The Age Old Tug of War Between Schools of Thought – Long Term Real Estate Investing

BawldGuy Here: I first published this piece about six months ago. I was thinkin’ it was time to put it up top again. Hope it sheds some light for ya.

There are multiple schools of thought related to investing in real estate for retirement. Two dominate.

One says you buy property, holding it forever. When you’ve saved sufficient capital to buy additional property, you do — then hold IT for evermore too. The idea is you allow rental income to pay off debt as quickly as possible, arriving at the point of a debt free cash flow machine. Do this a buncha times and you’ve built the foundation for a nice retirement income stream.

Or so the doctrine goes.

The other school’s doctrine teaches cash flow comes from the yield on capital or equity in an asset. The bigger the capital amount or equity in the asset, the greater the income, measured in dollars. The ‘yield’ itself is expressed in terms of a percentage. For example, 7.5%. This commandment says that since the yield is equal, more or less, for a more substantial or less generous figure, why not arrive at retirement with the largest amount of capital and/or equity possible?

The million dollar questions?

The ‘Buy & Hold’ school (BHS) gets you there. But in what condition? Furthermore, how much cash flow relative to the ‘Capital Growth First’ school (CGF)?

Buy and Hold

Limited to how fast investor can save capital for down/closing on each purchase

Properties are old, having high maintenance/expenses when investor retires

100% of income is devoid of any tax shelter — right when they need it most

Properties more likely than not to exhibit functional obsolescence upon retirement

Older properties generally don’t compete well for highest quality tenants

Props are old when you retire, & only get older each year — not a good trend

Rents will be less likely to keep up with the competition — or inflation

That’s the short list, but you get the idea. Buy and Hold should be called Buy and Mold.

First — Capital Growth

By ensuring a more or less superior capital growth rate — net worth increases

Capital growth is maintained by exchanging equities when the market dictates

Exchanging keeps the power of prudent leverage working

This results in significantly larger capital/equity base

Larger capital/equity base = larger income in terms of dollars using same yield % at retirement

Arrive at retirement with higher income, mostly tax sheltered

Able to execute strategies completely unavailable to Buy & Hold

Again, that’s a short list. You can readily see the advantages.

Here’s an example with some real life numbers for illustration. Sadly, the investor used in the example chose to stay his buy ‘n hold mold course. Here’s what coulda happened if he’d switched strategies.

Considering Real World Examples

“Wayne”, 71, came into my office many years ago — a genuine born again buy ‘n hold guy. His pride ‘n joy was a fourplex, purchased in his 30′s, now free & clear, spinning off a net income of roughly $2,900 monthly. This is in addition to two other income sources — Social Security and a taxable annuity.

Wayne’s paying a lotta taxes on the annuity income and the fourplex — neither of which is keepin’ pace with his cost of living. He retired in 2005. He bought the fourplex in 1975. We both live in San Diego, so I’ll be using that market to illustrate. The principle works for most any market — especially over the long haul.

He paid just about $80,000 back then. Upon retirement the value was nearly 10 times that. Where would he be today had he gone the capital growth route? So happy you asked.

The market would’ve signaled him to exchange his increased equity position in the first quarter of 1979, give or take. Having put 20% down, his equity at that point would’ve been around $100,000 — more than five times his originally invested capital. His cash flow for the period won’t be added into that, except for the paying of closing costs on his newly acquired exchange property(s).

He now owns about $400,000 in multifamily properties. He’s conservative, so due to interest rates at that time, he puts 25% down. He then waits for the next time the market signals him to make a move. It’ll be longer than four years this time, as the recession exacted its toll. Meanwhile, his units are rented, with slightly increased rents over the long term. The recovery arrives around the end of 1983. He waits, wanting to be sure. Values again start rising. Still, he waits. In roughly July of 1988 he triggers another tax deferred exchange with the following results.

Note: From roughly 1985 to the beginning of 1990 appreciation rates in SoCal were double digit, more or less depending what specific market. San Diego did, um, well.

His exchangeable net equity at that point was approximately $275,000. Again, he chose to put 25% down on his exchange uplegs. (newly acquired properties)

Let’s pause at this juncture to figure his capital growth rate.

It’s been 13 years since he began with about $18,000 to close his first investment back in 1975. He now has $275,000. That’s an annual capital growth rate, exclusive of tax benefits and cash flow of about 23% — a figure nobody with a three digit IQ would predict in public, but historically accurate nonetheless.

Anywho, he now owns about $1.1Mil dollars of multifamily properties. They not only pay for themselves, but cash flow — not heavily, but enough to make him happy. For the record, he does two things consistently along the way — one I recommend sometimes, and one on which I insist. He has way more than adequate cash reserves. I call it a Sominex Account, as when Murphy visits, you can still sleep at night.

