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Hey Worry Wart – Is Your Fear Irrational?

May 18, 2016

Have you ever heard of someone wearing a tin foil hat to protect them from mind control, radiation, or aliens sucking out their brains?

Yes, this is a real thing that some wackos believe. I love a good conspiracy theory, but stop short of actually believing them. (My favorite is the Denver Airport Conspiracy Theory – I try to watch it whenever I am flying through there, makes travel fun.)

I hope you aren’t wearing any tin foil right now. If you are, you can get a stylish upgrade with this Kickstarter campaign.

But are there other areas in your life where you have an irrational fear? Is it holding you back?

Fear of Managing

The biggest misconception about rental property investing is that you have to be a landlord and it takes a lot of work. People are frightened of this.

Good news – you can pay a property manager to do most the work for you! You don’t have to be a landlord, you just have to manage the manager.

Yet this is still scary to some people. What if they do a bad job? What if they charge too much for expenses? What if I have to fire them? What if what if?

Yes, there is a bit of a learning curve. I am not very far along this curve myself and things are working out fine. As I get more experience I’m sure I will improve my skills at identifying a great property manager and learn better ways to work with them. It’s ok to not know everything before getting started.

Gosh that still sounds annoying, why would anyone want to do that? Simply because the benefits outweigh the effort.

Before saying “this isn’t for me”, shouldn’t you know the results you are passing up? Can you make a 20% to 30% return elsewhere without any effort? Is a little bit of your time worth these amplified returns? Absolutely.

This effort required is actually a benefit – it keeps the masses away! Do you think the opportunity would be there for you or me if Wall Street could high frequency trade rental properties? Take advantage of this.

Everyone Hates Taxes

What if your tax bill went up from $20k to $25k? Would you be upset?

How about if it was because your income went from $80k to $100k? Still mad?

Can the irrational fear of paying more in taxes actually hold you back from earning more? Yes, it certainly can, which is why many people often consult tax advisors (perhaps they search for them by looking up keywords like tax consultants near me). It is true that most people are oblivious to the tax deductions they are eligible for. That is why taking the help of tax advisors can help them to save taxes and ensure that they are done correctly.

Anyway, coming back to the topic, I was discussing how crazy this is (the matter of tax) with my friend who does estate planning (the kind you can see on this website). Here is what he said:

Agreed, although my recent experience has been that this is a big mental barrier. I have several clients who have received ridiculous offers for their properties but have difficulty accepting the capital gains. It’s a great problem to have because it means the investment did well, but there’s a mental barrier that taxes are bad (which they are, but not if it means you had a huge gain). It’s not rational, but a couple of the clients have been extremely rational people, including the world’s most stereotypical engineer.

How it Applies to Real Estate Investing

When you invest in rental properties there are all sorts of tax advantages. Obviously consult an expert, not a random dude on the internet, but here is a quick explanation of how it works with capital gains.

A capital gain is when the price of your asset goes up. With a stock, if you buy at $20 and sell at $30 a couple years later, you have a capital gain of $10. You will pay taxes on that profit.

Same with real estate. Except there are some tax breaks you can take advantage of.

First, you can sell a property and buy a new one while paying no taxes with a 1031 exchange. So you can trade up and go from high effort properties like low-cost C neighborhoods to a class A duplex that requires less work. However, make sure to do your share of research into things like what a duplex is and how investing in it could be fruitful for you.

But all this time the potential capital gains are growing. That means you made money and if you sell, you will have to pay taxes on it.

Or another option is to not sell and hand it off to the next generation – they won’t have to pay all those years of capital gains. It goes away as the buy price “steps-up” to the price upon death.

Yet these potential capital gains taxes hold some people back from investing in real estate! Unfortunately for some, they have back taxes that are unable to pay off to get on the real estate ladder, as they may have made some wrong choices a while ago, stopping them today. You can learn more about how to deal with these back taxes by checking out websites such as taxrise.com and reading their articles on this area.

Is Your Fear Irrational?

Is a potential issue down the road holding you back from ever getting started on your journey?

The thing you need to ask yourself is – when I reach this obstacle, will I be able to figure out a way to solve it? Notice this is different than asking if you can solve the obstacle today.

