, real estate bubbles are typically characterized by rapid increases in the valuations of real property until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability.”

    In summary, real estate bubbles occur when property values deviate from their fundamental value as determined by economic indicators that measure values in relation to average rents and incomes. In addition, such deviation usually happens due to rapid increases in property values that are unsustained by economic fundamentals of supply and demand.

    Now that we have an idea about what a bubble is and how to identify it, let’s look at each of these factors separately and see how they apply to the real estate market in Houston Texas over the past year and a half.

    Economic Indicators of Fundamental Value

    There are numerous metrics (economic indicators) one can use to determine the fundamental value of an asset.  Two of the principal indicators are the price to rent ratio and price to income ratio. In the latest report on the Houston real estate market for the month of September, the average single family home price was $196,000 while average rent for the same property type was $20,988/year. Therefore the average price to rent ratio for the Houston market is 9.34. On most investment grade rental properties we analyze daily, the price to rent ratio is usually even lower at 7.5-8.2.

    In comparison, the average price to rent ratios in the US is approximately 22! As in, more than double the price/rent ratio for Houston.

    Now let’s take a look at the relationship between home prices and income to see if there’s an imbalance. Again the median home price is $196k according to latest HAR data while the median household income is $58,952 (Source: Forbes) so the price to income ratio is 3.32. Put a different way, the median house costs 3.32 times the median income. In comparison, the US price to income ratio was 3.76 in March 2014 (Source: Department of Numbers)

    Put differently, neither price to rent nor price to income ratios point to a bubble in the Houston market. Our price to rent ratio is about half the national average and our price to income ratio is in line with the national average.

    Unsustainable Rapid Increases in Property Values?

    In its summary of the last confirmed real estate bubble in the US. Wikipedia states that “despite greatly relaxed lending standards and low interest rates, many regions of the country saw very little growth during the “bubble period”. Out of 20 largest metropolitan areas tracked by the S&P/Case-Shiller house price index, six (Dallas, Cleveland, Detroit, Denver, Atlanta, and Charlotte) saw less than 10% price growth in inflation-adjusted terms in 2001–2006.[65] During the same period, seven metropolitan areas (Tampa, Miami, San Diego, Los Angeles, Las Vegas, Phoenix, and Washington, D.C.) appreciated by more than 80%.” (emphasis mine).

    Is something similar happening in the Houston market? Let’s look at the facts about property values and sales in Houston from 2006 to 2013.

    Houston Real Estate Sales and Prices (2006-2013)
    Year Sales (YOY) Median Prices
    2006 1.10% 1.40%
    2007 -19.10% 2.40%
    2008 -17.30% 0.00%
    2009 -8.20% 0.70%
    2010 -3.00% 4.00%
    2011 4.00% 0.70%
    2012 16.00% 6.10%
    2013 17.00% 9.40%
    Cummulative -9.50% 24.70%

    So what do the facts tell us? During 6 out of the last 8 years, the property values in Houston have been moving sideways: Either flat or barely keeping up with inflation. Moreover, during the last two years of recovery, the market performed same as historical appreciation in 2012 and almost reached 10% appreciation in 2013.

    If that’s a bubble, I’m an olympic gold medalist.

    Again, you don’t have to take my word for it. Just look at the empirical evidence. In the five year period between 2001-2006, markets that were proven to be in a real estate bubble appreciated by more than 80%. That’s an average of 16% per year for 5 years! But that’s not all. Most importantly, the economic fundamentals didn’t change a bit during that period to warrant such an increase. Prices rose just because. Just because there were loose lending practices and people turned their homes into ATMs, just because people speculated that they would all become millionaires but just holding on to their homes for half a decade, just because they thought it was normal for the price on a new home to be 100k higher three months after they bought it. I’m looking at you, Las Vegas.

    Unlike that situation, the economic fundamentals in Texas (generally) and Houston (specifically) are present to support a robust recovery.

    Let’s start with demand. Houston didn’t just become hip overnight and now all of a sudden everyone wants to move here because we’re the new Orange County. Houston has the highest population growth in the country for two simple reasons: Jobs and low cost of living. During the 8 year period from 2005-2013 employment has grown by 18.6% in Houston compared to 1.8% nationally. Also, Houston has the lowest cost of living among 10 most populated metro areas in the country at 5.6% less than the national average.

    When more people move into an area than leave, demand for housing grows. When Exxon Mobil builds a 20 building complex in North Houston that will house 10k employees (many of which have families), demand for housing in that area grows. From basic economics, what happens to prices when supply remains the same and demand rises? They must go up. It’s not speculation – It’s just how the world works.

