Is your home an asset?

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I spend a LOT of time on this blog talking about your home, and rightly so; your home is often regarded as your single largest asset.

Or, is it?

TraineeInvestor reopens the debate with what I think is a really interesting – seemingly ‘throwaway’ – line in his comment to this post:

The overwhelming consensus of opinion on internet forums and blogs is that your home is not an investment. (There are even people who think it is a liability rather than an asset!!!).

The “overwhelming consesus” hasn’t made $7 million in 7 years, and probably never will 😛

But there is grounding to the home-not-an-asset way of thinking; for example, in this post I quoted Robert Kiyosaki who first told me that a home is NOT an asset [AJC: Unlike many others, I am not a Robert Kiyosaki detractor … Rich Dad Poor Dad was the first book that I ever read on personal finance and, at the time, it really opened my eyes to the value of financial education].

Here’s what RK said: 

  My Poor Dad Says   My Rich Dad Says
       
  “My house is an asset.”   “My house is a liability.”
       
  Rich dad says, “If you stop working today, an asset puts money in your pocket and a liability takes money from your pocket. Too often people call liabilities assets. It’s important to know the difference between the two.

Yet, paradoxically, TraineeInvestor also pointed to the exact opposite: study after study has shown that the wealthy own their own homes and the ‘poor’ do not!

So, what do I think?

Well – and, this may also SEEM paradoxical – I actually agree that a home is not  an asset in the sense that it doesn’t earn an income.

Of course, you could rent to yourself.

Tell me then, though, when do you – could you – ever realize the value in that ‘asset’?

Only if you sell (you never will); or, pass it on (it’s not an asset for YOU).

Yet, there is one way to realize at least part of the value of your asset (while you still need a place to live), and that is to release some equity by refinancing.

So, technically, I agree with the ‘non-asset’ thinking, which is why I ask you to at least minimize the equity in your own home to a mere (by Dave Ramsey standards) 20% or less of your current Net Worth (and, review annually).

I also advocate buying your first home – more for some ‘human nature’ reasons rather than strict financial reasons – but, nowhere in this blog have I ever said: “… then, upgrade it”! 😉

Why bother keeping up an esoteric “is your home an asset or a liability?” debate at all, when the only real question that you need ask yourself is:

Can I reach my Number if I buy my own home, then keep [insert ‘% of current home value’ of choice: 0%; 10%; 20%; 50%; 100%; other] tied up as home equity?

My standard advice is, YES … if:

a) I buy my first home (with whatever starting equity that my bank and I can agree on), then

b) [as soon as reasonably possible, start to] maintain no more than 20% of my net worth in that – or, any future – home as equity

c) and, reassess b) annually (against both my home’s and my own net worth’s current value)

Ultimately, the equity that you choose to keep in your home either helps you to reach your Number, or it doesn’t.

For most people, “reaching their Number” means amasssing ‘real’ assets in the range of millions of dollars. Logically, tying up valuable equity in something that can’t possible reach ‘millions of dollars’ in value is wrong, so why do it?

What does this all mean for you?

My ‘rules’ of home ownership are designed to give you the best chance to reach your Number by your Date.

Depending on how YOU choose to look at it, your home is either your single largest asset or single largest liability …

… the real point of this blog is to make sure that it doesn’t stay that way 🙂

AJC’s Secret Strategy?

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Every financial ‘expert’ has a secret strategy …

… you know, the one that made them $1,000,000 simply by doing [insert: strategy of choice]; just try googling “how I made million” and you’ll come up with listings like:

How I Made $77 Million In Two Years & You Can Too by Vincent James

How This Kid Made $60 Million In 18 Months

How I made a million in 3 months.

How I made over $2 million with this blog

How I made my first million: Schoolboy entrepreneur…

7million7years- How to make 7 million in 7 years …

How I made a million dollars investing in real-estate

One link is about making millions in real-estate; another through marketing your business; another through online businesses; another through promoting yourself via your blog, and so on …

In fact, you’ll find one guy talking about how to make $7 million in 7 years through commercial real-estate and business 😉

At least that is the vibe that I am picking up, if Ryan at Planting Dollars (who kindly mentioned my blog in this post about personal finance outliers) is representative of my readers:

There are two blogs in the personal finance arena that are obviously outliers.

Adrian at 7 Million 7 Years… How many people do you know that are worth 7 million? Adrian did it in 7 years and writes about his strategies that are, of course, not common sense and not mainstream. He advocates starting businesses and investing in commercial real estate.

