The Mighty 401k Fights Back!

Posted on July 2, 2008 by Adrian

A short while ago I wrote a post challenging the notion that you should automatically plonk your money in your 401k, because:

1. It’s ‘forced savings’

2. It’s pre-tax savings

3. You get free money from your employer!

Yesterday I wrote a follow-up saying acknowledging that these are all good things to have in an investment.

But, not the only things … in fact, there’s only ONE THING that I want from an investment: that it gives me a return that supports My Life.

Not, the life that the investment is capable of supporting … not the life that I have … not even the life that I want … but, nothing less than the life that I need.

But, I expected to cop some flak, and here is some of it …

Traciatim said:

Historically real estate tracks inflation, not 6% annually. You’re also forgetting maintenance and property tax, water/sewage, heat, etc. When you want to retire you’re also forgetting the cost of selling the properties.

In fact, this is a really common theme amongst the detractors (there were a lot of positive comments, too) … but, who ever said that you should invest in ordinary residential real-estate in ordinary locations?

Also, those who ‘remembered’ the costs of these direct investments (which I did allow for) , we tend to forget the hidden management costs and fees of the funds that your 401k invests in (which I did not allow for).

Curt said:

If you wait three years, real estate ‘good deals’ will be everywhere and you won’t have to invest the time to find them. That will likely be a better time to move money back into real estate.

This is the mistake of trying to time the market; this affects both the 401k ‘option’ and the alternatives, and probably requires a whole post in itself … if you are interested in the real-estate option (and, it is just one of many non-401k options that you could take) and you can find something that ‘works’ now, go for it!

Paul said:

One major flaw in your analysis…and I’m sure I could find others if I look hard enough:

You’re not accurately accounting for taxes here at all. The contributions to the 401(k) Plan are on a pre-tax basis. If you’re saving money in a bank account to buy real estate, that’s on an after-tax basis. To save $5k in a 401(k) Plan, you have to earn $5k. To save $5k in a bank account, you’ll need to earn $6,667 assuming a 25% tax rate.

I didn’t even talk about the risk inherent in real estate versus a diversified portfolio, or how your analysis of the return on the employer match is a bit off.

While it is good to think in unconventional ways at times, you better make sure you are accurately looking at these scenarios before you risk your entire future on them. While it could pan out, it could also blow up in your face.

Wise words, Paul. Of all the criticisms of my post that I read, Paul’s is most valid: I did not do an after-tax treatment (although, I did mention Capital Gains Tax); it’s just too damn complicated to run the numbers for a post like this … and, doesn’t change the relative outcome.

In fact, why do you think so many wealthy people invest in businesses and real-estate? It’s partly FOR the tax breaks! How much tax do you think that they legitimately pay per dollar earned compared to you, even WITH your 401k?

And, it appears that Pinyo of Moolanomey actually reran the numbers:

AJC – Interesting post, but I have to agree with the naysayers. Your analysis in scenario 1 didn’t include mortgage and other expenses. In part 2 of scenario one where you actually account for expenses and deposit everything into CD, the true advantage is only $63,000 over 30 years and this is before tax — after tax it’s virtually wiped out.

Sorry, Pinyo, on this one we’ll have to agree to disagree … unless you want to share your numbers? Then, I’m happy to do [yet another] followup.

BTW: real-estate is not the only viable alternative to saving in your 401k; my arguments apply to any investment that has the following four characteristics: leverage, depreciation, other tax deduction/s, and inflation protection.

Guys, the critical difference is this one – hardly mentioned in the comments at all: Real-estate has an apparent risk … but, the 401k option has a hidden risk.

I think we all understand the apparent risks of alternate investments v the nice, safe 401k (if you were set to retire at the end of 2007 and you ‘forgot’ to shift the bulk of your funds to the bond market, you may have a slightly different view on this) …

I’ll leave you with one thought: when was the last time that you read this headline:

‘Multimillionaire thanks the tax system for favoring his 401k … says” “without it, I would not be sitting in my beach house in Maui sipping Pina Coladas today”

The Hidden Risk of your 401k …

Posted on July 1, 2008 by Adrian

Recently I wrote a post that challenged the ‘Set It And Forget It 401k Brigade’ to at least rethink their strategy instead of just automatically maxing out their 401k …

… in doing so, I mentioned that there was a ‘hidden risk’ in your 401k.

Whilst the 401k proponents put forth all the wonderful, low risk arguments in favor of 401k’s (quoting long-term market averages of 12%+) they conveniently forget:

1. Fees: Figure around 0.5% – 1.5% in fees set by the funds that your 401k invests in and the fees associated with managing the 401k and the underlying funds (but, only the ones that your employer doesn’t pay). Most of these are conveniently hidden in your returns.

2. Market Dips: Did you know that while the ‘market’ averages 12%+returns, you can only count on 8% as your 30 year return, 4% as your 20 year return, and 0% as your 10 year return from the market. My rule of thumb is: when planning your retirement, count on less … enjoy the possible upside when you are wrong!

3. Inflation: It takes time to get to the nest-egg that your 401k will give you … 20 – 40 years when you are starting out … so $1 Million just ain’t all that much money (now, let alone 20 – 40 years time!).

But, that’s not the hidden risk that I was talking about … it’s much, much more dangerous than those …

… the hidden risk of your 401k is that you may not get enough out of it to retire well.

