401k v Real-estate. A close call, then?

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I wrote a series of posts about a hypothetical ‘battle’ between the Mighty 401k and Humble Real-Estate. For those with a sharp eye, I posed the original post as a question, not a recommendation.

However, it is my contention that, for many people, the 401k will lose when compared to many other forms of active investment – including, but not just real-estate!

For those of you who read this highly contentious post – and, the follow-up posts (which you can find by following the ‘track-back’ links listed at the bottom of the original post) – you will, hopefully, realize by now that my point was simply this:

Don’t blindly follow the pack by simply plonking your money into your 401k to get the ‘free money’ employer match and tax-benefits!

Do your homework first … there may be better investment options out there, for you.

The example that I used was comparing the 401k to investing in 4 or 5 single-family homes as rentals; Pinyo said that he ran the numbers and the 401k ‘won’ (but, he didn’t provide any further details) and Jeff says that he ran the numbers are found it to be a close call – you always know that you’re in trouble when somebody begins with “I appreciate your attempt …” 😉

Anyhow, here’s Jeff’s comments:

I appreciate your attempt at explaining why Real Estate investing should at least be considered over equity investing in an employer-matched 401K. I ran the numbers using your assumptions (adding in tax consequences–property and income–and cost of property insurance) and, although the annualized return was much closer, your Real Estate investing scenerios came out slightly ahead. I expected this result as investment property investing usually carries increased risk (and hand holding) and thus should provide increased reward.

In going through the process of comparing investment options, I was suprised by a few things. 1) the Real Estate investment option, according to your scernio, suffered from 8-15 years of undiscussed or accounted for negative cash flows after costs, such as property tax, insurance, mortgage payments, and your 25% unrealized income either due to maintenance or unoccupancy, and 2), more importantly, the overall outcome (equity v. real estate) varied drastically based on 2 assumptions: estimated appreciation of real estate over 30 years and estimated return in the equities market over 30 years. Even a 1% point swing in either of these assumptions made a huge difference in projected outcome, i.e., which investment option was better.

I looked through your blog (not exhaustively) for a post discussing your reasoning behind these 2 estimates, but failed to find one. Since it seems that the accuracy of these estimates (best and worst cases scenerios over 30 years) is essential in determining if either investment option has a clear advantage, I was hoping you could either point me to a post of yours discussing them, or let me know of any books, articles, etc, that led you to your estimates.

As I said to Jeff, the mere fact that it is at least a close call means that it is no longer sensible to just automatically plonk your money into a 401k just to get the employer match.

Surely, your goal isn’t to gain ‘free money’ and/or tax benefits …

… it’s to end up with a sh*tload of money, right?!

You can only do that if you investigate all the options available to you. By that, I mean all the options that interest you!

For me, that’s stocks (but not mutual funds); real-estate (but not single-family homes); gold/silver (but not other commodities); etc.

For most people, it will simply mean putting up the 401k scenario against one or two other choices, just as I did in the original post with real-estate.

With all the online calculators available out there, it’s not hard to do a rough analysis, using the 401k option – with numbers that make sense to you – as your baseline.

If, as Jeff found, it turns out to be a close call, then stick with the 401k … it’s simple and at least gives the appearance of being low-risk.

For me, though, if it’s a close call I usually choose the most ‘active’ form of investment as I know that I haven’t factored in all the upside potential.

But, to answer Jeff’s questions; it all boils down to your estimates – or at least appears to:

Now, while I used 8% as the return from the 401k to allow for the very-slight-risk (even over 30 years) that you will pick the worst market time to start investing, you will find that the typical index fund will return upwards of 11% over 30 years minus costs (index fund costs; sales commissions; employer admin; etc; etc.).

This all depends upon your 401k and the options that your employer allows – a reasonable rule-of-thumb is to allow 1.5% for costs. So you could rerun the numbers at 9.5% returns.

Now, what company match will you assume? I allowed 100%.

However, will your employer give you 100% match now and for the next 30 years (since, you’ll likely change jobs 4 times in 30 years)? Think very carefully before answering this question!

