TOOLS OF THE RETIREMENT TRADE – REAL ESTATE PART 1

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I remember my friend Rob telling me about this book called Rich Dad, Poor Dad in 2003. We were both new dads and husbands. We were trying to figure out life in general. We were both entrepreneurial in spirit, but hadn’t yet found out place in the world.

I read the book in quick fashion. I was already working in the real estate business, but this book cemented my decision to go all in. I was going to create … cash flow. I was very excited. In 2007, I learned a hard lesson about investing in real estate.

In 2007, I learned a hard lesson about investing in real estate.

Recently, I was reading a magazine article about investing that explored the question, “Is housing still a good investment?” (Doti & Lawandy, 2017) The authors went on to illustrate that real estate could provide nearly triple the returns compared to the stock market.

Amazing.

However, there is one sentence that older investors may appreciate, “That’s the miracle of leverage.”

Some of you just wondered, “What is leverage?” Leverage is a fancy way of saying, “debt.” Leverage/debt magnifies returns and losses. If you have 2x leverage and the market rises by 1%, you get a 2% return. However, if the market falls by 1%, you receive a 2% loss. Let’s take this another step forward. Let’s assume you put down 5% to buy a house. This means you used $25,000 to buy a house worth $500,000. Many families do this when buying their first home. They are excited to buy that home! Their downpayment is now levered 20x on their investment/house. What happened to the poor soul that bought the home in 2007? Suddenly, not only did their equity disappear, they were upside down, in some cases, by hundreds of thousands of dollars!

Do you have the cash to pay for the flow?

The authors stated, “… the miracle of leverage results in … well, a miracle.” Awesome! If leverage is “miraculous” what if we applied it to the stock market too?! What if we compared a 3x stock return to their 20x real estate return? Considering the authors’ illustration, what kind of leverage would the stock market need to take to match real estate’s after tax return[1]? Did you even know you could buy an investment that gave you three times the gains and losses of the stock market? Could we even stomach watching our returns and losses be three times the stock market’s? That is a LOT of risk. Do you think the real estate market doesn’t come with risk? What happens when you multiply that risk by twenty? This isn’t to say the authors are wrong, but to illustrate that we are comparing apples to orangutans.

Families often ask if they should keep their real estate portfolio or sell or refinance. My typical answer is, “I dunno.” This takes work to figure out. We consider leverage, debt service, taxes, etc. Most importantly, we figure out cash flow.

Most people, when they hear cash flow, think rental income. No. Wrong. Alto. Rental income is the cash half of cash flow. Debt service, repairs, taxes, insurance, etc. is the flow half.

What happens when you don’t have renters 2 months out of the year? What about 3 months? 4 months? 5, 6, 7? What if you go 10 months with no rental income?! Do you have the cash to pay for the flow?

What happens when you don’t have renters 2 months out of the year?

Real estate is a fantastic investment, if you can keep it. Many real estate investors begin with huge amounts of leverage/debt. Most institutional investors have some sort of leverage/debt. Remember that this leverage exacerbates returns AND losses. This is OK so long as you can keep your investment in the lean times.

Real estate should fit somewhere within your investment portfolio, but it shouldn’t BE your investment portfolio.

Don’t accidentally allow one investment to expose ALL your investments to the risk that comes with leverage … and …

DON’T PLAY CHICKEN WITH YOUR NEST EGG!

[1] About 2.5x

References

Doti, J. L., & Lawandy, F. (2017). Is Housing Still a Good Investment? Orange County Business Journal.

 

 

 

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