is that if I keep up my focus, work and investing for another 5 years past my 10 year date, I can drop my required compound growth rate by 3%(from 40% down to 37%), however, quadruple my number accomplished from 4 million to 16 million, and i’ll still be in my 40’s.
Incredible what taking a little more time can do for you!
What Scott says is absolutely true, but also consider:
How much does delaying your Date by 1, 3 or 5 years (say) REDUCE your compound growth rate if you KEEP your Number?
Also, what does reducing your compound growth rate do for you in terms of changing the way that you need to think about building up your nest egg?
Does it mean that you no longer need to start a business, or invest in real-estate? Will keeping your money in Index Funds via your 401k do the trick?
So, rethink your Number and Date – but NOT at the expense of your Life’s Purpose …
… then, when you do get to your Date, DO allow the momentum of the activities that got you there to carry you on just a little bit further … you could double your Number, just like that!
Don’t believe me? It’s exactly what I did in the two years following my own 7 million 7 year journey 😉
I saw this on Get Rich Slowly and wonder what you think of it?
Since I didn’t allocate my own spending this way ‘on the way up’, I can’t comment either way … but, maybe some of you can?
Here’s how it works:
You take your After Tax income and divide it into three categories:
1. Needs – These are you ‘must haves’ i.e. things that you can’t go without: rent/mortgage; car; electricity; basic food (the book provides a ‘rule of thumb’ for this); and, so on.
You allocate 50% of your after tax income to these needs; given that we already have the 25% Income Rule (spend no more than 25% of your after tax income on rent/mortgage) that leaves 25% on all the other ‘needs’.
2. Wants – According to the book, you should have fun – and, budget 30% of your after-tax income for it. I happen to be of the same mindset … what is money, if not for spending (except that you must do it in a way that allows you to live your Life’s Purpose by your desired Date).
According to the book, ‘wants’ include additional food (i.e. lamb chops instead of dog food?), your cable TV and internet (these are definite needs for me, especially on my 100″ home theater screen … but, I can afford it!); trips and vacations; and, so on.
3. Savings – that leaves (or should leave) 20% of your after-tax income for your 401k investments and other savings/investment … since this is 5% to 10% more than most authors suggest, I commend it. Just remember, that even with 20% you’re not going to be able to save your way to wealth.
All in all, it seems like a pretty good savings plan to me … what improvements would you make?
What is the relationship between your income and your Net Worth? Does paying down a mortgage increase your Net Worth … these are the comments made by Diane to a reader who said that they had income that was going into CD’s, but still had a mortgage:
[If] you are paying down your mortgage some – rather than just interest … then your net worth may be going up [?]
I told Diane that it doesn’t work that way Where Diane is right that putting money into CD’s while you hold a mortgage is probably a sub-optimal financial decision, it’s NOT because your Net Worth would change … paying down your mortgage does NOT change your Net Worth – it just reduces both your CASH (on hand) and MORTGAGE balance columns in your NWiQ profile …
… your total of Assets – Liabilities (hence, your Net Worth) remains the same!
Diane took me to task:
I assume [that you would be] applying income to [your] net worth and that is NOT reflected in the assets/debt columns of the networth calculations – it’s future cash for the most part (those who have incomes ;)) — or did I miss how else the income is reflected other than as a header above (along with our education)???
These are very good ‘technical’ questions, that I can explain (for those who are business/finance minded) as follows:
Income/expenses is/are a bit like a business’ P&L (Profit and Loss Statement), and your Net Worth is like a Balance Sheet … the former is a ‘work in progress’ and the latter is a ‘snapshot’ at a specific point in time.
Both cash and loans sit on the Balance Sheet … or, in our case, on our statement of Net Worth. Simply moving amounts around does not change either. Your Balance Sheet only changes if you make or lose money, grow or reduce assets (as long as you are not turning them into cash or some other balance sheet item).
Similarly for your Net Worth: decreasing a positive bank balance (on one side of your Net Worth statement) in order to similarly decrease a negative house balance (a.k.a. a mortgage) on the other side hasn’t changed anything – except where you keep various components of your Net Worth.
On the other hand, earning more profits (reflected in a businesses P&L) is similar to earning a salary or other income for a person (income) provided that you don’t spend it all (expenses) …
… they all help to increase your Net Worth (or improve the value of the business, as reflected in an improved Balance Sheet).
BUT, it doesn’t matter if you ‘store’ that extra income in a bank account (i.e. the CASH column of your NWiQ profile) or in your mortgage (effectively reducing it) … your Net Worth goes up by the amount of income that you saved since you last calculated your Net Worth.