You will also find that your contributions are maxed to $15k or so a year, which kind of makes this analysis moot, because any serious investor will be wandering what to do with the rest of the money that they want to invest.

On the real-estate side, according to Todd Ballenger author of the new book Borrow Smart, Retire Rich “since 1945, the median house price in the United States has risen by an average of 6.23% per year”. Others will quote studies saying that single family homes only keep pace with inflation (currently 4% – 5%).

So, I selected 6%, which I feel is a little low, and allowed 5.25% for a fixed mortgage (which, now, is also a little low), and 5% rental return (which will start to become a little low again), and 25% of all other costs (incl. insurance, property taxes, R&M, etc.) which could be high or low.

Again, run the numbers and if it’s a close call, don’t bother with the investment option.; stick with the set-it-an-forget-it 401k.

But, let me pose a small question: does investing either way do it for you?

Does it make your Number?

If either way does (and, in the time frame that you want to get there), don’t sweat it … again, go for the 401k and relax.

Life wasn’t meant to be that difficult 🙂

But, if it does not ‘do it for you’, hang tight, I have more for you soon …

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38 thoughts on “401k v Real-estate. A close call, then?

  1. But is it really a binary decision?

    These calculations typically use average rates of return. Over 30 years, those averages can conceal a very wide variety of returns (positive and negative).

    There will be times when it pays to be in one strategy and times when the other will be the better investment. The low risk matched tax advantaged retirement account may be the better choice when property prices are very high and the expected return is consequently lower. Equally there will be times when property investors are an endangered species and properties can be picked up very cheaply and can be expected to show above average returns.

    I wouldn’t pick just one option and just stick with it for 30 years.

  2. @ Trainee – me either, but isn’t that what people do when they switch ON their 401k and switch OFF any other form of ‘retirement saving’ (“well, I’ve got my 401k and then there’s always Social …and, I do own my own home”) …

  3. I would also suggest looking at other tax sheltered accounts for retirement investing. A Roth IRA gives you far more investment options because you can open an account with any broker. You can pick which investment to buy from whatever the broker will sell so you have much more control and can pick the lowest fee mutual funds. The best part of a Roth account is that all of the gains are tax free! If you are young not having to pay taxes is huge due to compound interest!

    @ Trainee – That’s the idea behind diversification and rebalancing. If you invest in multiple things and periodically adjust the balance between them you are forced to buy low and sell high. BTW you can invest in a REIT in a 401K/Roth account too to have some real-estate element in your retirement savings if you don’t want to buy investment properties.

  4. @ Rick – With employer match? Without it, we are just comparing mutual fund performance v real-estate, both of which can be done WITHIN a ROTH IRA (subject to government imposed limits, of course).

    Also, I agree with the “buy low” part … but, why “sell high”? Warren Buffett got rich by not selling his winners … he holds on to them.

  5. AJC,

    I take advantage of the employer match for the 401K and have a ROTH IRA as well.
    I suspect having some money in each type of account will be beneficial in the future. Who knows what taxes will be in the future? Using both increases total I can put away tax sheltered as well.
    You choose an asset mixture for a reason- to have a certain level of risk. To maintain that level of risk or lower it as you become older you will need to rebalance.
    If you don’t have a large investment compared to your contributions you can rebalance just by changing what you buy. Have too much in stocks? Buy bonds. Too much in bonds? Buy stocks. However, after a number of years that isn’t practical because your contributions are too small to make an appreciable % change in your total portfolio.
    Another reason to sell is that there are bubbles where the valuation of particular resources is out of whack. Wouldn’t it be a good idea to sell off at some amount before the peak of the bubble then repurchase after the crash? If you could reliably time the market you would sell it all at the peak and buy at the trough. I don’t have a crystal ball and I’m terrible at market timing. I’ve accepted rebalancing as a reasonable compromise.
    As for Warren I know his favorite holding period is forever, but he is buying individual companies and is really good at valuing companies. He avoided the internet bubble like the plague, but I suspect that if he had stocks that became wildly valued he would sell them off.
    I’m open to better strategies, but rebalancing is easy and can be done in a few hours. I’ve tried market timing and I’m pretty confident I can’t do it well. Picking stocks like Warren is a LOT harder and is a full time job for him and how many of his staff? I couldn’t see that being viable without at least a million to invest. At that amount the difference between the market average and Warren’s long time average would pay for a full time salary. And that assumes I can lean to pick stocks as well as Warren does.