The recommendation at this point is to apply a portion of the cash flow to the loan balance. Back then it was almost a built in practice for my clients, due to interest rates 2-4 points higher than today’s. It just made sense. It’s called keepin’ your eye on the ball, which in this case is growing the guy’s capital/equity safely over the long haul with retirement always #1 on the hit list.

Around this time the S & L Crisis hits San Diego like boulder hits a bug. It was beyond horrible. Not only did we experience what everyone everywhere else did, we had the added thrill of losing two huge employers overnight. Talk about both barrels of the shotgun goin’ off point blank. Vacancy rates went from virtually zero to 10-15%, oft times more depending upon location. Rents plummeted even more in some cases. Bottom line? Wayne’s cash flow went from cool to break even faster than Rubio’s makes fish tacos.

This forced a holding period of about 10, no, more like 12 years. What’s an investor to do? Life happens. It certainly did back then. It seemed Murphy squatted in San Diego the whole time. Ever heard of O’Toole’s corollary to Murphy’s Law?

“Murphy was an optimist.”

Wayne executed another trade, tax deferred, in the early spring of 2000. His portfolio by then had risen at a more modest rate than in previous times. Real life. It’s now worth a total of $1.6Mil — give or take. His net tradeable equity is roughly $645,000. Relatively speaking, interest rates are a bit less, but he insists on a 30% down payment, overruling my advice to try 20% this time. It’s his money, so guess how much he put down? He’d been made nervous by his experience of the early 1990′s. Um, me too.

When the smoke cleared he ended up with $2.15Mil in multifamily property. It wasn’t cash flowing much, give or take $25,000 a year. His retirement was, according to him, a long way off. He changed his mind about that later.

In fact, he decided in early 2004 to call me about setting in motion his transition from capital growth to cash flow — he wanted to retire no later than spring of 2005, about 30 years after buying his first investment property. After much analysis and a few meetings of the mind, we agreed — he needed a property outside of California. The prices were simply outa whack in the Golden State, a fact of which we were both painfully aware. The search began.

First we had to ascertain how much equity we had to trade — cue the HappyFeet music.

Seems his luck had turned around again. From his latest acquisitions in 2000 his portfolio had grown in value from $2.15Mil to the neighborhood of $4Mil. His net tradable equity was about $2.2Mil. Let’s take a pause for the cause here, alright?

Is that a white flag I see being waved by the buy & hold crowd? Just askin’ . . .

We didn’t care much about growth now, as we wanted stable markets, not much prone to big swings either way, historically. Idaho, Texas and Kansas/Missouri ended up on the short list. We really liked Texas though, which is where we landed. We ended up with about $5.5-5.7Mil in cash flow properties. (Larger properties this time.) The cash on cash return averaged around 7-10% conservatively. This resulted in a yearly cash flow, the majority of which was tax sheltered by the way, of $140-200,000 yearly.

For discussion sake, discount the low part of that range by half. You still end up with $70,000 a year at retirement — mostly sheltered — not in ancient properties with ever rising operating costs. Even discounting the low end of the income range by half, he still finds himself with just short of double the retirement income he did applying the buy and mold, um, hold school of thought.

Of course, he won’t hafta discount all that mostly sheltered cash flow. A retirement income of five figures monthly. Sweet.

Here’s the real plot twist. Just as he did on the way there, Wayne can still apply a prudent amount of cash flow to the premature reduction of debt. Each multifamily property he pays off will increase it’s cash flow to him by a factor of 2-4. Nothing like getting a $500-1,500 a month boost in income on a regular schedule.

Real life for Wayne

Back to Wayne’s current reality. He’s now retired on just under $36,000 a year from his fourplex. His SS income and annuity supplement this. However, as pointed out earlier, every single dollar of the annuity and the real estate is taxable. Ouch. Furthermore, he’s now discovered, much to his chagrin, that he didn’t retire — he started serving a life sentence.

His option from Day 1 was to end up with so much sheltered retirement income that his SS check would simply be spending money.

So I restate the principle: Worshiping cash flow when capital growth is the appropriate approach will not have the happy ending you envision.

What school of thought do you favor? Let’s talk about your specific status quo and figure out what might be on your menu. Gimme a buzz at 619 889-7100. Or, if you’d rather, click on the ‘Contact BawldGuy’ button up top. Have a good one.

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3. Stocks vs Real Estate — Both Down Now — Long Term? RE Still Easy Winner
4. Rehabbing VS Long Term Investing — Who Has More Money In 20 Years?
5. The Short Term – Long Term – And End Game