As Scott says:
As long as you are living in your home, it is a liability and costing you money if anything.
That is, unless you are prepared to tap into that home’s equity and use that money to invest.
Yes, it’s what you ’save’ from your income (i.e. after expenses) that goes into improving your Net Worth regardless of whether you use it to build up your bank balace, pay down debt, or – as Scott suggests – buy a new asset.
Hopefully, my last post gave you the numbers, and today’s will explain the ‘deal’:
Summary
So, here is the crux of the deal:
1. I have a property with one good tenant (they are cashed up … because I just gave them the cash!) and an easily rentable smaller area for a second tenant.
2. If I borrow 75% at 6.5% fixed for 7 years, I get $63,000 cash (i.e. TOTAL INCOME – TOTAL EXPENSES) in Year 1 to spend (well, keep some in reserve against future repairs, vacancies, etc.).
3. My deposit is $700,000 so that $63,000 is a 9% return on my own money (subject to those unforeseen costs that I mentioned in 2.) … not a bad return on cash AND I get all the upside on the property.
4. If the second tenancy is vacant for any reason, I still almost break-even.
5. If the second tenancy rents at only $6 / sq. foot I still net $43k per year; if I get $10 / sq. foot I net $83k.
6. Properties in this area sold for $80k – $120k per sq. foot; even though the market has softened somewhat (commercial generally works on a slower up/down cycle than residential) I am buying it for $60 / sq. foot … clearly, if a condo. developer knocks on my door in 7 years and offers me $120 / sq. foot, I’ve doubled the whole $2.6 Mill. (not incl. Realtor’s commissions) purchase price!
Note: Think about that – when people say that RE only increases with inflation, therefore stocks are a better option: I make $63k a year less costs (est. 25% as a contingency), say, 6.75% net. The property then increases to $3.4 Mill. over the next 7 years (that’s only inflation):
I earn: $362k in rents (after the 25% contingency against, repairs, and with a 3% rent increase each year)
plus: I net $700k on the sale of the property (I’m expecting to make close to double that, but let’s just accept inflation for now).
I return: That’s a total of $1.362 against the $700,000 that I put in (the bank put up the rest, and they’ve already been paid interest and their money back in these numbers) or 11.5% on my money
I expect: But, that’s only if the building appreciates by inflation; I expect to net at least $1.5 Mill. on the sale of the property (if not $2.5 Mill.!) which brings the return up to 20% … secured by real-estate, no less!
7. If no purchaser does come along, I am earning a neat 9%+ on my $700k until somebody does buy it!
So, by all measures, this is a great deal … some common sense and some simple number-crunching tells me that, no ‘cap rates’, ‘proforma’s, or any other complex financial manipulations necessary.
BTW: I did a quick ‘drive by’ but haven’t even been inside, yet. It doesn’t matter … I won’t be ‘living there’ 🙂
OK – close your eyes (actually, keep them open so you can keep reading!) and imagine the complexity of analyzing cashflows and proformas for a real-estate deal north of $2.5 million …
Daunting, huh?
Well, that may be how OTHERS analyze a deal, but not me … all of my deals are done on the backs of envelopes … well one clean sheet of paper. I have this one right in front of me, in my own scrawly handwriting.
On the strength of it, I have authorized my Realtor to make a written offer, with a $200k ‘earnest money’ deposit on the $2.7 Mill. office/warehouse. Sure, the proformas will come later, but I’ll get him to prepare those for the bank … while I’m at the beach or off skiing someplace!
Here’s what the piece of paper says:
Purchase Costs
$2.7 Million (incl. $100k broker commission)
$5k Building / Environmental inspections
$15k Closing Costs (legals, bank fees, appraisals, etc.)
Of these, the $5k for the inspections is my only financial risk, as I need to undertake these during ‘due diligence’ (we’ll talk about this in a future post if the deal gets that far).
Finance
$2.7 Million Purchase Price (incl. broker’s commission)
$ 2 Million to be financed
Note: this is approx. 75% of purchase price to be financed; this is high for commercial which can be as low as 60% being the maximum that the bank will fund.
$700k – so this leaves me 25% of the purchase price, or $700k, to find as a deposit.
Note: I’m sure that the owner’s won’t ‘carry back’ a note on this one, as the whole purpose of the sale is to raise cash to keep their business afloat or growing.