Almost as bad, you may not care enough now to plan for what may happen then; after all, for you ‘retirement’ may be still 10 – 20 – 40 years away! Although, it need not be …

So, what do I mean?

As I said yesterday, the arguments that the 401k proponents put forth center around: it’s ‘forced savings’; it’s pre-tax savings; and, the possibility that you get free money from your employer!

All good things to have in an investment. But, not the only things …

… in fact, there’s only ONE THING that I want from an investment: that it gives me a return that supports My Life.

Not, the life that the investment is capable of supporting … not the life that I have … not even the life that I want … but, nothing less than the life that I need.

Just remember this: there’s nothing holy about a 401k.

The purpose of your 401k investment is NOT to get a tax break, not to put aside 15% of your gross salary a month, and not to get any employer match … they are just (important) features …

Just like any other investment, your 401k’s purpose is to help you get you to Your Number so that you can live Your Dream!

Anything less is just settling for less. So, let’s consider the binary options here:

1. Your 401k will get you to your Number

You know your Number, right? And, you know when you need it?

If not, either read this and do this … or, you’ve just wasted a valuable 3.5 minutes beer drinking, relaxing time that would have had a far more beneficial effect on your life than what you have just read … or, will ever read … on this blog!

And, you know what your 401k can deliver by then, right? Not when your employer says that you retire, but by when you need The Number!

If you haven’t done the calculation yet, ask a Financial Adviser to help you (or follow along with our 7 Millionaires … In Training! at http://7m7y.com starting with this article) …

… you think knowing this might be just a tad important?

Now compare what your 401k is likely to be able to produce (now, I would not be using ‘average returns from the stock market’ for this life-critical calculation … I’d want a buffer … but, that’s really up to you and your bean-counter) with Your Number …

… if they are much the same, stick with your 401k (after all, it is ‘set it and forget it simple’). Then concentrate on keeping your job and, getting bigger and bigger pay-rises, because you’ll need ’em!

2. Your 401k will NOT get you to your Number

If your 401k will not get you to your Number, what choice do you have but to at least consider alternates, be they instead of – or in addition to – your 401k savings plan …

… be they real-estate, stocks, 2nd/3rd/4th jobs, marrying into money, winning the lottery, businesses …

…. be they whatever …?

Of course, you could just give up and settle for your lot in life; who am to tell you not to give up on your dreams?

I’ll leave that little job up to Frankie 😉

Millionaire by 30?

Posted on June 17, 2008 by Adrian

The best way to become a Millionaire by 30 is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

_____________________________________________________

Recently I wrote a post that I consider to be one of the critical “you either get it or you don’t” pieces that will determine whether you will ‘make it’ or not …. if you haven’t seen it yet, fully understood it, or hotly debated it (with me, yourself, or your mother) then I highly recommend that you go and get to it!

Anyhow, Jim wrote a comment:

This video was suggested from one of my posts and I think it gives a pretty good example of your premise. This is Douglas Andrew, author of Missed Fortune…

I watched the video … and, set it aside presuming that because it was so short, the one or two glaring errors (did you spot them?) would have been addressed in the full video (or a Douglas Andrews seminar) …

… then I saw an article on My Money Blog:

The overall moral of this book review is that even though a book finds a publisher, it doesn’t mean the advice is accurate or applicable to you. The book Millionaire by Thirty: The Quickest Path to Early Financial Independence by Doug Andrews & Company appears to be very similar to the other Missed Fortune books by the same author. In fact, from reading the reviews all of these books seem to contain the exact same material.

Housing Prices Always Go Up, Take Out Largest Mortgage Possible!

“Do you rent? Rent is like throwing money down a black hole. It doesn’t matter how much money you have saved or how long you plan on staying in the same place, you should always try to buy a home. If you aren’t going to stay very long you can simply get an adjustable-rate loan with no down payment. Housing prices always go up, so you can enjoy the low interest for a couple of years, and then sell and make a nice profit.

If you are really smart and disciplined, you can even get an interest-only or negative-amortization loan because then you won’t build up any equity at all. Accumulating home equity is bad. Anytime you have any, you should take out a loan on it and invest it somewhere else, like a second home.”

The above are all the dangerous generalizations about real estate contained in this book. Newsflash… Renting can be the best option for many people. Housing prices do not always go up. Thousands of people who bought a home and now have to sell after a few years will have lost tens of thousands of dollars compared to if they had rented.

Summary
Many of the books I read may not be brilliant, but they contain generally good ideas and target a specific type of reader. However, this book is one that could actually hurt more people than it helps. This book is just plain misleading. It would be wonderful if home prices always went up and there was an investment where I could never pay taxes, have no downside risk, and get stock-like returns, but unfortunately both are too good to be true. I’ve tried to lay out my arguments for this briefly, but if you want a better description read the detailed reviews here and here. Clever Dude also shared his thoughts here.

Short version: Don’t read it, don’t buy it, don’t even borrow it from the library

Firstly, I agree with My Money Blog on the home ownership issue to a degree … owning your own home is not always the smartest FINANCIAL option.

However, here is where I differ: for MOST people, it’s the only way that they will get financially free for lots of psychological/emotional reasons, more than strictly financial. Also, I do agree with the ‘forced saving’ and ‘forced appreciation’ that it can give you (provided that you do something with the appreciation … you don’t want to die ‘house rich / cash poor’!).