    Now add to that the fact that supply has not remained the same. During the month of June 2008 (arguably the hottest month of year for real estate sales) there were 6.6 months of inventory in the Houston real estate market. Fast forward six years later and inventory during the month of June 2014 is 2.8 months. That’s a 67% drop in available properties while demand rose at the same time! Why is supply down? There are several reasons:

    1. Higher sales (demand) are depleting inventories faster
    2. Foreclosures accounted for 25% of sales in 2008. They account for about 5% of sales this year.
    3. Builders are struggling to fill the supply void with new home inventory

    Now what happens to price when demand is up at the same time that supply is low? They rise even faster.

    Basic supply and demand is at the basis of home price increases in the Houston market, not some speculative, unsustained inflation of a bubble.

    Here’s a final riddle for you: If prices are supposed to decline or remain flat during a recession, what are they supposed to do during a recovery?

    The answer may sound obvious, but if it is so obvious why are people screaming “bubble” after one or two years of higher than normal appreciation?

    Last but not least, Trulia’s Bubble Watch report (which is basis for most bubble predictions in Houston) posts “Home Prices relative to fundamentals” as their reason for determining if a market is over or undervalued. I would love to know what “fundamentals” they are using because whatever they are, they’re certainly not price to rent and price to income ratios or median home price appreciation over the last 9 years.

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    If you are interested in discussing a strategy that can build a six figure per year income stream while getting your net worth over the million dollar line , please email me or if you’re reading this from your email just hit reply.

     

     

     

  • Observations on income taxes on your free and clear investment portfolio

    Observations on income taxes on your free and clear investment portfolio

    Many of the articles I have written on InvestingArchitect.com have originated from discussions with investors like you. A few months back, Robert – a regular reader and “subscriber” to our Blueprint strategy – made the following observation.

    One thing I have noticed though is that the income taxes I am paying keep increasing as the properties are paid off. Typically when you have a leveraged property the cash flow is completely tax sheltered by the depreciation. When the property is free clear a large chunk of the cash flow is not sheltered.

    Keeping this in mind means that one pays a lot less income tax for the same amount of capital invested if that capital is spread out over more properties. The only problem is that one is also increasing their risk.

    I think that when I finally retire with that $100K/year this will be less of a problem as my 9 properties will shelter around $40K/year and the highest tax bracket on $60K married filing jointly is 15%. As apposed to my rental income now on top of my salary which puts me in the 33% bracket.

    I know you don’t like to include the topic of tax in your articles but I think this truism must be considered

    I think there is an important lesson for us tucked within Robert’s observation.

    Let’s look at some specific numbers in a simplified scenario that will illustrate my points.

    Scenario

    John owns a portfolio of nine identical properties that he purchased for $165k each and financed 75% of their purchase with a 30 year mortgage at 4.5% interest. For tax purposes, about $300k of the total asset value of this portfolio of $1.5M is allocated to land (therefore not depreciable) and the rest ($1.2M) is allocated to improvements depreciable over 27.5 years on a straight line schedule. This produces a depreciation expense of $43,200 per year over that 27.5 year time period.

    While the properties are still leveraged, they produce actual positive cashflow of $34,200/year. However, the fine folks at the IRS only allow the deduction of the interest portion of your mortgage payments for tax purposes. The amount that goes to principal is not an expense in their eyes and has to be added back to you cashflow for tax purposes. Therefore, positive cashflow after operating expenses and debt service for tax purposes is $52,167.31 from which we can deduct depreciation expenses of $43,200 leaving us with taxable cashflow of $8,967 for the entire portfolio. Assuming you are crushing it on the income front, we apply a 35% tax rate to that amount and we end up with $3,138.56 in taxes and after tax cashflow of $31,061.44.

    Fast forward twelve years later. John has followed our Blueprint strategy and executed it flawlessly leading to the eradication of the entire debt on his portfolio. Now he owns all nine properties free and clear so let’s look at the tax implications of such a state.

    Since there are no mortgages to pay, the entire amount of the portfolio’s debt service ($67,718.49) flows straight to the bottom line and  John’s pretax annual positive cashflow is now $101,918. Now there is no income expense on the debt to deduct so the only deduction left is the annual depreciation expense of $43,200 which results in taxable cashflow of $58,718. Since we don’t plan on retiring in survival mode, we assume your income still rocks and use a corresponding high tax rate of 35% which leads to annual taxes on the cashflow of $20,551.30 and after tax cashflow of $81,366.

    Income taxes on your real estate investments

    Observations

    Let’s address Robert’s last point first. The principal reason why I don’t usually delve into tax topics very often is because tax topics with all the convoluted numbers and IRS regulations can be as interesting as watching paint peel. However, we can only ignore tax implications at our own expense. Since I don’t suspect the government will make income taxes optional anytime soon (we can all dream…), these discussions affect the money you get to keep which is the money that matters.

