A new kind of slum dog millionaire …

KC points me to an article in Yahoo Finance:

A new AP-CNBC poll finds nearly one-third (31 percent) of U.S. residents believe they would need a minimum savings of \$100,000 to \$500,000 if retiring this year in order to be confident of living comfortably in retirement, and 22 percent believe the minimum is \$1 million or more to retire comfortably.

I’ve just conducted my own survey and I’ve found:

– Nearly one-third (31 percent) of U.S. residents are totally deluded if they think that they can retire on \$100,000 to \$500,000 today.

– 22% are only slightly less blinded to the obvious to think that even \$1 million will be enough to sustain them in retirement.

Let’s say that you can withdraw 4% of your portfolio ‘safely’ each year (a figure commonly promoted by the financial planning industry): then, you can give yourself a salary of:

– \$4,000 per year if you retire today on \$100,000

– \$20,000 per year if you retire today on \$500,000

– a whopping \$40,000 per year if you retire on \$1 million

Now, there’s be a whole bunch of people reading this who’ll say: “\$40k a year, indexed for inflation … for life … without working. Now I can live with that!”

So, let’s see what it will take to get to \$1 million in retirement savings; the same article says:

If you start with an initial \$10,000 investment and your portfolio grows by 5 percent every year, here’s how much you need to save each month to reach your \$1 million goal by age 70, according to Bankrate.com’s calculator.

• 25-year-olds have to save \$450 a month. That’s just \$15 a day for the rest of your working years.

• 35-year-olds have to save \$850 a month.

• 45-year-olds have to save \$1,700 a month.

• 55-year-olds have to save \$4,000 a month. (Of course, with an average inflation rate of 3 percent, that \$1,000,000 nest egg will only be worth \$642,000 in today’s dollars. So that means you’ll likely wind up having to save even more.)

Did you check out that last point? Even if you could save these amounts, your \$1 million is whittled down by inflation by the time you get there, so \$40k expected retirement salary is only worth (in today’s dollars):

– \$30,000 p.a., if you’re 55 and have 10 years to retirement

– \$20,000 p.a., if you’re 45 and have 20 years to retirement

– \$10,000 p.a. if you’re 35 and have 30 years to retirement

… or, to put it another way – because of inflation (even at only 3%), if you want to retire at age 65 on the equivalent of today’s \$40,000 salary, you need to:

– Quadruple the above suggested monthly savings rates if you’re 25

– Double the above suggested monthly savings rates if you’re 45

– Add 50% to the above suggested monthly savings rates if you’re 55

… Oh, and did I mention that these numbers are after tax?

And, just when you were kidding yourself that you really can save yourself to a decent retirement: current CD rates are 1% and inflation is still running close to 0.5%, meaning that even a 4% withdrawal rate – previously described as ‘safe’ according to the financial planning industry – is committing financial suicide.

On current returns, to safely pay yourself \$40,000 p.a. (indexed for just 0.5% inflation) you would need to retire with a nest egg of not just \$1,000,000 …

… but, \$8,000,000.

Or, you could just keep reading this blog and find a whole new way to look at your financial future 😉

[AJC: Try and find consensus on inflation; it’s hard! One article that I saw in researching this post suggested that inflation is currently running at just 0.5%, another says 4%, as suggested by Steve in the comments below – http://www.bls.gov/news.release/pdf/cpi.pdf. Since nobody really knows what inflation will be over a long enough period, I always use 3% – 4% just because it makes forward planning easy: just double your estimate for how much money you need to retire with for every 20 years until retirement]

Why sell property?

Richard sent me an e-mail [ajc AT 7million7years DOT com] asking:

I have read through most of your past posts. 2 questions come to my mind. Hope you can clarify.

1) You always tag a 30% return for real estate. If one puts 20% down on a prop and add in all the closing costs, capital up front will be like 25%. Assuming a 6% capital appreciation like you like to use, I don’t see how you can come out with 30% return on capital. My assumption is that we breakeven on cash flows. I did the calculation a while back and I think 15% is about the max.