You will learn a lot on your journey and be able to consult experts when the time comes. You don’t have to know everything right this second.

I encourage you to get moving on a conservative path to start your learning journey. Hit the bunny slopes first and gain valuable experience. Don’t look at an advanced obstacle far down the line and let it stop you from ever getting started.

Inflation: The Great Mortgage Destroyer

May 8, 2016

If there is one thing people don’t have an intuition for, it’s Einstein’s Theory of Relativity.

So you’re telling me that the speed of light is the same no matter what speed I’m going? So if I’m standing still it’s X and if I’m traveling the exact same direction as the light, going X speed myself, somehow the light is still traveling away from me at speed X?

So you’re telling me that time itself changes based on the observer? So if you have two twins, and one leaves earth to travel around the galaxy for a while at the speed of light, when he comes back he is somehow younger than the other twin?

Ya sure … sounds a little fishy to me. But ok, whatever you say Mr. Genius.

If There’s One More Thing People Don’t Have an Intuition For, It Is Compound Interest

In fact, Einstein himself might have pontificated on this (or maybe not).

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
-Albert Einstein

Compound interest works both ways whether you are lending or borrowing. Another form of compound interest is inflation – something everyone is affected by whether you know it or not.

How can we get these powerful forces to work for us rather than against us?

I believe the best way is to have a mortgage balance that someone else pays off. Alternatively, people can look on websites such as https://www.housebuyersofamerica.com/how-to-get-out-of-a-mortgage for more information on mortgages. More on that soon.

Inflation Over 30 Years

It is hard to comprehend how inflation destroys the purchasing power of the dollar over a long time horizon. But let me try to put it in perspective.

The rule of 72 is a shorthand way to estimate how long it takes for compound interest to double. You just divide 72 by your interest rate and that is the number of years it will take to double.

If we estimate an inflation rate of 4.8%, then in 15 years the purchasing power is cut in half. In another 15 year it is cut in half again. So in 30 years, things would be 4 times more expensive.

In other words, in 30 years a ticket to Disneyland will be approaching $500! Hopefully your paycheck keeps up over those 30 years as everything else will be more expensive too…

Maybe 4.8% is a little high to forecast for inflation over the next 30 years, but that is a discussion for another day.

Let’s look at a more generally accepted inflation rate of 3% over the course of 15 years. I think 15 years is about as far as people are comfortable projecting – that could be your target retirement, or when your toddler will head off to college.

$1 in 15 Years Has the Purchasing Power of 64 Cents Today

Inflation slowly destroys the value of the dollar. Even at just 3% per year, with a pretty long time horizon and the compounding effect, it is significant.

Or put another way, you would have to invest 64 cents today at 3% interest to get a dollar 15 years from now.

Notice that I’m not using some wacky high inflation numbers or time horizons. Yet when we go through the numbers for a rental property it yields some impressive results.

Fixed Monthly Mortgage Payments

Let’s imagine I purchase a $100k property with 20% down at a 5% interest rate 30 year mortgage. It rents for $1000 a month – pretty much exactly the same as the two properties I currently own.

My monthly principle and interest payments on that mortgage will be $430. The real shocker is it will be the same $430 payment every month for 30 years.

It never goes up! Over time this payment will feel smaller and smaller. Let’s look at some numbers:

In the first year, this principle and interest payment is 43% of the rent collected. Every year inflation will tick up the monthly rent, taxes, insurance, repair expenses, and property management fees. Yet the principle and interest payment stays the same.

After 15 years the monthly rent is $1513. The principle and interest payment is now just 28% of the rent collected!

With every passing year, the mortgage payment is easier and easier to make. And since it is fixed while our rents are rising, you’ll notice in the far right column, our monthly cash flow goes up.

What About the Mortgage Balance?

The mortgage payments are fixed and over time the tenant is paying down the mortgage for you. Your cash flow is going up, the mortgage balance is going down, and the value of the dollar is going down as well.

Let’s look at the numbers year by year:

At the end of year 1, we receive $1,540 in cash flow. But the value of the dollar is 3% less due to inflation, so is equivalent to $1,495 at the beginning of the year.