The ONLY time you shouldn’t invest in your own home, is to invest in income-producing property instead*.

And, while it’s true that real-estate doesn’t always go up, if you have a 20 – 30 year outlook and can lock in circa 6% interest for up to 30 years (another reason why your own home can be a good idea) … I think the future is exceedingly bright.

So, it is with a little surprise that I find myself actually siding with Doug – warts and all (!) – on this one …

But, I don’t agree with Doug that you shouldn’t have ANY equity in your own home (again, strictly financially speaking, he is probably correct), but I have proposed the 20% Rule that says that you should have no more than 20% of your Net Worth invested in your own home at any one time.

This rule, when understood and applied properly, accomplishes two key things:

1. Let’s you get/stay invested in your own home, but

2. Ensures that you maintain enough of your Net Worth in outside investments.

… without the screaming holes in the get-rich-quick schemes promoted by the ‘nothing down’ brigade!

So, go back and read all the posts that I have linked to … as I said at the very beginning, this could be the key to your wealth …

* or to invest in some other high-reward activity (e.g. buying/starting a business; leveraged
  investments; etc.) ... although, I would still prefer that you ALSO buy you own home 'just in case'
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Play the match game …

Posted on June 14, 2008 by Adrian

Here’s an ‘investing match game’ for you to try … simply match the active investment actions in Column A with the investment vehicle of choice in Column B (you must use each word in Column A once, and once only … you may use any word/s in Column B as often as you like):

Investment Actions		Investment Choice

Rehab’ing / Flipping		Real-Estate

Mortgaging / Leveraging		Motor Vehicle

No Money Down		Business Assets

Now, is this a trick question? If you’re honest, you probably answered:

Investment Actions		Investment Choice

Rehab’ing / Flipping		Real-Estate

Mortgaging / Leveraging		Real-Estate

No Money Down		Real-Estate

… after all, these are all ways to make money with real-estate; so did you pass the little test?

Good, because here is how they might work:

1. Rehab’ing, then flipping (quickly on-selling) real-estate

You can purchase a run-down property in a good location (usually a small house, condo, duplex, triplex or perhaps a run-down apartment complex), provide some of your own labor (or try and find a general contractor willing to work cheap) to fix up the kitchen and bathroom/s, apply a little paint and some new carpet, and … voila … you get to re-list the property and resell it for a price that covers your purchase price + rehab + profit (both yours and the general contractor). At least that how it used to be done – and, will again, sooner or later. Rehab’ing and flipping can be a useful way to generate a small lump of cash (also known as ‘chunking‘).

2. Mortgaging real-estate

You can purchase some real-estate, perhaps putting in a deposit of 10% – 20% and then using the bank’s money to pay for the balance. You can either live in the property or rent it out to help cover the cost of the mortgage (which you should usually fix so that you can be certain of your future costs). Since the mortgage payments do NOT rise with inflation (if you were smart enough to fix them), but rents do … over the long run you will earn an income and an eventual capital gain as the property increases in value. Buying and holding is a simple strategy for long-term wealth.

3. No Money Down

This is where you find a creative way to avoid paying a deposit (perhaps you don’t have the cash?) and then work with one of the other two strategies. There are people who swear by this method and others who say that there is no ethical way to use this strategy in a repeatable fashion. In either case, you use tools, like assuming an existing loan, and/or seller carry-back financing and/or finding a partner to avoid the necessity for fronting the 20% deposit yourself.

Of course, this little primer on real-estate was just a little ruse to stop you from peeking ahead …

… you see, even though I have also invested in real-estate in many different ways, here’s how I would match up those columns a little differently, based upon some things that I have actually done over the years:

Investment Actions		Investment Choice

Rehab’ing / Flipping		Motor Vehicle

Mortgaging Leveraging		Business Assets

No Money Down		Business Assets

i) Rehab’ing, then flipping a motor vehicle

Just out of college, I landed a high-flying job in the hot IT sector (yes, we had computers in the 80’s … just bigger) … when all of my friends were buying their first new car, I was selling mine, to buy …

… a 10 year old Porsche 911 (the particularly ‘hot’ S-model) for just $13,000 (she was a beauty, but more exhaust fumes ended up inside the car than outside … helps to explain the loss of a few memory cells).

The trouble is that she was that horrible bright/lime green that the German engineers thought was oh so appealing … yuk. I hired a compressor and bought some paint and materials … and, a friend who (said that he) had some experience spray painting, helped me to strip and sand the car’s exterior to bare metal then we spray painted it (in his backyard garage) a beautiful red … acrylic. We used over-the-counter enamel spray cans in a matching red to change the color of the interior of the doors, cabin, and engine/trunk because those areas were too hard to sand smooth and polish to a shine.

When we were finished the car ‘looked’ a million dollars …. needless to say I flipped it pretty quicky … selling it for $26,000. That was a decent profit for a not-long-out-of-college kid in the early 1980’s!

2. Mortgaging business assets

I mentioned in a previous post that I left my high-flying job just shy of 10 years to join my father in a very small finance business (just me, my father, and one administrative clerk); it didn’t perform very well, not even covering salaries. However, when my father got sick, I decided to buy out the family, leaving me $30k in debt.

