Real Estate 026: The Real Estate Advantage

When comparing different asset classes for investing long term, the most talked about classes that I have found, were stocks, bonds and real estate. Real estate is often viewed as a middle ground between the high volatility of the stock market and the low returns of the bond market. Stocks definitely have their advantages and disadvantages when put head to head against tangible rental real estate (e.g. Not REITs, private lending, notes, etc).

In my opinion, rental real estate is a far better way for the average person to become wealthy and retire early through the various tax advantages and steady cash flow that rental properties provide the landlord. Lets take a look at some of the pros and cons as listed below an discuss the key features:

Stock Market

Advantages

• Liquidity: Stocks are a liquid asset, meaning that it is very easy for an investor to buy or sell parts of their portfolio, if not all, within a couple days (assuming its publicly trade).

• Less work: Investors who typically invest through their retirement account have the option of choosing from a pool of funds pre-selected by the brokerage. This equates to less work in researching the underlying shares within a fund and looking into individual financial statements, their projected earnings, and other metrics.

• Diversification: By investing in stocks, it is easy to pick and choose individual shares (slices of the pie) or purchase funds (whole pies) that have a mix of equity, large cap, small cap, international, and bonds (toppings and flavors) that provide diversification.

Disadvantages

• Short Term Flux: Stocks are known to have extreme fluctuations in a relatively short period of time, and this can negatively impact an investor who is trying to live off of their investments during retirement. Further, for the average investor with limited resources, it is even more difficult to understand the reasoning behind the fluctuations and the internal/external influences that impact the value of a portfolio.

• Market Value: Investments are typically made at market value or the trading price as the market is efficient, meaning that you cannot negotiate a discounted share or find a "distressed company." Although you can study the company and be a prudent investor in what you believe to be undervalued, there is also a chance it can plummet to zero.

• Less control: An investor has the ability to pick their fund or individual stock, but they do not generally have a say in the day to day operations of the company. Shareholders with a significant position can choose the Board of Directors who oversee operations, but for the average investor, they are merely a passive investor that does not have control of the decision-making process.

Real Estate

Advantages

• Tax Benefits: One of the largest benefits enjoyed by real estate owners is the numerous tax benefits currently in the IRS tax code. Write offs can relate to depreciation, maintenance and repairs, business travel & meals, mortgage interest, and many more. Further, you can defer the gains of the sale of one asset through a 1031 exchange into a new property.

• Inefficient Market: The real estate market is inefficient compared to the stock market, and investors will always be able to find distressed property and motivated sellers (e.g. death, divorce, inheritance, exit strategy, etc.). This gives real estate investors the ability to find discounted properties and create equity through hard work.

• Complete Control: With real estate, you are in complete control of the asset in terms of the purchase price, location, rent-to-value, choosing tenants, and exit strategy. You can choose to sell off your asset, 1031 exchange into a larger rental, or seller finance it to a tenant (lease option).

Disadvantages

• Illiquid Asset: Once you have purchased a rental property, it is much more difficult to sell or transfer than a typical stock. Even for an all cash transaction, a typical escrow may take 7-14 days to close due to inspections, and other contingencies.

• More Up-Front Work: Compared to purchasing stock through a fund, real estate requires you to do some research on the market, the team, and the property. With time, you can use your knowledge and streamline different processes or outsource the most of the work, however, getting to that point will require commitment from the investor.

• Tenant Risk: Rental properties have tenants living in the units, as such, comes with added risk unseen in the stock market. You have to be well versed in the local laws and regulations to ensure that you are not exposing yourself to necessary lawsuits and liability.
  

The simply way I view investing in stock vs real estate is by looking at my competitive advantage. For me, I know that there are hundreds of smart, capable people on Wall Street with deep pockets and resources to out perform the average investor. On the flip side, real estate markets are local, meaning what happens in Los Angeles, doesn't necessarily impact Texas the same way, and vice versa. This allows an investor to choose where they want to compete (e.g. single family vs multifamily, A class vs C class neighborhoods, primary markets vs secondary markets) and avoid stiff competition.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Investing 004: Opening a 401K Retirement Account

As you enter the workforce as a young adult, you are faced with many questions such as finding a good career, finding a place to live outside the parent’s nest, paying off student loans, and others. Many of these factors and more also play a key role in how you prepare for retirement. One of the most important decisions you will make is how you plan to fund your retirement. One of the most common themes I often hear from employees in all walks of life is that they simply do not think they have enough money to save or invest. As mentioned in previous blog posts, a key strategy to my retirement plan is to automate my savings and investing. As millions of baby boomers are set to retire in the next decade, they are now more aware than ever of their retirement account balances, or lack thereof. In order to hep facilitate savings, many employers have begun employer sponsored retirement plans such as the 401(k) that help employees automatically set aside funds in tax-advantaged accounts. Tax advantaged accounts can significantly change the amount of money you are left with during retirement if you plan correctly. Many 401(k) plans take small amounts of funds selected by the employee and directs it into the employee’s beneficiary account. Furthermore, many employers offer a matching program on all or a portion of their contribution up to a certain limit to entice their employees. Lets take a deeper look into the anatomy of a 401(k) and how you can get started:

What exactly is a 401(k)?