The tenant has paid down the mortgage balance a little bit for us. It is now at $78,820. But here is the crazy thing – at the end of the year the mortgage balance is also easier to pay thanks to inflation. To help your intuition on this, we can translate that loan balance to what it would feel like at the beginning of year 1: $76,524.

Do this for 15 years and where do we stand?

$1 in 15 years is equal in purchasing power to 64 cents today. Our yearly cash flow has gone all the way up to $4,974 (remember it increases due to the fixed principle and interest payments with rising rents and expenses) – or translated into today’s purchasing power it is $3,193. The purchasing power from the cash flow has more than doubled!

In 15 years the mortgage balance stands at $54,307, which the tenants have been kind enough to pay it down for us. But that $54k doesn’t seem as significant when inflation has raised the prices of everything. Translated into today’s purchasing power, it is equivalent to just $34,858!

Inflation is the Great Mortgage Destroyer

Prices keep rising, the mortgage payment stays the same. The mortgage payment is easier and easier to make and the mortgage balance feels less and less significant. Thus, if you feel like you should look for homes and would opt for a mortgage payment system for it, you could look at lenders similar to a Mortgage Broker Colorado who can help you out!

If you can master the concepts of compound interest and inflation, you can use them to your advantage.

There really aren’t any other opportunities where an average Joe has the ability to borrow money like this and return a cash flow. The fact that you can go get an extremely reasonable rate for an investment mortgage is frankly amazing, whether you get one to purchase a property in your own country or consult with someone like simon conn with a view to buying a property overseas to let to holidaymakers. It is a gift everyone should take advantage of. However, if you are simply a military veteran after an affordable mortgage so you can own your home then it might be worth using this mortgage calculator.

All you have to do is sit tight while the tenant pays down the mortgage for you and inflation does the rest.

What are your thoughts? Do you understand how powerful a mortgage destroyer inflation is? What’s holding you back from taking advantage of it?

If you are interested in playing around with the numbers yourself, here is the spreadsheet I used.

Forget Risk-Reward, With Rental Properties Think About Effort-Reward

May 3, 2016

I am a ruthless competitor.

I just prefer not to show it – if I can secretly work harder than anyone else, I will.

Some people make small-talk during Scrabble. I’m constantly thinking through possibilities and just nodding along to whatever you are saying to me. “Ya, uh huh, sure”.

When it comes to investing, I am also going to put in more effort than the average person. To me the average person is lazy and accepts poor results. See the mutual fund industry for more info.

But effort takes time and time is non-renewable. So maybe I shouldn’t put in too much effort… ?

Investors Talk Risk-Reward

When investing there is a trade off between potential return and how risky it is.

As an example, an established company like Coca-Cola isn’t going away any time soon. If you invest in it, you can be pretty certain the company will keep on chugging along as it has for the last hundred years.

If your friend’s cousin has an iPhone app company that is running out of money and needs investors, run for the hills. Well, unless they make it worth your while. Since there is a decent likelihood the company will implode, they will offer you significant upside for investing.

With the potential for downside losses comes the potential for upside profits. Otherwise, you would just go with the sure thing every time. This could be similar to investing in a listed company, if you analyze the financials of a company before buying its shares, you may be able to predict the future of that firm. With the rise in numbers of investors across the world, service providers like Debtwire tend to provide necessary tools for stock analysis. Debtwire launches new platform to analyze the liquidity status and financial operation of any listed company. Such services can come in handy for an investor while adding new firms to the portfolio.

Rental Properties Risk-Reward

With rental properties there can certainly be a risk-reward component. You can invest in a Manhattan sky-rise condo, rent it out, and pray the value increases.

I call that gambling.

Is there potential for huge returns? Yes, but it isn’t worth it because you can lose everything.

If the market softens, your tenant will move out because rents are lower elsewhere. It already didn’t quite provide enough cash flow to cover your monthly expenses – now it is vacant and will rent at a lower price. It bleeds money every month and if your day job can’t support it, you can’t even sell because it is underwater. So bankruptcy is the only option.

This scenario might be unlikely, but it isn’t worth the risk because you can make excellent money in rentals without it.

I prefer to take the most conservative approach possible, investing in low-cost cities with excellent rental income. The cash flow provides enough cushion to wait out any downturn. I use my decades long timeline to my advantage. The leverage on these low risk rentals makes it a homerun.