    -Rick Francis

  6. Thanks for the follow-up post. I was being sincere when I started off my comment “I appreciate your attempt.” Most of blogs/sites I’ve seen just say RE investing is too risky or too good to be true without any analysis. I always knew I would investigate RE investing someday…your post just started the ball rolling for me.

    After reading a couple books, it looks like the majority of the return comes from leveraging your money and keeping your money leveraged over your holding period. Also, reinvesting your cash flows into another investment (instead of living off of them) adds additional compounded return over the long haul. These, however, dramatically increase risk…but, no risk, no reward.

  7. @ Jeff – Reinvesting your cash flows, instead of spending them, actually REDUCES risk; the only one that matters: the risk that you WON’T make your financial goals! 🙂

  8. Excellent post, I agree with you about the number. However, think you should use real rates of returns not some theoretical possibility. For example your number on mutual funds is 9.5%. Well actual rates of returns for individuals investing in mutual funds averaged 4.4% over the last 20 years (Dalbar, Inc. Vanguard, etc.). I can’t get the raw data from these folks, but an educated guess is that less than 2% of investors in mutual funds get anywhere near that 9.5% return. I have (and I am sure you have also) seen real estate returns averaging 20% over that same 20 years when using 4:1 leverage. Add in the positive cash flow and you can easily have another $1 million over that time.

    [link removed]

    Keep up the great blog!

  9. Nice play on words…I get your point though…if an investment cannot provide enough return to reach your goal, then you need to look for another investment (or reevaluate your goal).

    As you probably know, I was using the term “risk” a bit differently. When evaluating an investment, I think of “risk” as a range of outcomes that the investment can provide. By increasing risk (by leveraging your money or reinvesting cash flows in the RE investing example), you are increasing the spread of available outcomes–both good and bad.

    When you have lofty goals, increased risk can push the potential return past the threshold required to meet your financial goals. The increased risk, however, can also have the opposite effect–which is mostly ignored by your blog, as it treats all outcomes other than reaching your financial goals as a failure–whether that outcome is being destitude or becoming a multi-millionaire (albeit several million short of your goal and a decade or two late).

  10. @ Shaferfinancial – I should write post about stock market returns: is it 21%? 15%? 12%? 9.5%? 8%? 2.5% – 4% … all valid numbers, depending on your definition and how / how long you invest.

    @ Jeff – Aah well, that’s a different point entirely: if you are going to fail, how badly do you NOT want to fail? 😉 But, I think we can have our ‘risk cake’ and eat it: choose the lowest risk method that YOU think is highly likely to meet your ultimate financial goal … not, the ‘like to get’ goal/s, but the ‘absolutely must have’ goal.

  11. @Jeff, using leverage allows you to take on less risk and still gain a rate of return that will produce wealth. Add on strategic long range analysis and you have a winning formula. The question you have to ask yourself is what happens when your investment has some down side experience. Margin calls can be dangerous if you don’t have a cash reserve to cover them. Same as real estate when rents fall or you have a tough time renting units. I think real estate makes the most sense for average folks because the analysis is much more accesible. If you get a 5% appreciation for twenty years and use 4 to 1 leverage you approach 20% return. The majority of markets in the US average 5% over a 20 year period, so the risk is minimized (not eliminated). As long as you have some cash flow to take care of maintainance, rental lapses, management, etc. you should be fine even in a down market.

  12. @ Shafer – Thanks for the comments. There are risks in investing in RE and in stocks … it’s up to the reader to determine which one/s will get them to their goals. The ‘tie breaker’ for me is the leverage that you can apply to RE.