The only problem was, that being a finance company, the business needed funding – bank funding, and a lot of it. The best solution that I could come up with was to find a bank who would treat the business assets (the ‘paper’ that we were funding) just like real-estate: I had no trouble finding a major bank willing to lend me 75% against those assets at a middling-to-high interest rate (leaving me to find the 25% deposit … by way of a partner whom I found then later bought out). The bank took no other security other than my personal guarantee … now, I have banks lining up to fund millions at up to 95% of those same assets (sub-prime or no sub-prime!) with no additional security and, now at an excellent rate.

3. No Money Down

Obviously, finding a partner for that business was a ‘no money down’ technique as applied to business, rather than real-estate. However, I came to the USA to sell some software to a related business. What I found was a business that had been family-owned for 50 years, allowed to run down, then been purchased by a large multinational for a ridiculous sum.

Naturally, the part of the business that I was interested in was not operating profitably, so instead of selling them my software and services to help them ‘fix’ the business themselves, I provided a cost-benefit that showed that they should give me majority share – for nothing – in return for taking over, and re-engineering its operations.

My team and I turned that business around in just a few, short months, and I sold my share to another public company for a huge gain (what’s the return on ‘no money down’? Infinite!) just 2 years later.

The point here is that money can be made anywhere, in any manner … all you need to apply is the NEED to achieve a certain level of financial result, the VISION to see a way to get there, and the PERSISTENCE to see it through …

… failure to do so will NEVER be for a lack of opportunity!

What are the pro's and con's of value investing?

Posted on June 13, 2008 by Adrian

I answered a great question at TickerHound posted by the staff (as they do from time to time to stimulate discussion) that I thought I should simply repeat here:

What are the pro’s and con’s of value investing? Do you think it’s a worthwhile strategy or are you more of a “efficient market” proponent?

Well, I consider myself a Value Investor in everything that I do … stocks, real-estate, etc. The only exception is in the case of businesses, I’m generally a Growth Investor or a Value Investor.

Value Investing simply means “buying something worth $2 for $1” … well, not exactly, but you get my point: buying something for less than it is WORTH.

Now, this is a critical distinction: just because something was selling for $2 last week, and is selling for $1 this week, doesn’t mean that it is a VALUE Stock … it may only be ‘worth’ $0.50 and the market may simply be driving the price down to that … and, beyond!

In fact, that same stock (really ‘worth’ only $0.50) may BECOME a Value Stock if/when the market overshoots and sends the price down to $0.25.

The problem with Value Stocks is then one of KNOWING what they are truly worth at any point in time, and only buying when they are selling for a price less than that (preferably, with a large Margin of Safety … which simply means, buying it for MUCH LESS than what you THINK it is worth “just in case” …).

Now that we have covered the basics, what is the PRO of Value Investing?

Exactly that … being able to buy something ‘worth’ $2 for only $1. I can’t think of a better, more sure way of making money than that!

Then, what is the CON of value Investing … after all, there must be some or we’d ALL be doing it?

Simple: as I said before, it’s all about KNOWING which stock that is currently selling for $1 is actually worth $2 (and, avoiding the ones that are only worth $0.50!!). And, that takes some knowledge and skill. Warren Buffett has that knowledge and skill … so do many others, to a greater or lesser extent.

One other CON – one that is, ironically enough, addressed by another TickerHound question: “Is technical analysis still applicable in a “news driven” market like the one we’re in now?”:

If a stock that you KNOW is worth $2 is currently selling for $1, is it an automatic BUY?

Well NO … you see, you KNOW it is worth $2, but the rest of the market may not!

Or, it may have BEEN worth $2 but there is something happening (maybe a pending lawsuit around a key patent, or the loss of a major contract, or … ) that YOU don’t know about because it hasn’t hit the “news” (or TickerHound) yet, but those ‘in the know’ are selling off the stock by the truckload.

So, that’s where technical analysis is not just applicable in a “news driven” market like the one we’re in now, but absolutely CRITICAL for buying Value Stocks …

… it will tell you WHEN to buy (or sell off) that stock holding, based upon what the “insiders” are doing.

If you want to learn more about Value Investing, and using Technical Analysis to know when to get in/out of a Value position, I recommend picking up a copy of Phil Town’s excellent primer: Rule 1 Investing …

… and, Good Luck!

The $7million Real-Estate Rule

Posted on June 11, 2008 by Adrian

Yesterday’s post, The $7million Real-Estate Question(s), was aimed at the first-time investor, perhaps stuck on making their first real-estate investment (not home) purchase decision by the – perhaps too many – factors that they would need to consider.

In essence, what I said is: in a commodity market, buy the commodity at commodity prices … and wait!

Wait for what?

Ideally, forever … but, at least until the values have improved.

But, what kind of real-estate are commodities?

Houses and apartments in most areas are commodities; small multi-units (duplex / triplex / quadraplex) can be, too. Anywhere where there are lots of them near each other …

… preferably lots for sale, and fewer vacant [AJC: Too many vacancies can show an area that’s declining in population and/or jobs (with job growth being, by far, the most important of the two) … we don’t want that!].

Also, for residential property (that you don’t intend to live in) you really need to go for an area that will/can appreciate as it can be very difficult – if not impossible – to get them to cashflow-positive on a reasonable deposit (say, 10% – $20%).

Even so, my first two $7million Questions showed you the right type of market to buy in … which is, right now!