Jacob at Early Retirement Extreme… He retired in 5 years via traditional work, lots of traditional work, and cutting his living expenses to the bare minimum.

I may have used real-estate (both commercial and residential) – fueled by very modest (at the time) business-generated cashflow – to make my first $7 million, and then actually selling the businesses to make my next … but, I also used stocks, negotiating, options, gold, and relationships to make a few more million, as well.

Starting a business and/or investing in commercial real-estate may be the exact wrong – or right – strategy for you to make your $7 million in 7 years, too.

It all depends …

First, though, if there’s any ‘secret’ to making millions, it’s to truly understand the game of financial roshambo:

Stocks have no intrinsic advantage over Real-Estate; Real-Estate has no intrinsic advantage over Business; Business has no instrinsic advantage over Stocks.

This applies equally to how you choose to earn your money, as well as how you choose to invest it.

In fact …

It’s the combination of what you earn (income) and what you do with it (invest) that provides the compounding that you need in order to reach your Number.

For example, if you put a little extra salt-and-pepper into your income-producing strategy, you may be able to back-off the gas a little with your investing strategy (as long as you have cultivated excellent MM101 habits, so that you don’t just piss it all away).

On the other hand, if you are subsisting on a meagre office-job salary, you may need to ramp up your income with a little side business and you may need to seriously ramp up your investment strategy with some RE and/or stocks.

Three examples:

– I pursued a high risk / high reward business strategy to generate the cash that I then invested in real-estate and stocks to allow me to reach my Number; to ensure my success, I chose to push the risk throttle by expanding my businesses internationally.

–  Josh has chosen an  even higher risk / higher reward income-producing strategy by trading ‘penny’ pharma stocks with ever larger portions of his Networth going into one or two ‘trading positions’; I advised him to put a portion of his ‘winnings’ into lower risk / lower reward investments such as buy/hold RE, Value stocks, Index Funds, or (dare I say it), Bonds or CD’s to ensure that he reaches his Number.

– Mike has chosen  a high-income-employment path to producing the income required to fuel his investment strategy, but has chosen to ‘invest’ his Net Worth mainly in cash. I advised him to maintain his current earning capability, but ‘up’ his investment risk profile up the scale to, say, Index Funds so that he can then pretty much cruise to his Number.

It’s different for everybody …

In neither Josh’s nor Mike’s case does commercial real-estate or business need to figure greatly in their journey towards their Number.

And, it may not figure in yours 🙂

Hypothetical Mike … and, Beyond!

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The story so far:

Hypothetical Mike (the hero of our story) has super income-earning powers (ranging between $250k and $350k p.a.) … his powers also extend to corporate high flying, not to mention having a super-strong handshake 😛

His mission: to amass $10 million within 14 years.

But, like every superhero, he has a weakness: he keeps too much of his current $1.7 million networth in cash … $1.3 million of it to be precise.

Cash is kryptonite to financial superheroes like Hypothetical Mike!

Does HypeMike – as he is known in superhero and rapper circles – need to fly higher and higher in order to fulfil his mission? Or, can he simply destroy that stash of kryptonite and let the natural laws of investing wisely take over?

In an unusual twist, we let the readers decide the outcome of this story …

For example, here is what Steve said:

What are Hypothetical Mike’s Talents and hobbies? Based on what he likes to do in his spare time. I might recommend starting a business, that could bring in an income and later be sold for a nice return. This could help him reach that goal quite well. It would be less like running a business cause it would be something he enjoys anyway.

If HypeMike were a mere mortal, I would agree with Steve: you and I should ramp up our Making Money 201 activities in an attempt to accelerate our income … 

… but, HypeMike already has his MM201 ‘money tree’ (i.e. his relatively high-paying job); coupled with his $1.7 million starting bank and his 14 year timeframe, he need leap no tall buildings to reach his Number.

A relatively mere 13.5% compound growth rate will do the job … PROVIDED that HypeMike doesn’t lose his main ‘super power’ i.e. his ability to keep earning superhero-like salaries.

Hypothetical Mike shouldn’t do ANYTHING to jeopardize his job, hence his income stream (e.g. moonlighting might be against company rules, or might distract him, tire him out, etc., etc.).

On the other hand, a number of readers commented that HypeMike’s money – merely sitting in cash – is his real problem. For example, Brad said:

If you are successful at running this business (you said you turned it profitable) then you should be in a position to negotiate larger and larger bonuses or equity ownership. Seems like THAT is what you are talented in. Don’t feel like you need to start investing in real estate or small biz because that is how OTHER people might have gotten rich.