A 401(k) retirement plan was established through section 401(k) of the Internal Revenue Code (IRS) that gave employees the ability to defer taxes on their contributions towards their retirement up to the annual limit, or in the case of a Roth 401(k), allowed them to pay taxes when they contribute, but draw funds tax free at retirement. Furthermore, it allowed employers to contribute company funds towards their employee’s retirement through an employee match, providing additional perks and incentives to retain key employees for longer periods of time. In general, Companies typically partner up with mutual funds (e.g. Vanguard, T.Rowe Price, Fidelity, Charles Schwab, to name a few) to pick a handful of investments that employees can use to allocate their funds in the portfolio. An advantage is that most of these large mutual fund companies provide lower fee structures for institutional (Companies) clients, but a drawback is that there are limited options if an employee wanted a “specific” vendor or fund to invest in. The biggest takeaway in setting up a 401(k) early on in your career is the ability to lower your taxable income in the amount equal to your contributions. As such, if you made a $100K/year, but contributed $15K towards your 401(k) retirement, ignoring tax credits and deductions, you will have reduced your taxable income by $15K, which at a typical 25-30% tax bracket for single workers in California, equates to about $3,750-4,500 in cash savings per year.

How to open a 401(k)

Now that we have looked into what a 401(k) is, lets find out how to get one started. Assuming that your Company offers this plan (not all Companies do this as there are cost/benefits in maintaining this service), you can first talk to the hiring manager or human resources to find out if you are eligible, as some companies require a minimum time of service prior to enrollment. Next, you will need to identify how much you want to invest per pay period, whether it is a fixed dollar amount or percentage of your paycheck. Once that is determined, you will need to select the allocation percentage from different fund options selected by your employer. For example, lets say you decide to contribute a fixed amount of $500/month towards your 401(k) retirement, or $6,000/year. Out of 12 mutual fund options, you decide to choose 3: SP500, international stock fund, and bond fund. You can decide to allocate 50% to the SP500, and remaining 25% to each of the funds, or you can split equally in 33.33%. Please note you can “rebalance” your portfolio as they balances move up and down throughout the year, and also re-allocate funds from one to another if you feel like doing so.

Managing your 401(k)

An importance piece to owning a 401(k) plan is that this offering is typically reserved for “employees” only. Meaning that if you ever decide to move to another company or simply quit/retire, you will generally have three options: 1) Move the 401(k) funds into the new employer’s 401(k) through a trustee to trustee transfer 2) Move the 401(k) funds into an IRA (Individual Retirement Account) 3) Withdraw funds. Its very important to note that when you are going with option #1 and #2, you cannot request the funds through check/wire into your bank account and send it to the next institution. Even though you send the exact same amount that may have come in, it may trigger a taxable event identified as a withdrawal, that will add penalties if you are not of retirement age. As such, please consult your CPA and retirement plan administrator prior to making changes and to understand the implications of the transfer.

As mentioned previously, a huge benefit in 401(k) plans is the possibility of an employee match. For example, if your employer is providing a 50% match on the first 6% of contributions, your contributions can look as follows: Employee makes $100K /year and decides to contribute the maximum employer match of 6%, which is $6,000/year. In this scenario, the employer will contribute $3,000/year total towards the employee’s account. That is a guaranteed 50% return on investment on the employees contribution, even if the mutual fund does not go up or down a single penny throughout the year. Please note that some employers do not allow employees to front load or back load their contributions, meaning contributing $6,000K in January and pausing month 2-12, or vice-versa. Employers may only provide matching when employees are consistently contributing to their account with each paycheck, so please check with your plan administrator.

In conclusion, saving and investing for your retirement is going to be an important decision. Making good choices early on will allow you to take advantage of compounding interest and time. Whether you invest in real estate, or individual stocks, a 401(k) may be a great way to diversify, automate your savings, and also take advantage of company matching (aka free money). My personal investing strategy consists of 70% real estate and 30% stocks (IRA/401(k)), but I sometimes use 401(k) funds to purchase rental real estate through a 401(k) loan or use as reserves for the Fannie Mae underwriting requirements. I will post more blog posts about creative financing with 401(k) loans in a new blog.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 025: Scaling your Real Estate Portfolio

After meeting with hundreds of real estate investors through BiggerPockets, Real Estate Meetups and Conferences, I have seldom met an investor who does only one deal. The goal is to find a formula that works for you and your goals, and repeat the process enough times to achieve the target passive income. The big question becomes, how does an investor scale from a handful of properties to tens or hundreds of units? I have highlighted four different ways that an investor can scale their portfolio below:

Spend less and invest the difference

This option may seem like a no brainer, but its sometimes easy to be overlooked. As a buy and hold investor, you are in it for the long haul, meaning that you have to be consistently earning more than you spend (I personally suggest you get to a place where you are able to comfortably stash away 40% of your earnings), invest the savings into cash flowing real estate, and repeat the process. Each time you go through this cycle, you should have additional funds from your new rental property to help enhance the velocity of this cycle. One mistake I see investors make, is they begin to inflate their lifestyle along with their newly built portfolio. For example, they may put $25,000 down to purchase a turnkey duplex property in the Midwest that generates $400/month in passive income after all expenses and debt service. They use this $400/month to pay for a new car lease that they wouldn't have bought otherwise. While rewarding yourself is important, this is a risky move as that $400/month cash flow is never 100% guaranteed. Meaning the tenant could stop paying, leading to an eviction and couple months loss of rent before that $400 starts coming in again. During this time, you are left paying the mortgage and expenses related to upkeep of the rental in addition to the new lease payment. You have effectively dug yourself a bigger hole to climb out of.

My advice is to continue living as if you have not creating the additional stream of income. Think of it almost as a 401K or IRA account that is restricted from use. By placing this phantom restrictions on this newly created income, you will be able to reinvest the earnings into your business again and again and exponentially assist in the growth of your portfolio. Lets say you were able to buy 2 rentals a year through this process. By year 5, you have  10 properties that generate $4000/month in passive income, which means that every 6 months, the cash flow from your portfolio alone is enough to purchase another rental so you can buy 4 properties a year instead of 2. This will shorten the growth from 5 to 2 years, and so forth. This is the snowball effect that myself, and many other investors have realized while building their portfolio. I have personally increased my W-2 income by 28% during the growth of my portfolio, reduced my expenses, and did not use the cash flow from my rentals to offset any of my personal living expenses. That way, I was able to allocate nearly 30-40% of my earnings straight into investing for my future.

Private lenders & BRRRR

Another way of building your rental portfolio is through using private lenders.  A private money lender is an investor who makes loans secured by real estate or promissory note, typically charging higher rates than banks but also sometimes making loans that banks would not make (rehab loans), funding more quickly than banks and/or requiring less documentation than banks.  Private money lenders exist because many real estate investors need a quick response and quick funding to secure a deal when looking for a real estate loan. Banks and other institutional lenders that offer the lowest interest rates don’t provide the same combination of speed and transparency in their decision making process, along with quick access to capital. By securing private lenders who will fund 80-90% of the purchase price and/or rehab, you have significantly reduced the amount of capital you need to acquire a new deal. As long as you can find a deal that is "all-in" near 70% of the ARV, then you are able to find a discounted property, renovate it, and force the appreciation (read: sweat equity), that will take place of a normal cash downpayment. You can repeat this property to scale your portfolio, otherwise known as the BRRRR (buy rehab rent refinance repeat) strategy.

HELOC

A HELOC, or home equity line of credit, is a 2nd mortgage (home serves as collateral), but a HELOC is a form of revolving debt, like a credit card with simple interest (not amortized). This means that you are able to withdraw money up to an approved limit, using a bank transfer, card or check, repay it and draw it down again within the predefined terms of the loan. As a HELOC is a secured loan, you are able to obtain a lower interest rate than the average credit card (around 22-25%) or personal bank line of credit (typically 8-12%). Savvy investors will use the equity in their primary residence or rental property to withdraw capital at low interest rates (e.g. 5%) and re-invest the funds into another cash flow rental property (e.g. 15% cash on cash) and make money on the spread, or difference of the return (10%). As you are cash flow positive in this scenario, you can effectively continue this cycle until your HELOC is fully utilized. Be sure that you are investing into a deal has significant upside, as a HELOC typically has variable interest that may jump up and eat into your profits. I personally only use my HELOC on the BRRRR strategy as I have a exit strategy (re-finance) and pay off my HELOC balance in less than 6 months, reducing my overall risk to variable interest.

Partnerships

Whether your expertise is in finding good deals, underwriting potential leads, or bringing the capital to fund the deals, each investor that you meet may be a potential partner. If you find someone who has complimentary skills, you may consider bringing them on as an equity partner. I have personally bought 4 units together with an equity partner and there are multiple benefits such as pooling of resources, increased capital, and diversification of risk. Lets say that you are great at marketing, and can find distressed properties from motivated sellers for 20-40 cents on the dollar. This is a huge value add for an investor who has capital but does not have time to conduct direct mail campaigns or call motivated sellers for screening. By teaming up with each other, you are able to take down a property with significant upside and refinance once the rehab is complete to allow each of the partners to recoup their initial investment and/or create equity that would otherwise be unavailable had they chosen to work as separate individuals.

These are the four ways that have allowed me to purchase 12 units in about 1 year, and as you continue gaining experience, you will learn to add more tools to your tool belt such as seller financing, subject to, and other methods that allow you to scale by being a little creative. There is more than one way to invest in real estate, so find a way that works best to meet your goals. As mentioned above, it may feel as if $400/month is not life changing, however, the steps that you took and knowledge gained to increase your passive income IS. These small changes and building blocks will be the foundation that will eventually lead you to create thousands of dollars in passive cash flow a month and achieve financial freedom years.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!