But, when evaluating more complex real-estate transactions, such as: commercial apartments (6 and above); offices and factories of all sizes … surely the The $7million Real-Estate Questions are not enough?

And, surely you are right …

These types of properties are sold as ‘businesses’ in that they have:

a. Income (or rent)

b. Expenses (or outgoings)

c. Taxes (unfortunately)

d. Profit/Loss (or Net Operating Income)

I will run you through how to analyse some of these types of property in future posts; for now, I want to tell you one way to assess these types of Investors’ Real-Estate that is NOT as important as you may be lead to believe, and another way that is MUCH MORE IMPORTANT.

Because commercial property runs at a profit (or loss) and has an Income Statement, people tend to buy (and sell) these types of rel-estate on the basis of their financial statements alone …

… and, not on the sale of comparable buildings around!

This is critical to understand – as it is totally opposite for the types of residential real-estate that most of us are used to.

The second thing to realize is that these buildings sell on a variety of bases, but usually the ‘expert’ real-estate acquirer will assess the Net Operating Income during Due Diligence and buy for a multiple of that … there is usually a multiplier [AJC: that the real-estate books that you read will all say is around 10 … but, these days in many of the hotter markets in the US and overseas, it will be as high as 12 to 16 – or even more when things get crazy].

This is called a Capitalization Rate or simply Cap. Rate.

Yippee!

This is just another way of saying that when you buy the building, it will return 10% of the Purchase Price (for a cap. rate of 10) by way of Net Operating Income (which should improve as you increase rents).

A larger Cap. Rate when you talk “times” (or smaller when you express it as a %) is BAD for purchasing (but, great for selling if you can increase the rents a lot!); here’s why:

A 12 times Cap. Rate means that a $1,000,000 property will only return (NOI or Profit) a little over 8%

A 16 times Cap. Rate means that a $1,000,000 property will only return (NOI or Profit) a little over 6%

So, a serious investor will pull out all the numbers, take a look at the Cap. Rate and make a decision whether to buy (obviously, there will be a lot of other factors … this will drive the financial decision).

How will they typically make that decision?

Well, they’ll compare the % return to what the cost of funds are … if they can make enough to cover the mortgage … then they’re in. So, with a Cap. Rate of 8% and Mortgage Interest rates at, say, 7%, it’s slim … but, they’re in front!

Cap. Rates are really useful, when you can a property for, say, $1,000,000 – add $50,000 of renovations that allow you to increase rents by 10% … all of a sudden, your property is now worth $1,100,000 – a 100% Return on your $50k rehab. investment!

But the Cap. Rate alone doesn’t give you the true picture for the original purchase decision … there’s a MUCH better way to look at the financial decision … first, here’s why:

A. Your investment in real-estate is only the deposit – typically 25% (plus Closing Costs) on commercial

B. The Bank’s investment in real-estate is the mortgage – typically 75%

But, you get the ‘return’ or the Net Operating Income on the entire building …

Because of this wonderful benefit of buy-and-hold, income-producing real-estate, the ‘right’way to value an investment is by it’s return on what YOU put in: it’s called your Cash-on-Cash Return.

So if you put in 25% deposit on a $1,000,000 building with a Cap. Rate that’s returning 1% over the mortgage rate, then you are getting:

1. 8% return for the 25% that you put in, plus

2. A ‘free’ 1% for each matching 25% that the Bank puts in – since they put in the other 75% that’s another 3% effective return.

All of a sudden that ‘small’ 8% return that seems only a little above the bank’s interest rate of 7% swells into a real 11% Return on your money [AJC: most investors will look for a return on their money (in real-estate) in the 10% – 20% range; this requirement will increase as Mortgage Interest Rates increase] … and, we haven’t even counted on any appreciation, yet (!):

i) As Rents increase, so does your return because YOU don’t have to put in any more money … inflation does all the work for you!

Example: if interest rates remain the same (and, they will because you DID fix them, right?), but the rents go up a mere 4% per year over costs (and, they will because you DID put a ratchet clause in the lease, right?), in just three years the building’s 8% return will swell to 9% …

… and your cash-on-cash return will jump to 9% + (3 x 2%) = 15% – try getting thatin CD’s, Bonds or Stock Funds!

ii) As the building appreciates, so does your future return, even though you can’t cash on this right now (unless you refinance, of course).

Example: If cap rates don’t change (that, unfortunately, is up to the market), the 4% increase in rents will ALSO increase the value of the property by 4%. Which sounds great, until you realize that you only put up 25% of that …

… so, YOUR return increases by 16% – try doing that with Stocks!

Now, how does a 30% return (half now, half when you sell) sound to you? And, what happens if you hold for a little longer?

You do the math!

The $7million Real-Estate Question

Posted on June 10, 2008 by Adrian

I’ve posted recently on the importance of real-estate to your portfolio …

… only ‘important’ of course, if you intend to retire on more than the Pauper’s Million 😉 Well, at least important enough that you probably need to find a good reason NOT to invest in it (e.g. can’t stand the stuff; market is too crappy; can’t find a deposit; etc.)