2) I read that you have sold off your commercial properties and are looking to get back in. Why do you sell it of if real estate investing is for the long term? Can’t you refinance to tap into the equity and use it for other investments? Why do you want to “time” the market? Transaction costs are heavy in RE.

Let’s deal with the first part of the questions first: 30% is a very hard ask for any traditional investment, let alone real-estate. But, it can be done … if you’re a highly geared and successful [read: lucky] property developer.

More typical maximum investment returns can be seen in the following table:

By putting Franchises into this table – which many would consider more business than investment (but, I treat as an investment IF you can be an absentee-owner and acquire multiple franchises under the franchisor’s rules) I guess that I’m framing that you need to do a lot more than simply buy your own home and pay off your own mortgage to get these kinds of returns.

Real-Estate sits in the middle of this part of the growth table and, I agree with Richard, is probably closer to the 15% compound growth rate end than 30%.

But, the key question is: how does this kind of growth occur?

It occurs because of leverage:

1. Financial leverage – You can use the bank’s money  to gain a ‘free additional compound return’. Here’s how it might work:

You put 20% (or \$20k) down on a house that costs \$100,000 (ignoring closing costs for the sale of simplicity).

IF property only increased by 6% per annum, as Richard suggests (it’s actually a historical, US-wide growth rate quoted by a number of analysts in the past), and mortgage rates are around 4%, then the house will increase in value by \$6k, but your mortgage will cost you \$4k (actually, only 80% of that, since you put in \$20k cash). Fortunately, this is a rental, so let’s say that you earn another \$4k (4%) in rent.

Your total return is \$6k, which doesn’t sound like a lot for a \$100k asset (but DOES sound like Richard’s 6%), but you forgot one thing: you didn’t put in \$100k … you only put in \$20k, which you have just grown to \$26k (in some mix of cash and/or equity) which is an ‘easy’ 30% return.

Now, you may not have picked this up, but who said that you needed to put down 20%? If the bank, fair enough …

… but, what if the bank allowed you to go with 10% (or, \$10,000) down? Then your return almost doubles.

Even so, because real-estate is rarely cash-flow positive in the early years and appreciation isn’t always all that you expect, you need to add other kinds of leverage.

Here are some examples:

2. Knowledge leverage: If 6% is the average increase in home values across the entire country, do you think that you may be able to do better with a little research? For example, could you choose an urban area rather than a rural area (urban areas typically grow faster than average, and rural areas grow less)? Could you choose an upcoming neighborhood to invest in (one with lots of new families moving in, rather than one with an aging population where people are moving out)? Could you choose a high-demand location (one near a beach, near a park, near transport, near schools, near a mall, and so on) rather than one near factories and warehouses?

3. Value-added leverage: Could you take the least-loved house in the street and add value by: adding a bedroom? Painting the house? Cleaning up the garden? Upgrading the kitchen and bathrooms?

4. Opportunity leverage: could you find a house that nobody wants and buy it at a discount before it even comes onto the market? Could you find a poorly managed rental and be a little more hands-on in terms of looking after the property and tenants in order to increase rents over time?

Any ONE of these factors could positively influence your compound growth rate well over the averages. Combining as many of these factors as possible could positively hit your real-estate returns our of the ball-park.

As to the second part of Richard’s question, he is quite correct: buying real-estate and holding for the long-term is usually the right strategy.

However, circumstances may arise where that strategy does not make sense: e.g. I owned my office building, but once the business was bought and the tenants (my former company) moved out, I didn’t want to hold the commercial property while I was overseas and look for tenants.

In hindsight, I should have kept it.

When is a JV not a JV?

Last week I wrote about joint ventures (JV’s) in real-estate; personally, I don’t like ’em but I showed you the right way and wrong way to enter into one. You should also read the comments.

Today, I want to share an interesting e-mail discourse that I had with another reader who wants to set up  what he calls a “JV with a manufacturer”.

Firstly, what he proposed is not a JV; to me, this is one of the most overused terms. He wants a manufacturer to help him design, then manufacture a new product.

What he is setting up is a supply chain relationship, not a joint venture.

To me a JV occurs when both parties take significant risk in the ‘venture’ and in some way share the upside / downside risks.