So, that’s the purchase / financing side of the equation, now let’s see if it can make me any money …
Income
$175k – Rent for Tenant 1 @ $8 / sq. foot
Note: the current owners will lease 2/3 of the property for the above fee (probably 5 years, with a 3% yearly increase)
$80k – Rent for Tenant 2 @ $8 / sq. foot (we need to find this smaller tenant)
Note: the property is street front with car park, so we feel is should be easy to find a second tenant in the $6 – $10 / sq. foot price range
$255k TOTAL INCOME
Expenses
Note: the GREAT thing about commercial properties is that most expenses (and in a ‘triple net property, all expenses – unfortunately, this is NOT one of those) are handled by the tenant, leaving me just …
$45k Taxes
$7k Building Insurance
$10k Management Fees
Note: Rental management fees can vary from 4% – 6% of the rent if you don’t want to deal with the tenants yourself; keep in mind that commercial property is very different to residential and you won’t have as many issues dealing directly with commercial tenants – they are responsible for all repairs & maintenance … but, if the roof springs a leak, you’ll be expected to act quick! I will use an agent ( my friend).
$130k – Bank Interest @ 6.5%
Note: this is the ‘biggie’ and I haven’t spoken to any banks, yet; obviously, that’s my next port of call but my Realtor friend tells me that I shouldn’t have any problem getting funding fixed for 7 years (or a 25 year P&I loan with a 7 year balloon) around these rates. Variable can be as low as 4%, but I prefer to ‘fix my costs’.
$192k TOTAL EXPENSES
In the final part [AJC: when I return from my ‘winter break’ on Jan 5], I’ll summarize this all for you and explain why I like the deal so much …
… coincidentally, I have been working on a commercial RE deal in the $2.5 mill. price range, so I thought that I should simply share.
Warning: like most deals, this deal could simply fall through at the first hurdle. Let me explain by sharing the story so far:
All good real-estate transactions, in my opinion, start with finding a good broker who is working for you.
As it happens, I have a close friend who is a commercial real-estate broker who meets the ‘trifecta’ that I mentioned in that last post: (a) I like/trust him, (b) he works with commercial RE in the area/s that I am interested in, and (c) he invests heavily in commercial RE himself (buy/hold).
I have been pestering him for the last 4 years to find me a deal … interestingly, and this is something that you should take mental note of, he says that he is asked by most people he meets to ‘find them a deal’ but almost none ‘pull the trigger’ …
… so, forgive your broker if they don’t fall all over themselves with excitement until you actually close on your first deal with them 😉
Anyhow, finally a deal came up that seemed to fit my criteria. I didn’t even request financials at that stage or see the property: on the strength of my friend’s recommendation (it was a deal he wanted, but the $700k deposit was a bit too steep for him) I authorized him to put in a written offer.
I don’t recommend that you do this, you will pick up where this post leaves off …
Anyhow, the current owners occupy the premises (they were planning a sale/leaseback i.e. they sell the property to me, then lease 2/3 of it from me on a 5 year lease) and decided to first see if they could simply refinance their loan and take some cash out.
Naturally, in the current market this has proved difficult, so they have put the property back on the market … my friend is the listing broker, so I have first ‘dibs’ on the deal.
So, I am now at Stage 1: I have a deal in front of me; presumably, motivated sellers (we’ll find out, if they accept the new offer); and, I need to decide whether and how to proceed.
In Part 2 I’ll step you through exactly how I decided this was the ‘deal for me’ …
This video is essentially an ad for Robert Kiyosaki’s (Rich Dad, Poor Dad author) board game … a game that I own but have NEVER played. But, the video is also a snapshot of how you can use assets to buy consumer goods. Watch the (visually OK, but aurally uninspiring) video, then read on as I have some comments …
[AJC: Finished watching? Good …. now read on ….]
1. The assumption is that you are smart enough NOT to finance a depreciating ‘asset’ (actually, liability) and save up enough money to pay CASH for your boat: GOOD
2. Can you see how Robert Kiyosaki then suggests that you buy a cashflow positive property, using the cash that you saved for the boat as a deposit on the property instead? Robert implies that the property produces enough cash to then pay for the loan repayments on the boat: BETTER
But, Robert is suggesting that we BREAK a key making Money 101 Rule: that we should borrow to by a consumer item (this is BAD debt); Robert also suggests that ‘delayed gratifiction’ is good. So, let’s make use of this to see if we can come up with a better outcome.
Using a very simple loan calculator, I find that the $16,000 boat will actually cost us $21,600 over 4 years (assuming 10.5% interest, and $343 / month payments) …
… but, if we instead SAVE the full $750 / month that the property spins off as money in our pocket (after mortgage, etc.), we will have SAVED up enough to pay CASH for the boat in just under 2 years (21 months)! What’s more, over the four years that we have NOT been paying the boat loan, our money has been earning us approx. an extra $100 – $400 in bank interest.