So, how do you tell a good real-estate investment from a bad one? There are so many variables:

1. Purchase Price – This varies by type of property and area

2. Deposit Required – This varies by type of property and Lender

3. Mortgage Repayments – This varies by type of property and Lender

4. Comparable Returns – What would other investments produce?

5. Comparable Risks – How risky is this investment v. other uses that you put your money to?

For the new real-estate investor, these factors are almost impossible to accurately assess, so investing in real-estate usually comes down to:

(i) What kind of real-estate appeals to me as an investor? Residential – Houses; Residential – Condos; Residential – Multifamily; Commercial – Apartments; Commercial – Offices; Commercial – Retail; Vacant Land; and the list goes on

(ii) What area/s am I interested in? For most real-estate ‘noobs’, that means their local neighbourhood, town, city, or possibly state.

(iii) What price range can I invest in? For most this is dictated by Type of Property, Deposit Available, Income available to service the loan, and the Lender’s Rules

Which is all well and good, but here is how most real-estate investors ACTUALLY invest:

They see something that they like and can afford, and:

a) They buy if they are not too chicken, or

b) They pass if they are … well, you know … cluck, cluck cluck.

Since, I am usually scratching in the yard myself, please don’t consider this an insult 🙂 I actually think that this is a perfectly reasonable way to buy real-estate IF you first (more bullet-points!) ask the $7million Questions:

A. Is the market off its high?

B. Do you at least understand the type of property that you are looking at – and, the area – and consider it a reasonable buy (i.e. you don’t think you are paying ‘top dollar’ to get in)?

C. Are Interest rates off their highs?

D. Can you can afford the payments?

E. Ideally: Will the property be cash-flow positive (or very close to it)?

F. Can you (will you!) hold on to the property for a very, very long time?

Here is the basic principle:

Certain types of real-estate (certainly the entry-level types that most beginners would look at) are virtual commodities … you can pretty easily assess their value (and, potential rents) by looking up a few databases (Zillow, RealtyTrac, Loopnet, Rent.com) and/or newspapers.

There are more intelligent people than you and I out there who actually know how to assess this type of stuff … just trust a ‘commodity market’ to price reasonably accurately and you can’t buy too wrong.

One of my first acquisitions was a simple little condo … the market had been low but was starting to appreciate (how did I know, my 20 year-old nephews told me … they had just bought two condo’s in the same area!).

I didn’t know very much about the values, but I found a condo that was going to auction (actually, the most common way that condo’s were sold in this particular location) and the real-estate agency was from out of town, so I figured that they would attract fewer buyers than an well-advertised local agent would.

The only other keen buyer appeared to be a young builder: I could tell by his overalls, ass sticking out, and his trusty tape measure in hand.

So, what did I do? I just bid at the auction until it came down to just him and I … and, I kept bidding slightly more than him, until he stopped bidding!

I figured that HE knew how to do his sums and HE would not overpay … so, the max. I could overpay is by the amount over his bid that I would have to bid. Risky: you betch’a! Did it work: you betch’a!

His advantage: any rehab would be ‘at builder’s cost’ (I at least knew this would relatively minor … kitchen / bathroom / carpet / paint / lights / knobs). My advantage: Time … I could afford to hold.

In fact, we still own this condo and it has done very nicely thanks … it’s the only single condo left in our portfolio.

But, you could do even better: if you are prepared to do what most other (lazy) people won’t do – which is turn over a lot of rocks and put in a lot of low-ball offers before one is accepted – then you might actually out-smart the so-called ‘smart investors’.

So, how and when to get started?

For those who are following along, you will realize that the current market satisfies $7m Questions A. and C. … a bit of work will help you decide on $7m Question B. … and, your Lender will pretty quickly sort you out on $7m Question D.

$7m Question E. is the one that will give you the most difficulty … as you may not know how to estimate the costs (loss of rental; utilities; Repairs and Maintenance; etc. etc. … if that’s the case, don’t worry TOO much:

TIME (which is why you hold for a long, long time) will cure most ills … and, my $7m Questions … will protect you from disaster.

Oh, and do JUST ONE ONE MORE THING:

Lock in the current low interest rate for as long as the lender will let you!

That will help TIME help the MARKET do its thing … which is get the property/s to appreciate and the rents to rise 🙂

Now, if you can do the analysis that a ‘seasoned’ real-estate investor can do … well, go do it … you will make more money / faster, if you do.

But don’t let fear and ‘paralysis by analysis’ stop you … just use the $7 Million Dollar Questions, and …

Good luck!

The lesser of two evils?

Posted on June 9, 2008 by Adrian

Ramit Seth of I Will Teach You To Be Rich recently arose from his bunker – where he has been holed up, busy polishing the manuscript to his latest book [publishers please!] to pose the question:

“Should I invest in CDs or a Roth IRA?”

The post was brief, and to the point:

Sherene writes:

“I am a recent college graduate and I want to put the little money I have saved (approx $3,000) into something that will give me good returns over the years. Would you suggest I get CDs or a Roth IRA?”

The two are very different.

A Roth IRA is an investment account, but once you get it, you have to put money in it and invest. You can read all about it on my article The World’s Easiest Guide to Retirement Accounts.

A CD is a type of investment, which you can buy inside (or outside) of any investment account. And if you’re wondering what I think about CDs/bonds…

It was the last line that triggered the most comments … and, of course those comments were split into four camps:

1. Pro-CD’s

2. Pro-Bonds

3. A little of both

4. Ramit, why don’t you write more 😉

But, these miss the point …

Are you an ACTIVE investor or a PASSIVE investor?