Effort-Reward

We don’t have to worry about the risk-reward trade off since we are going with the most conservative properties.

Instead real estate investing should be considered an effort-reward trade off.

There are an incredible number of ways to be a “real estate investor”. For business developers, it can mean checking commercial building loans in florida or a place where they are planning on starting a business. That can also mean speculating on condos or flipping homes in your suburb. Those two have almost nothing in common.

When it comes to rental properties, there are still many ways to go about it. You can take care of everything end -to-end, finding a distressed property, rehabbing it yourself, and showing it to prospective tenants. Or you can pay someone to do that for you.

It shouldn’t surprise you that if you do less work, you can expect fewer returns. An extreme example of this is investing in real estate through a REIT (real estate investment trust). You do no work, purchase it just like a stock, and get an 8% to 12% return. Of course, it is not the same as commercial real estate investment which tends to be a lot more intricate. Businesses often get aid from companies such as CRE PropTech to carry out the transactions and manage their investment funds.

If you buy turnkey properties like I do, you put in significantly more work. You have to build relationships, perform due-diligence, and muddle through legalese. But once the property is purchased, the property manager makes it so you average less than an hour spent per month. You can expect a 20% to 30% return when you factor in all 5 components.

If you take on more responsibility, you can certainly up your returns: less middle-men make a profit off you. You can be the property manager for an extra hundred dollars a month. You can do the wholesaling to save thousands off the purchase price. You can schlep your toolbox over there on weekends to rehab it.

But is the reward worth the effort?

Don’t Forget to Evaluate the Effort Involved

You might hear statements like “I made ten thousand dollars flipping a house.” How much work went into it? Were you rehabbing yourself on weekends or dealing with pain-in-the-butt contractors? How many dozens of properties did you look at before your offer was finally accepted?

They want to tell you the good part and leave out the work required.

It’s similar for people who save money by being their own property manager. You might hear “I get an infinite return by managing it myself” because they put in no additional money. But you know better – putting in time and effort is just another form of the same thing.

This helps keep me grounded. I am not doing as well in real estate investing as plenty of people. It is easy to hear their success stories and feel like I’m not doing enough. It is natural to want more.

But at what cost? What is the effort required? How can I put in 20% of the effort and get 80% of the results?

For me the answer is purchasing buy-and-hold rental properties from out-of-state turnkey operators who do most of the work. I’m still able to get a 29% annual return and that’s good enough for me!

The 4 Reasons Why Dividend Investors Should Own Rental Properties

April 25, 2016

Can you ever have too much of a good thing?

Yes – doughnut holes. Once you have more than 10, you run out of fingers to put them on. Somehow they don’t taste as good after that…

What about cash flow? Can you ever have too much money flowing into your bank account?

This is what dividend stock investors are chasing. Allow me to set the record straight – there is a better way.

The Appeal of Dividend Paying Stocks

First, what is a dividend stock? It is one that actually pays it’s shareholders a fraction of the profits each year. What a novel concept!

Let’s imagine a company – Beagle Inc. Their shares cost $100 each and you buy one.

Beagle is a great company that turns a profit every year. However, they aren’t in an industry where reinvesting the profits back into the company will produce even better results in the long run. So rather than scaling up, they decide to pay a portion of the profits as a dividend to the share holders. Typically this runs in the 2 to 3 percent range per year.

So at the end of the year, your 1 share of Beagle Inc pays you $2.

Not bad! Most dividend investors will reinvest this back into the company or dividend index fund (yes, you can group together tons of companies that pay dividends) to purchase another fraction of a share (in this case 1/50th).

The following year you own 1.02 shares and earn a larger dividend payout. Fast forward a couple decades and with the power of compound interest, you receive larger and larger payments.

Over time investors hope that the stock price rises, the dividend payments slowly increase, and you can start a snowball effect by constantly reinvesting the dividends in new shares.

What’s not to love?

It Could Be Better…

Companies that pay dividends are not going to experience hyper growth. They are usually well established with predictable profit margins. If they saw the opportunity to reinvest their profits to take on a new market, they would.