  13. @shaferfinancial
    “using leverage allows you to take on less risk”

    What?!? We must be using a different definition of risk or I’m missing something…

  14. Certainly.

    Let’s pretend that to make your number you require a 20% rate of return. Now there are few unleveraged asset classes where 20% over a long period of time has shown to be feasible. These assets classes are universally high risk even for folks with expertice. In other words they are high risk/high reward.

    But if you employ 4 to 1 leverage, then the underlying asset only has to average a 5% rate of return. Now there are many asset classes where one can reasonably expect to get a 5% rate of return. The assets classes you pick from that even amatuers can get 5% is a whole lot larger and more diverse than the class that only a few select professionals have managed to get 20%. Take stocks for example. There is only one person/company that in public has produced greater than 20% for over 20 years (Warren Buffett, 21% for 43 years). 1 person out of literally thousands of professional money managers! So in fact your odds are much better at finding an asset than can get 5% than one that can get 20%. You have to reach alot futher into the risk basket to find one to get 20% and you pay for the downside risk much more, in my opinion, than what the downside risk is in the leveraged situation.

  15. @ ShaferFinancial – Thanks! You are basically saying that once you pick a rate of return, leverage is a way to reduce risk by using a ‘safer’ class of investment to produce that same return through the power of leverage.

    I agree that RE leveraged 4:1 is safer than trying to pick, say, stocks that average 20% compound return (given that 75% of professional money managers fall short of this target by 5% – 10% and ‘the world’s greatest investor’ only beats it by 1%) I would have to agree.

    But, first you would need to explain how RE leveraged at 4:1 produces a 20% return from a 5% base/unleveraged return – once you also take income/expenses into account (and tax benefits/cost, if you like!) … Jeff, are you still with us, so far?

  16. I guess what I mean is that you discussed how leveraging into an investment can multiply the potential return positively, but didn’t talk about how leveraging can multiply the potential return negatively (when investment return < loan interest rate).

    As AJC points out, in ShaferFinancial’s example, he didn’t take into consideration loan costs. For instance, if you have a 80% leveraged investment @ 7% interest (and maintain that 80% leverage throughout the holding period–which is an interesting proposition by itself), you need to find an investment to leverage that gets 9.6% return in order to receive the 20% overall return–about double the 5% estimate above.

    Sure there are investments that can return 9.6% over the long term, such as the stock market, but in shorter periods, they can behave much differently. Thus, in the short term, there is a very real likelihood that you will incur short falls (when investment return < loan interest rate) that will require 1) an influx of capital (severely reducing your annualized return), 2) an additional loan (adding even more risk), 3) selling at least a portion of the investment (possibly reducing the potential return out of target range), or 4) it could even cause you to go into default and lose some or all of your initial investment, or more.

    Ultimately, I just want to figure out how to calculate (take into consideration) the additional risk–or variance in outcome–that leveraging adds to an investment, so can make educated investment decisions.

  17. @ Jeff – Hopefully, ShaferFinancial can show us his calc’s; else, we can assume that he was oversimplifying the 4:1. We’ll deal with risk in a couple of upcoming posts …

  18. I was talking in generalities and because I am very conservative, giving worst case numbers. If you do the math the return is actually higher.

    If you take out a 80% loan to value mortgage on a $200,000 investment property then you have put $40,000 of your own money in it. Add, another %4,000 for loan expenses, closing costs, etc and you have a total of $44,000 in. If it goes up 5% then the asset is worth $10,000 more. So for your $44,000 investment you have a return of $10,000 or a 23% return.

    Now here is where most people make their mistakes. By putting down 20% you should always have a positive cash flow. If you don’t then you need to move on to another property or another geographic area.

    AJC can tell you about how to run the numbers, but here is how I do it. I add up all known expenses which would include mortgage expense, taxes, insurance, management fee, possibly utilities, and a small deferred maintenance account. Then I look at what the market tells me the most likely rental income is (this may be very different from the current rent payment) and multiply by .85 to account for vacancies. Now if the expenses are more than the expected rent, then you pass. If the rental income is greater than the expected rent, then I put it on the list as a possible purchase. Never purchase an investment property that the expected cash flow is negative. So, all that stuff about the mortgage expense, etc. is taken care of by the cash flow from rent. When you good at investing you can use CAP rates for an easy comparision between properties.