Active Investor

You will have realized that you can’t retire on $1,000,000 in 15 to 20 years. And, inflation will serve to ensure that investing greatly in either Bonds or CD’s will keep you poor.

Therefore, you will be looking for direct (maybe leveraged through margin borrowing, if you have the ‘appetite’) investments in a very few stocks that you understand and love, a business here or there if you have the aptitude and interest, and/or a few well-chosen real-estate investments.

You will manage these for growth and hold until they no longer make sense to keep, or you retire (and, want to adjust your investment strategy).

I don’t see any room in this portfolio for either CD’s or Bonds, except as short-term vehicles for parking cash while you gear up for the ‘next big thing’ do you?

Passive Investor

OK, so we don’t all want to be rich … and some of you are just window-shopping this blog (or, seeing how the ‘other half’ lives?).

Let’s say that you DO subscribe to the $1,000,000 (or even $2,000,000) in 15 – 20 year philosophy (yes, I even had some applicants for my 7 Millionaires … In Training! ‘experiment’ with that outlook … they don’t need my training; they just need Valium!) … what then?

Firstly, you will be looking to max out your 401k/ROTH certainly enough for the full employer-match; this will probably mean selecting from the list of funds available … unlikely to include Bonds (although, there may be a Bond Fund in there, somewhere) and certainly CD’s won’t be an option. So, it’s a moot point.

Secondly, you will probably be looking to invest in buying a home … saving a deposit, making payments, etc. then trading up as soon as the sun starts to shine (now, there’s a financial treadmill for you!). So, it’s a moot point.

But, Uncle Harry might die and leave you with $20,000 and you are suddenly faced with the decision: CD’s or Bonds …

…. hah, you think you got me? No way!

I would be immediately looking at becoming an Active Investor ($20k might just be enough for a deposit on that nice little rental ‘fixer upper’ down the street).

But, let’s say that you still are determined to retire late and poor … but, don’t want to be quite so poor … where would I go for advice on conservatively investing that nice little chunk of change?

Hmmm … when I look for investing advice, I usually look to the best in the business. That’s why I went to Warren Buffett’s Annual General Meeting in Omaha a few weeks ago.

At the meeting, Warren suggested that IF you don’t really know what you’re doing, you should dollar-cost average (that means put a little bit over time) into little pieces of all of “American Business” … he later clarified that to mean a low-cost Index Fund (in fact, he named Vanguard).

Why?

Well inflation will keep your CD’s and Bonds worthless … by buying and holding Index Funds (LOW-COST ones) for a VERY LONG time, the market will go up (there hasn’t been a SINGLE 30-year period where the market hasn’t averaged an 8% return) and you will stand a better chance to beat inflation …

Of course, none of these PASSIVE investment strategies will make you rich (or even financially free at a young age), but Warren’s strategy at least has a better chance of keeping you out of the poor house, and giving you a chance of retiring at 55 or 65 … IF you start young enough, and maintain the course for 20+ years!

But, what if you don’t want to invest in stocks at all … even via an ultra-low-cost Index Fund? Is it thenOK to invest in Bonds or CD’s?

Maybe, but I would much rather plonk that $20k into my mortgage!

I know that I said that it’s a dumb strategy, but it’s sure better than the CD/Bond alternative (better after-tax returns, but check with your financial adviser before doing anything!).

In fact, the only time that I would invest in:

1. CD’s – when I need to ‘park’ some money for a while … waiting for the next ideal investment to come along.

2. Bonds – when I am already rich and retired: Bonds can play an important part in maintaining wealth as part of a Making Money 301 strategy. As Ramit mentions in his comments, Bonds can be laddered (that means bought with a variety of expiry/cash-out dates).

For two great Bonds-in-Retirement strategies, read: Worry Free Investing by Zvi Bodie and The Grangaard Strategy by Paul Grangaard.

Now, let’s go and get rich!

PS For more Personal Finance articles visit: http://ptmoney.com/2008/06/09/the-156th-carnival-of-personal-finance-songs-of-summer/

Who wants to retire in their 20's, anyway?

Posted on June 4, 2008 by Adrian

Join AJC’s Live Video Chat on Thursday @ 8pm CST … 7 Millionaires … In Training LIVE Results Show: Final 30 announced live tomorrow (!)

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Yesterday we talked about starting young, not just as it applies to saving, but as it applies to accelerating your retirement plan.

Maybe you couldn’t find your WHY?

After all, who wants to think about retirement when they are still in their 20’s or even 30’s? Most are still thinking about their job!

Yet, as yesterday’s post showed, there are some good reasons for starting early. And, who wouldn’t want to retire early if their goals matched these from a recent survey of GenXfinance‘s readers:

Being a ‘Gen X’ PF site, we can probably assume that most of the respondents were younger than, say, me. But, it’s even more interesting to notice how each of the first three categories (where the majority of the votes fell) require MONEY and/or TIME:

1. Extensive Travel

Think about it, you can escape money to a greater of lesser degree if you are willing to travel frugally, work at least during some of your stopovers (haven’t you noticed how all the ‘servers’ in restaurants in vacations areas are young foreigners?) …

… but, you can’t escape the time element: this means that you have to be ‘retired’ from your day job.