Therefore, much of the growth of the stock price and dividend payments will be due to inflation. Meaning, if a company like AT&T experiences profit growth, it likely isn’t because they launched some new-fangled product. It’s because as inflation happens, they slowly keep raising prices.

So you have an investment that keeps up with inflation, pays a bit of a cash flow that you can reinvest, and allows you to start a snowball effect of compound interest. Sounds like investing in rental properties!

Rental properties have four advantages though that make them more appealing than dividend stocks.

1. Better Dividends

Most dividend paying stocks will pay out 2 or 3 percent of the share price per year. Of course there are outliers, but they are riskier. You used to be able to get around 5% a year, but that was likely due to times with higher inflation.

How does that compare to rental property investing? Pretty pathetic.

I’ve been earning about 9% cash return per year on my rental properties. This might be a little higher than longer term projections, but it shouldn’t be hard to get above 6% per year.

This is due in large part to #2 and #3.

2. Better Financing

You don’t have to buy a rental property with all cash! You only have to put down 20% of the value of the property and a bank will loan you the rest at a very attractive interest rate. Well, choosing a rental property that can generate good revenue can be a difficult task. This might be the reason why many of the real estate investors tend to hire agents (similar to realtors Lynchburg) who can filter the search process and find good rental properties for them to buy.

That said, what about Stocks? Almost everyone pays the full price up front. You can technically buy on margin, but even then you need 50% and at any point they can decide they want their money back.

With rental properties you lock in that financing for 30 years.

Most investors don’t understand the power of leverage. A stable rental property in a boring, low-cost city with plenty of jobs will keep up with inflation. Combine that with smart leverage and instead of your investment just keeping up with inflation, you are raking in the big bucks.

3. Better Taxes

Dividend income you have to pay taxes on, even if you immediately reinvest it in more shares. By default this is treated as ordinary income, which means substantial taxes.

However the IRS treats certain dividend investments as qualified dividends. If it’s a US company and you’ve own the shares for at least 60 days, you can usually pay the capital gains rate on those dividends. For me that would mean 15% federal. For the ultra-richies it is 20%.

That’s a pretty nice tax advantage for dividends. But can rental properties top it?

Well, ya! Unfortunately, there isn’t just one number that I can quote you it varies. You get to deduct “phantom expenses” like depreciation. This means you didn’t actually have to pay anything out of your pocket that year, but still get to act as you did on your tax returns. However, make sure to have a separate account for these transactions, so you would be aware of the tax or dividend returns you are getting. If unsure, you can take a look at this list of Best Business Checking Account – Our Top 6 Picks for 2022. It would likely give you an idea about the types of business accounts available for enterprises and you can pick the one best suited for your requirements. This way, you could also find a way to save your taxes.

Moreover, with depreciation alone, most of your cash flow will be tax free! I go into this more in Behind the Numbers – How I Calculated the Return on My Rental Properties.

4. More Control

When you buy a share of stock, you joins millions of other shareholders. Occasionally there might be a shareholder vote, but I think it is safe to say you have zero control.

What if the company decides to go invest heavily in some new market or pay the CEO a $100M bonus? Your only option is to sell your shares.

As a direct investor in rental properties, you run the show. You can reinvest the cash flow, just as you would with dividends, but there are also many more knobs and levers you can use.

One powerful strategy is the cash out refinance – over the years as you build up equity, you can refinance your loan to access the equity tax-free. That’s right, you can receive tens of thousands of dollars, pay zero dollars in tax, and reinvest it in another property (or any other way for that matter). Wow.

You can also “trade up” – selling your property, paying zero in taxes with a 1031 exchange and buying a duplex, four-plex, or apartment building. This is certainly something 1031 exchange brokers can help with!

Maybe remodeling the kitchen would allow you to charge higher rents… think something like that would be possible in dividend investing?

Rentals vs. Dividends

Both are chasing the same thing – cash flow. Yield. Dividends. Whatever you want to call it.

Both allow for the snowball effect of compound interest, which over the course of decades is extremely powerful.

Both are largely dependent upon inflation for growth in the underlying asset, as well as for the cash flow to increase.

But with these four advantages, rental properties clearly win.

What do you think? Should dividend investors consider switching to investing in rental properties?