An example might be where you come up with an idea for a new product (as this reader has) and approach a manufacturer who is willing to take your sketch or prototype and turn it into a manufacturable product at no cost to you. Or, if at cost, then the cost is shared to some significant portion, say 50/50. In return, you pay the manufacturer a (hopefully, reduced) price for the finished product + a % of sales (better yet, % of profits).

I had a number of true business joint ventures: these are when two businesses create a third business party owned by both (it need not be 50/50, in my case one was 51/49 and the other was 40/60). In a true JV both parties bring something significant to the table that makes the JV better than either party going it alone … in our case, my business brought niche industry expertise, unique software and processes and the other party brought infrastructure, client relationships and customer service.

However, if you’re thinking of entering into a JV I can only point you to a conversation that I had just prior to signing my first one:

I was on the plane with a friend heading to see the Rugby World Cup in Sydney. I told him about my plans for a series of JV’s to help me expand to other countries. He cautioned me that he was privvy to a study that showed that JV’s were successful proportionally according to size-parity between the the parties.

The corollary was that where one party was tiny (my company, at that time of 30 employees in Australia) and the other large (my \$2 Bill. multinational proposed JV partner) JV’s generally did NOT work … the small guy was almost always swallowed up by the big guy.

In my case, the JV’s actually did work, but they were difficult to manage and even where I held majority ownership (as in the USA JV), that did not translate into effective control.

In the end, it all worked out well for me and for my JV partner, but always remember: it is very difficult for a fly to steer an elephant. 😉

The problem with financial advice – Part II

Why do you see a financial advisor?

ONE reason that people go, is because they expect that the financial advisor has great modeling tools, so they should be able to calculate your financial position and future needs with great accuracy.

What if I told you that doing your own financial planning using the simplest possible online tools and financial spreadsheets would get you closer – much closer – to your real financial needs than any ‘typical’ financial advisor can? What if I told you that is exactly the reason why I do my own financial planning using those exact same simple online tools and financial spreadsheets?

But, what if I told you that most financial advisors routinely underestimate your retirement needs by ~80%?

Would you even pay for such ‘professional’ financial advice again?

Need proof?

Well, a week ago I covered the first of best selling author, Dan Ariely’s comments about financial advisors, but he then goes on to say:

In one study, we asked people the same question that financial advisors ask: How much of your final salary will you need in retirement? The common answer was 75 percent. When we … asked where they got this advice, we found that most people heard this from the financial industry. You see the circularity and the inanity: Financial advisors are asking a question that their customers rely on them for the answer. So what’s the point of the question?!

In our study, we then took a different approach and instead asked people: How do you want to live in retirement? Where do you want to live? What activities you want to engage in? And similar questions geared to assess the quality of life that people expected in retirement. We then took these answers and itemized them, pricing out their retirement based on the things that people said they’d want to do and have in their retirement. Using these calculations, we found that these people (who told us that they will need 75% of their salary) would actually need 135 percent of their final income to live in the way that they want to in retirement.

This is a really important point; let’s say that your expected final salary is \$100,000 in today’s dollars.

Then at 75%, you would need a nest-egg of \$75,000 x 20 = \$1,500,000

But at 135%, you would need a nest-egg of \$135,000 x 20 = \$2,700,000

[AJC: the ’20’ in the above calculations comes from my Rule of 20; see this early post]

That’s a shortfall in your retirement of \$1,200,000 … more, if your expected ending salary is over \$100k.

Now, what if I told you that I think your shortfall is not likely to be \$1.2 million, but closer to \$2mill – \$3mill or even more?

I’ll let you know how I think you should calculate your true retirement needs in the next – and, final – post in this short series, because knowing what you’re aiming for now will stop a LOT of disappointment later 😉

How to structure a real-estate partnership?

A friend and I are in the process of writing an operating agreement for an LLC and I’ve got a question for you. We have raised capital for the down payment on an apartment building. I have raised \$15,000 (\$10,000 my own and \$5,000 from family) while my friend has raised \$25,000 (all from family). We both have a 50% ownership in the LLC. Once we start to produce income, is it fair to distribute funds according to initial capital invested? Is it even possible to do 50/50?