I do agree that you should keep some cash positions if that makes you feel secure, but also to keep the bulk of your invest-able assets in at least an S&P500 index fund.

In my [AJC: emminently unqualified] opinion, Brad is 100% correct.

Hypothetical Mike should take a close look at Brad’s advice and follow it!

[Disclaimer: Brad is likely just as unqualified as I am to offer personal financial advice … always seek professional advice!].

A hidden risk of reward …

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I have postulated before on the $5m5y Phenomenon: why is it that 80% of lottery winners, winning absolutely life-changing amounts such as $5 million (all the way up to $150 million) lose 100% of their winnings within 5 years?

Think about it, it’s a staggering amount of money: how would you even go about spending $1m+ a year for 5 years, starting from an almost zero spending base?

Jake hits the nail on the head for at least one of those reasons:

When you hit your number or are well on your way toward it, how do you deal with family that are not making progress to their number (or likely ever will get there).

Specifically, how do you keep a cordial relationship – i.e avoiding acting like a heartless a-hole but also avoiding being the family patsy / sucker who pays for everything.

If you are making good progress toward your number, you are likely very hard working, talented and lucky. Chances are that family members lagging behind are lacking one or more of those traits, often the one associated with hard work.

Yes, after the houses, boats, vacations, girl/boy friends, and Ferraris come the financial-vacuum-cleaning carpet snakes:

Your friends and relatives 😉

Having had [AJC: too much] personal experience dealing with exactly this type of issue, let me try and give you some random pointers, which you will need as your journey progresses:

Stage 1 – When you are still on your journey towards your Number

– Lie about your financial circumstances; the corollary is to keep your spending under control, which has the side benefit of actually helping you to reach your Number

– Complain about everything: business is bad, your investments aren’t doing as well as you hoped, and so on

– Take a preemptive step: actually try and borrow money from those most likely to put the hard word on you [AJC: don’t try too hard though, you don’t actually want to owe your relatives anything]

Stage 2 – Just as you reach Number

– OK, it might be difficult to hide behind a veil of poverty (unless you are some sort of miser); so, you will need to rely on the old “can’t confirm/deny anything” … this is best done by attitude rather than words: in other words, when one of your friends says “Frank’s really loaded now”, just smile wryly or – if you have to say something – try “don’t believe everything you hear”

– You could still try and borrow money from your relatives to “help pay some back taxes that I owe … nothing serious”; this works best if you also put a For Sale sign on your Ferrari.

– At least try and keep your post-windfall spending spree in check; and, it’s likely – if you’ve been following the advice on this blog – that your Lifestyle isn’t going to to take a big jump, rather you will not have to work to maintain it.

Stage 3 – Making Money 301

You have your Number, but you forgot to build into your chosen lifestyle a certain amount for ‘paying off the friends and relatives’ [AJC: if you’re still calculating your Number, now’s your chance to put something in there], what to do?

– You will have no choice but to do certain ‘good deeds of kindness’; for example, we paid for two tickets for family members to fly to the US to see us. We flew them coach, provided no spending money, looked after them generously while they were with us (we paid for all meals, etc.), but they were grateful.

– Keep these ‘acts of generosity’ few and far between, or they will be soon seen as ‘rights’ and you will end up wearing all the cost with none of the benefit.

– Simply accept it as a ‘cost of doing [family] business’ that you will be the one footing the bill at all family events; we find ‘prior engagements’ for as many of those family functions as possible: out of sight, out of our pocket.

– Give 30% to 50% (only for family … friends get no more from you than anybody else) more generously for gifts than others; it will be expected and there’s not much you can do.

– Ditto for tips; if they know who you are, you had better be a little more generous if you want to avoid your food being spat in.

– Listen politely but offer little when friends and relatives come asking you for ‘advice’ … they are really sounding you out to ask you for money (they will call it a ‘loan’, but you know it for what it really is); your only protection is preemptive (see above).

– You are far better off to be seen doing ‘good works’ and giving to charity; the aim is to be seen as a good role model and something that your good-for-nothing-freeloading-ex-friends-and-still-relatives can aspire to when they make their own money.

Just remember, unless you built a huge Charity Case Buffer into the calculation of your Number, you have no choice but to let your friends/relatives do the right thing and work on their own Numbers … unless, you no longer want to be able to live your own Life Purpose?! 😉

Risk is in the eye of the beholder …

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Our Philip Brewer Confest is almost over, and it’s time to thank him for his articles and inspiration for a series of posts exploring the concepts of safe withdrawal rates [AJC: which has more to do with financial planning than family planning 😉 ], however I did want to wind up by exploring one of his comments:

I think your step 1 is the most important: Decide what you want to do with your life.