    Second, let’s tackle the crux of the matter. It is absolutely true that while the investment properties in your portfolio are leveraged, the actual tax rate you will pay is much lower than when your portfolio is free and clear. From Wikipedia, the effective tax rate is used in financial reporting to measure the total tax paid as a percentage of the individuals’s accounting income, instead of as a percentage of the taxable income. Or for the rest of us humans, the actual taxes paid divided by the actual positive cashflow.

    Looking back at our scenario, $34,2000 of actual positive cashflow from leveraged properties resulted in a $3138.56 tax bill or an effective tax rate of 9.17%. On the other hand, when properties were paid off, the actual positive cashflow of  $101,918 resulted in $20,551.30 or an effective tax rate of 20.16%.

    No arguments from me up to this point. However, let’s be clear about one crucial distinction.

    In most cases, the principal purpose of a long term real estate investment portfolio is to create an after tax income stream that affords you the lifestyle you want to live in retirement. It is not to minimize your taxes or achieve the lowest effective tax rate.

    If minimizing taxes was your principal goal, then you should only purchase investment properties that break even.  In that case, you will not only avoid paying taxes on the positive cashflow (since it doesn’t exist) but will likely get a tax benefit from “paper losses” that result from depreciation expenses. These paper losses are treated differently depending on your job income. If your income is $150k per year and up, all paper losses are collected into an “accumulated losses” account and can be applied toward any future gains upon the sale of the property. If your income is under the $150k threshold, you would receive a reduction in your taxes due for that year equal to the amount of the loss multiplied by your tax rate.

    Let’s get back to the heart of the matter. Robert was concerned with the increasing tax liability as he paid off the debt on his portfolio. Every sophisticated investor should strive to legally reduce taxes wherever possible. However, we shouldn’t let tax reduction become our main focus. Your goal is to build a specific after tax (read: spendable) income stream using a portfolio of high quality real estate investments. Any and all tax implications can only be considered in the context of how they impact this future income stream.

    When you pay off the debt on your properties, the taxes will be higher because your income will be higher. That’s no different than an individual paying far more taxes when they make 200k per year than they did when they make $50k per year. Does that mean you keep yourself from earning more to avoid writing a bigger check to the IRS? Look, I hate writing a check to the IRS as much as the next guy but over the years I’ve learned to smile as I write that check since higher taxes usually occur as a result of a higher income with which to pay them.

    I’m oversimplifying, I know. And Robert’s point that taxes per amount of invested capital go up when your properties are paid off is well taken.  Unlike your job income, in your real estate portfolio, you can choose to earn that higher income by spreading your capital over more leveraged properties. But as Robert mentioned, your risk would be significantly higher to offset your higher returns from leverage as well as reduced taxes. Most importantly, your hassle would also be much higher when you manage a larger number of properties. I don’t know about you but I wouldn’t want to retire from my job only to take a position as a property manager for my own properties. You could hire a property manager but the hit to your returns from shaving 8-10% off your top (income) line will be much more substantial than the one from the higher tax liability that started this whole discussion.

    So keep your eyes on the ball and focus on the number that matters: Your income goal. All other metrics: ROI, effective tax rate, leverage only matter insofar as they allow you to accomplish that income goal. If you achieve an incredible ROI on a single property that doesn’t get you to the income you need, you have not crossed the finish line. If you achieve zero tax liability on an otherwise unimpressive income stream, ditto. Focus on your goal and let the rest of the chips fall where they may.

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    If you are interested in a little known strategy to significantly reduce or eliminate taxes on a portfolio with multiple properties while staying on track for your retirement income goals, please email me or if you’re reading this from your email just hit reply.

     

  • How to increase velocity of money to turbocharge your investment returns

    How to increase velocity of money to turbocharge your investment returns

    Fact: Every investor I’ve had the privilege to help has worked extremely hard to earn and save the capital required to make long term real estate investments. So it’s no wonder that as an investor you want to put in practice strategies that maximize your return on that capital. But I have a slightly different take on this matter. Because I’ve seen first hand how hard many of you work to create that capital, we have a duty to make that capital work as hard as possible to help achieve your financial goals.

    So in that vein, today I want to introduce the concept of velocity of money and show you a strategy to increase the velocity of money your real estate investments produce and turbocharge your returns in the process. First of all, the concept of velocity of money can mean very different things depending on the context (i.e macro economic or field specific). For the purposes of this article we are looking at velocity of money strictly as it applies to long term real estate investments.

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    In simple terms, consider the following analogy to illustrate velocity of money at work. Imagine that an investment property is an actual vehicle and the initial capital to acquire that property is the fuel for that vehicle. When you put your capital to work in a long term investment property, it produces positive cashflow that represents a return on that capital. In our illustration, when you put “fuel” in your “vehicle” and engage the first gear, it will reach a certain speed or velocity. But now that you receive the return on your initial investment you come to an important fork in the road. You could spend the positive cashflow on regular expenses or leisure (as it’s your right) or you could put the cashflow back to work to earn even more. In our analogy, this would be the equivalent of “staying on first” or engaging the second gear and making the vehicle go even faster.   That’s velocity of money in a nutshell: When you re-invest the earnings of your capital to earn even more, the overall return on your original capital increases significantly. Compound interest – a much more familiar concept – is essentially velocity of money at work.