Firstly, I don’t like buying long-term assets in partnership … times change … longer times change even more 😉

For example, to help a friend out (really!) my wife talked me into buying a half share in a downtown property. In ordinary circumstances it would have been a great, long-term hold.

However, two brothers-in-law had gone into partnership to acquire it and some years later one of the brothers-in-law wanted OUT. The problem was, the other B-in-L couldn’t afford to buy him out, and didn’t want to sell.

These sorts of decisions break up families … and was threatening to do exactly that to this family. Our friend, the third brother-in-law (and the only one of the three NOT involved in the deal) asked us to help out by buying out the one B-in-L who wanted to sell.

And, that’s what we did: bought 50% of a building that we know that we can never sell without causing the same situation to erupt again. My wife talked me into in … that’s my only excuse 😉

But, if you still DO want to go into partnership, here’s what I suggested to MoneyRunner:

All is fair and possible in business and investing … as long as you both agree!
You will most likely need a shareholder’s agreement drawn up by your attorney, if the equity and/or profits are not to be split equally.
However, a simple way to deal with your situation is:
1. Both put in \$15k as capital (it makes no difference HOW or WHERE you each got the money).
2. Let your friend put in the extra \$10k as a loan.
3. Agree a rate of interest (say, mortgage rate plus x% e.g. if the current mortgage interest rate that you are paying on the property is 6%, your friend might get 10% for his \$10k).
4. Split the equity and remaining profits (i.e. rent MINUS mortgage + interest owing to friend + expenses) 50/50
Here’s why you will still need a shareholders agreement:
– Rules as to how/if/when your friend’s loan is to be repaid,
– Rules as to who can force a sale of the property and how you deal with each other’s share in the property in the event of a dispute.

However, there are other ways to enter a ‘partnership’ that stop all of these issues:

My first real-estate purchase was with a friend of mine who found a new condo development in foreclosure; the bank was selling off the individual condos. My friend thought that we would get a better deal if we bought two condos together.

… and, we did!

We negotiated a price of \$55k for each condo.

How did we deal with the partnership issue? Simple!

We each bought one codo in our own names. Then, when I stupidly decided to sell (I was still young and reckless, and this was my first ever real-estate purchase), I didn’t need to ask him. I sold it for just over \$75k about 2 years later [AJC: But, it would be worth closer to \$500k now, 25 years later] … not a bad deal, and no stress on our ‘partnership’.

The problem with financial advice – Part I

Now, I’m just some semi-anonymous blogger, so what do I know, right?

So, sometimes it’s nice if I can point you to others who share my opinions on controversial financial matters [AJC: I write almost exclusively about controversial financial matters … why write something that’s already in 5,000 other blogs, therefore, has a 99.9999% chance of being wrong?!].

For example, my opinion on financial advisors is that they are a waste of money.

But, Dan Ariely, a behavioral economist and author of two best-sellers, including Predictably Irrational, agrees:

From a behavioral economics point of view, the field of financial advice is quite strange and not very useful. For the most part, professional financial services rely on clients’ answers to two questions:

• How much of your current salary will you need in retirement?
• What is your risk attitude on a seven-point scale?

From my perspective, these are remarkably useless questions — but we’ll get to that in a minute. First, let’s think about the financial advisor’s business model. An advisor will optimize your portfolio based on the answers to these two questions. For this service, the advisor typically will take one percent of assets under management – and he will get this every year!

I agree with Dan when he says:

Not to be offensive, but I think that a simple algorithm can do this, and probably with fewer errors. Moving money around from stocks to bonds or vice versa is just not something for which we should pay one percent of assets under management.

Now, this is targeted at funds managers (both retail and institutional) as well as those who charge fees and/or commissions to prepare similar financial advice.

Remember, funds tend to fall short of the market in performance over time, by about how much they charge in fees …

Lesson: if you really want to short-change your financial future by investing in funds and over-diversifying (two sure ways to die broke), do what Warren Buffett suggests and invest in super-low cost Index Funds:

A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.

In the next part of this special three part series, I will show you how most people short-change their retirement by 60%,