I wanted to write fiction. That doesn’t take much money, but it does require time (and high-quality time at that). So, for me, getting free of a regular job as soon as possible was a much higher priority than accumulating a vast amount of wealth.

For me, too, the turning point for my financial life – indeed my whole life – came in Step 1: finding my Life’s Purpose then using that to calculate my Number. For me, though, it happened to turn up a Large Number / Soon Date … that may not be the case for everybody.

Just remember that Time = Money and if you are desperate to achieve that financial freedom (e.g. in Phil’s case, so that he can write that book) you may need a lot of both …

… IF so, then I have a hypothesis [AJC: tested on a subject of one i.e. me] that goes like this:

When you find your Life’s Purpose, you will most likely find that you will come up with a Large Number / Soon Date [AJC: remember, this is just my hypothesis albeit, now, supported by a little research] and you will not stop until you get it …

… your priorities (including your financial priorities) will drastically change.

 But, what about Philip’s thoughts about risk?

I would like to suggest, though, that your ideas on which assets are secure and which aren’t could use some fine tuning.

It’s true that you may not be able to work during your retirement, but most people will be able to earn at least some money if they need to. It’s also true that government pensions can be taken away—but so can anything else.

And don’t forget all the other ways that things can be lost or taken away—declining market can sap your portfolio, a lawsuit can seize your assets, a natural disaster can destroy your house.

My point is not that it’s hopeless, but rather that while racking up assets may increase your standard of living, at a certain point it no longer increases your security. (A flood can destroy a house worth $1 million as completely as it can destroy a house worth $100,000.).

At some point—and to my mind the point is well before you have $7 million—you don’t get as much security from adding another million to your portfolio.

I beg to differ: until I made my $7 million Number, my thoughts were EXACTLY about ” adding another million to my portfolio” … but, that’s only because I calculated that I needed it – not want, not desire, but need – to live my Life’s Purpose.

But, that may not be you; like Phil, you might just need a little extra time to write your book or to support huminitarian projects like backpacking to hotspots like Haiti, so your Number may be $100k, $1 mill., or … ?

And, unlike me, your assessment of your Number may include allowances for earning extra income through part time work, income producing projects, pensions, inheritences, or even handouts.

In that case, I challenge you to substiute your Number where, in my blog, I use the $7m7y illustration … the principles won’t change much.

[AJC: unless, you have a “<$1 million in >20 years”-type Number, in which case this blog is NOT for you 🙂 ]

So, substituting your Number for mine, here is the second part of my hypothesis:

– While you are trying to reach [insert your Number] so that you can achieve your Life’s Purpose, ‘hold back’ concepts such as risk take a backfoot to ‘push forward’ concepts such as REWARD, suddenly opening your eyes to the ‘benefits’ of burning the candle at both ends, starting a business or three, trying to become a stock market and/or real-estate mogul, etc.

BUT

– Once you reach [insert your Number], somehow your brain resets such that RISK (i.e. protecting your nest-egg) seems to become much more important than reward (i.e. growing the nest-egg) and all of a sudden CD’s, bond laddering, (dare I say it!?), index funds, 100%-paid-for-by-cash real-estate, etc. becomes much more attractive.

At least, that’s how it happened for me …

This doesn’t mean that risk isn’t important (after all, we spend a lot of time on this blog covering strategies to manage risk), it’s just that in some respects, it’s in the eye of the beholder 🙂

The Ideal Perpetual Money Machine …

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So,  it seems that creating a mix of bonds and stocks and then picking some magic withdrawal rate (e.g. 4%) is not the ideal way to plan our retirement (a.k.a. life after work) after all …

… instead, it seems that we need to create our own Perpetual Money Machine: a renewable resource of cash 😉

The ideal Perpetual Money Machine – at least, according to my liking – is Real-Estate (more wealthy people build their own Perpetual Money Machines using real-estate that any other investment, even more so than cash, CD’s, bonds, mutual funds, or stocks):

1. Real-Estate (particularly commercial real-estate, when purchased well) protects your capital and keeps pace with inflation; it will last as long as you do, and then some!

2. Real-Estate (when managed well -and, this is something that you CAN confidently outsource) protects your income (i.e. net rents; they will grow with inflation).