    Now some folks have found properties that cash flow with only 10% down. Great, their return will be higher. Of course over time, your leverage will decrease. As this happens you need to make decisions about selling the property and buying more units or refinancing and putting the equity to work for you elsewhere.

    So let us take a look at the risk. You have assumed a 5% return which historically is lower than what real estate has returned. Hopefully, you have looked at other local economic factors too. You own a property that actually gives you cash flow every month after you pay your expenses. Your risk is in not being able to rent it out (remember you have a 15% cushion on this) for periods of time and the costs of tenant turnovers (once again you have a account with some money in it for maintenance issues). The saying is that you make money on real estate when you buy not when you sell and this provides an example of this. Now remember, I have not credited the real estate with an increasing cash flow, which should happen over time as area rents increase. If you add this in, then the returns start to rachet up pretty rapidly.

    Now, I am not a real estate broker or agent, have no ax to grind and personally invest in stocks as well as real estate of all kinds with all different risks associated with them. I do that because the biggest risk to me is that I will not be able to retire with enough money to produce a decent income, which is what investing in mutual funds will do for you!
    That’s why I find all this talk about risk…well entertaining. People are very bad at understanding risk, and even worse at managing it in my opinion.

  19. Also there are three different kinds of leverage. We have been talking about financial leverage. There is also value added leverage, where you add value to an asset and then sell it with the added value having improved the price. Land development is a prime example of this. And there is labor leverage, where you have employees that add more value to a product or service than what it costs to employ them.

  20. Sorry about the multiple posts, but just wanted to point out that with the post on real estate investing, I did not even add in the depreciation tax advantages, nor the 1031 exchanges. One important idea about building wealth is to avoid outgoing cash flow like taxes. There is very few places that allow you to do that as well as real estate. Taxes represent the #1 expense for most people with it averaging over 30% in the US!

  21. @ Schafer – Yes the ‘technical’ risk is in vacancies; repairs & Maintenance; un- or under-insured catastrophes; and market risks (e.g. real-estate does not appreciate). It is up to each person to decide if these usually quite manageable ‘technical risks’ are offset by the potential huge returns that you can get from (usually hard to come by) positively-geared real-estate.

    On the other hand, for me, the real answer is in your last para which describes what I call the ‘absolute risk’ of NOT being “able to retire with enough money to produce a decent income.” … well said!

  22. @SaferFinancial,

    Thanks for the more in-depth example of leveraging using RE investing. It confirmed my understanding of the potential beneficial return and of the practical up-front process that you can implement in an attempt to limit downside, i.e., purchasing properties that have cash flows in excess of your expected costs (and have a reasonable expectation of maintaining or increasing those cash flows going forward). That being said, your example did not address my previous concerns about increased downside that leveraging introduces into the equation, and thus I still remain unpersuaded that leveraging “reduces risk” as your argued above.

    I agree, the “technical risks” need be manageable. But, how much does the management of these risks (infusion of cash when necessary) reduce your return?
    For instance, do you keep a safety net for possible negative cash flows (high-yield savings account, CD)? Do you then bundle the two investments (investment property return plus safety net return) to determine the actual return of the investment property?
    Do you pull cash out-of-pocket to cover short falls? Since you don’t receive any additional growth from this new cash and the new cash is added to your capital investment amount, it drastically reduces your present and future return from the investment.
    Do you borrow more money to cover the cash flows? Since this borrowed money provides no additional return it puts you in severe negative leverage situation. Further, that loan has to be paid back with future cash flows from the investment property that you were expecting to give you the return your initially expected–for lack of a better term–compounding the damage of the negative cash flow.
    Do you use a cash flows from another property to cover the short falls? This seems to be the best solution for the property receiving the infusion of cash, but to what extent doe sit reduce the return of the other investment property–by reinvesting its cash flows in an investment that provides no additional return? Put differently, it is a loss of opportunity to invest those cash flows in something that will bring additional return–rather than saving your RE investment from foreclosure.