2. Not going to work; just taking things one day at a time

Obviously, this means that you are retired from your day job … but, two things happen when this occurs:

i) Your income goes DOWN

ii) Your spending goes UP

For those who subscribe to the “75% of current income in retirement” theory, I ask this: have you ever tried spending time doing anything BESIDES WORKING that doesn’t COST money?

Think about it … it stopped me from cashing out when I was offered $4 mill. a few years before I eventually did cash out (for a helluva lot more!).

3. Doing volunteer or charity work

All [charity] work and no play makes Jack a dull boy … this is really 2. plus you are spending some of your time (perhaps a lot) giving back. This is a good thing … as well as the great work you are doing, you are spending less time … well … spending!

4. Other

If you scroll down the comments attached to GenXfinance’s post, you will see that most of the ‘other’-folk either mean not retiring at all (like the ‘pursuing a second career’ option) or involve a similar outflow of money and/or a similar savings-account-draining, non-income-earning amount of time.

But, they are all things that you will probably want to start whilst still young enough to enjoy them …

… which means starting to build a pretty damn large nest-egg pretty damn soon!

Let me know what (and how much by when) ‘retirement’ means to you?

The Myth of Diversification

Posted on June 2, 2008 by Adrian

Important Announcement: Applications for my 7 Millionaires … In Training! ‘grand experiment’ CLOSE TONIGHT (June 2) at Midnight CST !!! This is your last chance to throw your hat in the ring …

I have been just itching to write this post … it falls straight into the category of ‘uncommon wisdom’ and will probably be jumped on by every Personal Finance author and self-appointed ‘finance guru’ out there.

All I can say is …

… bring it on, baby!

If you’ve read my posts on the only three ways to invest in stocks and the follow-up post that quoted some of Warren Buffet’s views on Index Funds vs direct stock investments, you’ll have some idea where this is heading.

But, if you’re just reading 7million7years for the first time, here it is in a nutshell:

1. Diversification is only suitable as a mid-term saving strategy – it automatically limits you to mediocre returns: The Market – Costs = All You Get … period!

Now, saving money this way, and compounding over time (a loooooonnnnnngggggg time) will put you way ahead of the typical American Spend-All-You-Earn-Then-Some Consumer ….

Just don’t confuse it with investing or wealth-building: it simply can’t, won’t, will never make you rich … nor will it make you wealthy …. nor will it even make you well-off ….

… because as long as you run, the dog of inflation is nipping at your heels!

However, it WILL stop you from being poor, broke and you may even be able to retire before 70, on the equivalent of $30k or $40k a year – not in today’s dollars, but in the inflation-ravaged dollars of the day that you retire!

But, if that’s all you need, then relax, that’s all that you need to do 🙂 But, if you need more then …

2. Concentration puts all of your eggs into one (well, a very few) baskets – it automatically gets you above average returns … if you get it right!

Investing implies taking some risk … it means choosing a vehicle (stocks, business, real-estate) … it means selecting one or a very few, well-chosen targets … it means putting your all into those well-selected targets and actively managing them for above-average market returns … until you get close to retirement.

Now, I could wax lyrical on this subject all day, every day … but, why trust me when you hardly know me and you can simply go to a source that everybody knows and can respect … Warren Buffet, who says:

I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. “Lebron James” analogy. If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.

Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.

Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.

In stocks, it’s the only place where when things go on sale, people get unhappy. If I like a business, then it makes sense to buy more at 20 than at 30. If McDonalds reduces the price of hamburgers, I think it’s great. [W. E. B. 2/15/08 ]

So Warren Buffett seems to be suggesting that the average investor should be diversifying … not true. He is saying that unless you educate yourself, you should be ‘saving’ not ‘investing’ … but, here is what the difference between the two strategies means to you financially:

i) Warren Buffet-style Portfolio Concentrationhas produced 21% returns compounded annually since warren Buffett took the reins of Berkshire-Hathaway 44 years ago. This is how he became the world’s richest man, and created many other multi-millionaires in his wake.

ii) Common Wisdom Portfolio Diversificationas measured by an index such as the Dow Jones Industrial Average (DJIA) averages out to just 5.3% compounded annually, even though the DJIA appeared to “surge” from 66 to 11,497 during the 20th century.

When you subtract 4% average inflation from each of these sets of returns, which do you think has ANY CHANCE of making you rich?

But, it’s true that it is far better to be earning $30k – $40k (albeit in ‘future dollars’) in retirement than being flat-broke … so you need to build a safety net before you take on the additional risk that concentration implies.

Here’s how:

1. Create two buckets of money: your long-term savings, and your risk-capital.

You should first create your long-term savings bucket, as your fall-back … this means, max’ing your 401k; being consumer-debt-free; buying your own home and building up sufficient equity to satisfy the 20% Rule; and holding some money in reserve (this could be a 3 – 6 month emergency fund, or extra equity in your home that you are prepared to release in an emergency).

2. Maintain your long-term savings with the first 10% of your current gross salary, but using excess savings (i.e. any additional money no longer required to pay off debt now that you are debt-free); 50% of future pay-rises or other ‘found money’; 50% of any second income (e.g. from a part-time business) all to fund your risk-capital account.

3. Educate yourself on the investments that you will specialize in … then do your homework on the specific investments that you want to make and seek professional advice before stepping (not jumping) in.

4. If you fail … fall back to Step 2. then try and learn from your mistakes … but do try again/smarter.

Which path will you take?

7million7years

How to make 7 million in 7 years …

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