OK, so the $100 – $400 extra interest we earn (if the money just sits in CD’s) is not exciting, but also SAVING $5,600 … a total of nearly $6k … surely is? So waiting less than 2 years, then paying cash for the boat, thus saving ourselves nearly $6,000: BEST
There is an exception: where the expense is a business expense it may be OK to finance … Robert gives the example in one of his books about how he was going to buy a Ferrari, but his wife (who’s obviously smarter – as well as better looking – than him) told him to buy a self-storage business instead, and use that to fund the payments on the Ferrari.
Smart … but, I’m sure the IRS would have some words about the deductibility of a Ferrari as ‘company car’ for a self-storage business 😉
There is a certain appeal to diversification, particularly when seen as a risk-minimization strategy.
Rick sums this ‘certain something’ up nicely in this recommended twist to how he would set up his own Perpetual Money Machine:
Nothing in life is without risk- but you can minimize risks by diversifying- use multiple types of wealth capacitors some properties, some stocks, even some bonds. You can further diversify with a mixture of commercial and residential properties, properties in different locations, etc.
Similarly you can diversify stocks through buying small cap, large cap, mid cap, and foreign stocks.
If you diversify you can be fairly sure that one bad event doesn’t ruin everything. Of course if the sun goes supernova all bets are off but barring that you should do fine.
And, this is certainly appealing …
… don’t forget that I have been well diversified in almost every area that Rick mentions: multiple businesses; multiple RE investments in different classes (residential; commercial; single condos / houses; multifamily; retail; office; etc.); stocks (but, no mutual funds of any kind … and, I intend to keep it that way!) … but, I don’t recommend it!
Why?
I see two problems with this:
1. You spread yourself pretty thinly – you risk becoming a Jack of All Investments But Master of None … this lack of specialized expertise (which you can, of course, try and ‘buy in’) and focus can actually INCREASE your investment risk, hence DECREASE your investment returns, and
2. You automatically consign your returns to the mean/average – not all of your investments can perform as well as your best investment …. if you are comfortable with this ‘best’ investment (or, at least one of your ‘above average’ ones) surely you would put more effort into doing more of those?
The usually arguments FOR diversification then say things like “well, look at the sub-prime and what that’s done to [Investment Class A], therefore you should also do [Investment Class B]” …
… but, they conveniently forget that [Investment Class B] tanked 5 years ago, and will probably tank even worse 5 years hence, whilst [Investment Class A] recovers.
If you diversify you run the risk of averaging your returns down.
In other words, if you can choose your investments wisely your best hedge against risk are a combination of:
a. Time: make sure you can hold the damn thing for 10 to 30 years … if you have a short investment horizon, no amount of diversification will protect you.
b. Higher Returns: if you can hold long enough, every investment worth its salt will recover – and, then some; and, isn’t a ton of cashflow a great ‘insurance’ against risk?
Of course, if you can’t choose your investments wisely, then a ‘regression to the mean’ becomes a GOOD thing … just don’t expect to get rich if you can’t develop any special expertise 🙂
Nope, Rick, my Perpetual Money Machine – which asks me to generate my active income one way (e.g. my job or business), and then create passive income in another way (e.g. stocks or real-estate) gives me all the diversification that I need!
But that’s not the question that you actually asked; you asked how to build up $7 Million dollars worth of PROPERTY (i.e. real-estate) in 7 years, and that’s another matter entirely.
For example, you will notice that I didn’t reach my 7m7y from real-estate alone (and, you’re not likely to be able to, either): my ‘energy source’ was a business (actually, more than one), but my ‘capacitor’ was (largely) real-estate.
If you are asking if you could build a $7 Million real-estate portfolio in 7 years, using just your income from a job (even a pretty high paying job) I would have to say “not bloody likely, mate” …
… your income just can’t ‘fuel’ enough real-estate deals to produce the annual compound growth rate that’s required!
To see what energy source and compound growth rate combination that YOU need, FIRST you must start with knowing your Number / Date:
If you need, say, “1 million in 20 years’ (and, let’s assume that you’re starting from, say, $10,000 in the bank instead of my $30k in the hole), a job (as your ‘energy source’) + real-estate together with stocks (as your ‘capacitor’) should do the trick.
But, if it’s “7 million in 7 years” you want (starting with the same $10k), then you’ll be needing a more aggressive set of ‘energy sources’ and ‘capacitors’ for your perpetual Money Machine, i.e.:
Your own business (excess cashflow) + real-estate.