    When you experience short falls in RE investing, which one of these options is best? What did you do when you experienced cash short falls, and why? …and what effect did/does it have on your annualized return?

  23. @ Jeff – Great questions, Jeff! However, I would caution you to remember the phrase: “paralysis by analysis” … in a practical sense, once I satisfy myself that (a) a certain type of investment is within my skill/interest level, AND (b) is LIKELY to meet my investment targets, AND (c) I can cover the risks – usually through a ‘reserve’ which may or may not be sitting in a shoebox with the word ‘RESERVE’ etched in the side, then … shoot … I’ll close my eyes and just go for it!

  24. “paralysis by analysis” — I knew that was coming 🙂
    My prior analysis has led me to eliminate RE investing as an option (for now), as I’ve determined my local market is not advantageous at this time. Since I’m not comfortable buying outside my local area and I am currently pursuing other (what I believe) are more lucrutive options, my pursuit of RE investing had to be put on hold. Normally, after I make that decision I move on, but the fiscal analysis of RE has me intrigued. I’m acutally more worried that my facination with RE investing will drive me to invest in RE for fun, even if it is not in my best financial interests.

    Usually, I can find a good book to answer all of the questions I’ve been having, but so far I’ve been unable to find one. Most of the ones I’ve been reading are just practical RE investment guides…hopefully to one I just bought will help answer my questions so I can stop bothering you 🙂

  25. @ Jeff – actually, this is great discussion and I have reserved a very slightly more detailed (but, I fear, just as unfulfilling – for you) response for a future post.

    BTW: Would love (seriously!) to hear what you consider to provide a better LONG TERM (10 – 30 year time holding period) investment than reasonably leveraged RE? I am struggling to find one that matches its risk/reward ‘ratio’, as is ShaferFinancial, as is Michael Masterson, as is Lowry/Lindahl/Reed/et al …

  26. @AJC,

    …hate to dissappoint you (and everyone else), but I’m pursuing business opportunities (not traditional investments) in my area of expertise. Probably too much risk and effort (read: time) for those just trying to make their money work for them, but the potential return on both the initial investment and time is great!

    Look forward to your future post.

  27. @ Jeff – we don’t judge anybody here! We are all trying to get each other to look outside of our comfort zones: that equally applies to you trying to make us look more analytically at risk!

    And, I only say the next post will be ‘less than fulfilling’ because I won’t be answering your specific questions (well, I will answer one).

    Finally, I agree with Shafer: who cares about RE per se? I just like the risk/reward profile that certain kinds of (conservative) RE investing can provide. Equally, I like value stocks, businesses, etc. … for example, your business(es). QUESTION: what will you do with the free-cashflows they will produce once off and running? ‘Business + RE’ is a winning formula!

  28. AJC had hit it on the head. The data for wealth in the US demonstrates that business ownership and investment real estate is the two most concentrated areas for the wealthy. It matters not which came first! But, the asset that lasts the longest (generations) is usually the real estate.

  29. WOW , all this talk about 401 K’s, I gotta post this little warning . I just read an article about 401 K’s that everybody needs to take into account here. It seems that many(perhaps not all ) banks and other 401 K account holders have been playing us for fools in the years past.

    We all know that they charge a handling or management fee for attending to all this money. But , apparently, these fees were just not enough to satisfy the money hungry Bas***ds. You see, they have been charging some underground fees,that no one is supposed to know about , and ordering their managers to invest our money in some average or under performing stocks (which they were getting kick backs to recommend). So, that 8 % average return could be much much less due to the underground fees and the under performance of these stocks.

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  33. While I agree with the points in 401k v Real-estate. A close call, then?-
    7million7years , I think the positive sentiment around today is a concequence of a false set of circumstances. The demand for consumer loans is still weak and there is no significant improvement in the housing market. The developed nations are surviving on their governments ability to just borrow and spend into their countries which is unsustainable. Regards, Antione Latassa.

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