    Two strategies to increase velocity of money

    In long term real estate investing there are two principal methods to turbocharge investment returns by increasing the velocity of money.

    The first method involves using the positive cashflow produced from your initial capital to pay off existing debt. In this scenario, the added return on your positive cashflow is the interest cost saved by paying down the principal on the mortgage. Let’s take a look at a concrete example.

    Suppose you acquire an investment property for $160,000 with a down payment of $32,000 (20%) and closing costs of $3,000 for a total initial investment of $35,000. For the remaining balance you take a 30 year fixed rate mortgage at 4.75%. At the end of the year, the property produces $4,500 in positive cashflow after all expenses and mortgage payments, which represents a 12.9% cash on cash return. If you take the positive cashflow and re-employ it to accelerate the payoff on the mortgage on your investment property, that results in interest cost savings of $214 per year bringing your total return on your initial $35,000 to $4,714 which represents a 13.5% cash on cash return.

    The above example is the reason why I burst out laughing when critics of the Domino strategy brand it as “paying off low interest debt with high return dollars”. You see, when you accelerate the payoff on debt, you’re not substituting high return dollars for paid off low interest debt. You are increasing the return of those high return dollars even further instead of stashing them away in a bank account paying 0.00017% interest or worse, spending it.

    The second method to increase the velocity of money in your real estate investments is to recycle the positive cashflow produced by your properties into acquisition capital (down payment) for additional properties to acquire according to your Blueprint.

    Let’s resume the example where we left off. Suppose that a year after you acquired the first investment property above, you want to acquire another, identical property that requires $35,000 in initial capital. But this time, instead of coming up with the entire amount from your savings, you use the $4500 in positive cashflow from your first acquisition and make up the difference from your savings. In this scenario, the $4,500 cashflow that produced a 12.9% return on your original $35,000 capital is earning 12.9% when invested in the second property. That’s another $581 return on the original capital which increases the cash on cash return to 14.5%.

    Here’s the real kicker: So far, we’ve spoken only about increasing cash on cash returns. What happens when the property increases in value and you are leveraging your positive cashflow further to earn additional double digit returns? Don’t answer that.

    Which method should you choose?

    By now you must be thinking to yourself: Recycling cashflow into acquisition capital seems to be the no-brainer method of choice among the two. But there’s one crucial ingredient missing in that “stew” of thought: Risk. I know it’s not as much fun to discuss risk as it is returns. But this pesky socialite attends  every party real estate investments attend. So we must account for risk  at the outset or pay for it from our checkbook. The first method of increasing returns by paying off debt seems understated in its added return but what it does offer in addition is risk reduction. Everytime you get a step closer to a paid off investment property, you are shaving off a chunk of risk from your porfolio. That’s why the increase in returns is smaller. When you recycle the cashflow into acquisition capital, it will earn a higher added return but it involves the acquisition of another asset. In addition to the return it produces, it increases risk as well.

    So what should you do – which method should you pick? As with all good questions, the answer is “it depends”.

    One factor to determine which method is the best for you is whether or not the investor has the savings capacity from her income to save all the capital required to make all the acquisitions per her Blueprint. If the answer is yes, then the investor is better off working both sides in parallel. In other words, she can use the cashflow to accelerate the payoff on her debt and use her savings capacity to complete her acquisitions. If the answer is no, then you’d be better off putting aside debt acceleration for a short while and employ all cashflow and savings to complete your acquisitions – then resume the Domino strategy once your portfolio is complete.

    But – you might say – that may seem counterintuitive. Even if you have the money to complete acquisitions from your savings, why wouldn’t you use the cashflow since that yields the highest added return? The reason is simple: Our ultimate goal as long term real estate investors, isn’t to get the highest return on investment but rather to reach our income stream goal through a paid off real estate portfolio within the allotted investment timeframe.

    Therefore, the true question isn’t whether you pay off debt to increase velocity of money but rather when to pay off debt. Depending on your level of risk aversion, available time to reach your goals and your overall preference you may decide to start the debt payoff right away or once your acquisitions are complete. But start it you must if you are to achieve the level of income you seek at retirement.

    In conclusion, your money has to work at the very least as hard as you do and ideally multiple times harder. The way to achieve the highest possible return from your investment capital without adding reckless levels of risk is to increase the velocity of money by re-employing positive cashflow to earn at its maximum potential.

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    For more on velocity of money and how to think and invest like a banker, I strongly recommend the book “The Bankers Code” by George Antone. It was recommended to me by a good friend and it’s a very powerful book.