It’s all in your required annual compound growth rate … find yours, and work backwards from there …
… but, Caprica – as I suspect do many of my readers, after all of this time – already understands this:
I realized after I posted my response I already knew the answer …, which was to start one or more businesses to help you generate enough money to buy your passive income source.
I wrote a post about an insidiously appealing – yet flawed – approach to investing promoted by the financial services industry (I wonder if high turnover helps them or hinders them?) called ‘re-balancing’ …
… even if it were sensible (it’s not), it requires an even more flawed base to sit upon: a diversified portfolio. Now that is something that the financial services industry makes money from! 🙂
That post inspired a discussion with Jeff, who provides some useful number-crunching to support his ultimate argument for rebalancing:
Consider two cases in the first you rebalance in the second you don’t:
Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
37.5K 37.5K 75K After rebalancing
75K 37.5K 112.5K Right after market recovery
56.25K 56.25K 112.5K After rebalancing
No Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
50K 50K 100K Right after market recovery
Note rebalancing earned an extra $12.5K over doing nothing, it doesn’t compare to perfect market timing but there was no crystal ball required! Jeff pointed out rebalancing maintains the risk level. Was it less risky to hold half stocks half bonds? Yes, in the 50% market crash there was only 25K in losses rather than a 50K loss.
Again rebalancing helps prevent losses over doing nothing. If you are invested in more than one asset class you should rebalance.
So, it seems that rebalancing is inexorably tied to diversification: do one and you should do the other, but what of the reverse?
Let’s turn again to Jeff [AJC: I cut/pasted a couple of Jeff’s comments … you can read the entire thread in its original form here] , who says:
If you have elected to diversify your portfolio I would argue that you should rebalance to maintain your initial asset class mix.
You add bonds to your portfolio to reduce risk. Failing to rebalance increases the your risk as time goes on…which is typically the opposite of what most investors desire. The reason you do this is not to maximize return, but to maintain the same risk that you had when you started.
The real reason people diversify into higher risk asset classes is to increase their return per unit of risk. Even when a higher risk asset class increases the overall risk of your portfolio, the excess return is disproportionately large when compared to the excess risk. Thus, overall the return per unit of risk increases, helping you to maximize the amount of return you receive for the risk that you take on.
Rather than focusing on return per unit of risk, shouldn’t we look at risk per unit of required return?
Surely we should:
1. FIRST look at what RETURN we need in order to achieve a required financial goal, and
3. USE THAT menu of qualifying investments to make our investment selection from?
If your financial goal – e.g. Your Number – is sufficiently large and/or your desired timeline – e.g Your Date – sufficiently soon, diversifying/rebalancing may be among the highest risk options available, along with any other investment strategy that fails to meet your required annual compound growth rate!
Diversification/Rebalancing simply may not return a high enough amount to fuel the annual compound growth rate required to get you there!
In which case, you only have some combination of the following three choices:
i) Reduce your Number, and/or
ii) Extend your Date, and/or
iii) Accept a higher level of technical risk in your investment choice/s
But, is there a point in life when it makes sense to switch to a risk-above-return strategy?
Yes!
As Jeff says:
As I get older I will be increasing the % of bonds that I hold and will be rebalancing.
But, I would not (first) look at my age … again, I would first tie this to my financial goal i.e. my Number:
When I reach my Number (or, if I fail and am within 7 years of my latest retirement age), I would shift to a Making Money 301 Wealth Preservation Strategy, such as:
1. That promoted by Prof. Zvi Bodie (Worry Free Investing) – putting 95% – 100% of my Investment Net Worth into Treasury Inflation Protected Securities (TIPS) and the remainder (0% – 5%) into call Options over the S&P 500, or
2. That promoted by Paul Grangaard (The Grangaard Strategy) – putting 70% of my Investment Net Worth into a low cost S&P 500 Stock Index Fund and 30% into a bond-laddering strategy to cover my anticipated spending for the next 5 years (then ‘repeat’ every 5 years), or
3. Putting 80% of my Investment Net Worth into positive cashflow (before tax) real-estate (I would ‘jiggle’ my deposit amount to ensure at least a 6.5% return p.a.) and keeping 20% in cash and CD’s as a buffer against vacancies, repairs and maintenance, taxes, etc.
4. If all else failed, or as a ‘last ditch’ effort to avoid leaving too much in cash/bonds, a diversified portfolio of stocks and bonds … possibly to be rebalanced each year.
But, the last word goes to Jeff:
This, of course, doesn’t mean anything unless the new return is something that you desire.
Where Diane is right that putting money into CD’s while you hold a mortgage is probably a sub-optimal financial decision, it’s NOT because your Net Worth would change … paying down your mortgage does NOT change your Net Worth – it just reduces