3. The bumps in your real-estate road can be managed with insurance and provisions: you can insure against most catastrophic losses (and, you can spead your RE investments to minimize even those risks), and you can keep a % of your rents (and, starting capital) aside to help smooth your income stream (against vacancies, repairs and maintenance, etc.).

For example, with $7 million (aiming for a $350k per year gross income – indexed for inflation – which should net $200k – $250k after tax), you could:

1. Keep $500,000 as a two years of living expenses cash buffer (one year to allow for the rents to start coming in, another year “just in case”),

2. Invest $6.5 million CASH into 5 x $1.0 million to $1.25 million dollar properties (allowing for closing costs, etc.),

3. Which should provide 5 x 7.5% x $1.0 million to $1.25 million = $400,000 gross rental income

4. Of which you would pay tax of 30% (say) and divert another 25% of the remainder to your ’emergency / provision fund’ leaving $215k (PLUS, tax benefits such as depreciation, tax deductions of cars, certain travel and other business expenses etc.).

After every few ‘good years’, you can trim your provision fund back to two years of living expenses, allowing you to buy some more real-estate (therefore, providing the basis for another future pay rise!).

If you don’t like real-estate, then you can always lower your spending expectations and dust off your bond-laddering books 🙂

The broke actuary …

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All this talk of ‘safe withdrawal rates’ begs the question: can you build a perpetual money machine from stocks and bonds?

I’m going to go out on a limb, here, and say NO.

To help us find out why, let’s try and answer Rick’s question:

I agree if you can live on what your investments produce over inflation you’ll never run out of money.

Does it still make sense to plan using the rule of 20 when you don’t think you will be able to reliably pull out 5%?

It seems to me use a more conservative rule say 25 or 30.

Also, you could still use stocks- you would need some other income sources too- bonds or cash to draw upon in down years.

Rick raises a three part question:

1. Why base the Rule of 20 on a 5% withdrawal rate, when that doesn’t appear to be safe?

Well, given that I don’t think ANY withdrawal rate is safe, for me at least, the Rule of 20 should only be used as a PLANNING figure i.e. to help you convert  your required annual income into your Number.

As a planning figure, I think the Rule of 20 underestimates your Number; the chances are that you will overachieve it rather than underachieve it.

Given that it’s extremely unlikely that you will exactly achieve your Number, you will either undershoot or overshoot it … if you wait until your Number is a virtual gimme before selling your [Insert Number Reaching System Of Choice: business, real-estate, stocks, horses, etc., etc.] you will probably find that it takes time to decide what/how/when to sell and in that time, your assets have appreciated even more.

If you don’t think that’s the case for you, use a higher multiplier … I just don’t think it’s necessary to stress over it 🙂

2. Why can’t you use stocks to create your ‘perpetual money machine’?

It is a rare stock that provides the kind of income that we need without compromising the underlying business, but they certainly do exist: you would need to find a business (that you can buy stock in) that generates at least a 4% dividend, yet still grows the stock price at least according to inflation … consistently, over 30 to 50 years after you stop work!

However, using “bonds or cash to draw upon in down years” is a losing proposition (it’s not income … you are spending your capital!); I think that a two year emergency fund is a great idea … but, is there a reasonable chance of a stock downswing that will deplete that fund?

If so, I would not like this stock+bonds+cash retirement strategy one little bit … which brings me to the final – and, key – question:

3. Can’t we use a more conservative rule say 25 or 30?

Here’s the crux; the Trinity Study (for example) says that we have a small chance of running out of money, even if we choose a “safe” 4% withdrawal rate …

… the longer we expect to live – hence have our money last – the larger the failure rate (which can be as low as 2%).

Here’s my question to you: if you are facing even a 2% failure rate, what are the chances that your money will last as long as you do?

98%?

Well, you would think so, but I once asked a doctor friend a similar question when – in a moment of rare weakness (thankfully now passed) – I actually thought about getting a vasectomy.

I told him that I heard that the operation was quite reversible. I asked him what the reversal success rate was. 

 “In your case” he said ” exactly 50/50 …

… either it will work, or it won’t!” 

So, Rick, find an actuary to help you choose any multiplier that you like and the chance is still 50/50 for you: either your Number will be enough to last as long as you do, or it won’t 😉

The fundamental rule of money?

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Here’s the difference between conventional personal financial advice and 7m7y thinking in one slide; according to Brian Taylor the fundamental rule of money is to:

Either earn more than you spend or spend less than you earn.

Simple … and, much better than the alternative (spending more than you earn) …

… but, wrong!

There is only one fundamental rule of money:

Earn more than you spend

Can you see why? Your financial future depends upon it 🙂