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Why Real Estate Should Be A Part Of Your Retirement Strategy

September 29, 2014 | Financial Samurai

What is your definition of wealth? Some might say a wealthy person is someone who does not have to worry about money. She can do as she pleases without ever having to check in with anybody. Others say wealth equals a nice cash hoard and a robust stock portfolio. All are valid definitions of wealth. I’m going to argue that wealth = real tangible assets.

After about five years of diligently saving 50% of my after-tax income by living in a cheap part of town and subsisting on ramen noodles, water, and fruits, I began to question the point of working and saving so much money. Yes, I wanted to achieve financial freedom sooner, rather than later, but there was something very empty watching the numbers pile up in my bank and stock accounts. The more I saved, the less motivated I became.

I was about to give it all up and return to Hawaii to farm mangos until I stumbled upon this two bedroom, two bathroom condo with parking in Pacific Heights, San Francisco. The condo was built in 1970, had 8 foot ceilings, mediocre appliances, and carpet. In other words, it was nothing special except for the location right across from a park. There weren’t any pictures online, but I was attracted by the price. “Only” $580,000!

When I finally stepped into the condo, I was pleasantly surprised to find that it not only had a balcony, but a priceless view of Lafayette Park. You couldn’t see any cars from the living room, just lush greens that made you feel like you were in some nature wonderland. I was instantly sold and told my agent that I would pay $500 over asking to win the bid.

The retired lady accepted and she told me that I would love it here. She was right. I’ve owned the property since early 2003 and never plan on selling. Ironically, the condo renewed my motivation to work hard and make as much money as possible because I now had debt.

Financial Samurai Rental Property

WHY YOU SHOULD OWN REAL ESTATE

Although the 2008-2009 financial crisis rocked the country’s real estate market and practically every other investable asset class, I believe there are incredible benefits to investing in real estate to ensure a healthier retirement. As soon as you find a place you can envision yourself living for at least five years, it’s probably a good time to start your property search.

1) Inflationary asset. I remember thinking to myself back in 1994 how ridiculous it was to pay $1,000 a month for a one bedroom in Boston when I was paying $350 a month to rent a room in a townhouse with my buddy in Virginia. Today, a similar one bedroom is over $3,000 a month. Inflation is a powerful economic force that’s difficult to stop. You want to own inflating assets rather than always be a price taker. Eventually your income will stop growing, decline, or eventually disappear, making survival that much harder if you must continue renting.

2) A hedge against conflict. Whenever there is geopolitical risk, a major natural disaster, or a terrorist attack, notice how US Treasury yields go down due to a flight to safer assets. Housing is a direct beneficiary of lower interest rates due to the common practice of borrowing to own. When interest rates go down, refinancing activity also picks up, increasing the cash flow of homeowners everywhere. I have personally refinanced five times with various properties and am paying $3,500 less in interest a month than 11 years ago.

3) A leveraged play in a bull market. When times are good, assets tend to inflate quicker due to higher employment, rising wages, and rising corporate profits. Real estate tends to be a major beneficiary during a bull market. Earning a 32% equity return in 2013 was fantastic. But earning a 75% cash on cash return on your 20% equity thanks to a 15% rise in home prices is even better.

4) Tax benefits. The US government has deemed real estate part of the American dream with mortgage interest deduction, the 1031 exchange program to defer taxes, and a generous $250,000 tax free gain for singles and $500,000 tax free gain for married couples. It takes a $714,000 return at a 30% effective tax rate to clear $500,000 in profits. Based on my research, I’ve found that the ideal mortgage amount and income combo is $1 million and $250,000 a year based on today’s rates.

5) Much easier for a regular person to understand and manage. Real estate is a relatively easy business to understand compared to investing in stocks. Good location, good tenants, manageable maintenance, and rental growth are all it basically takes to make for a solid real estate investment. Stocks have so many more variables to deal with, including: management credibility, industry growth, competition, politics, regulation, tax policies, inventory turns, margin analysis, operating profit growth, and more. It’s no wonder you’ll find plenty of first generation immigrants focus on accumulating property.

6) Less temptation to sell out too soon. Thanks to still stubbornly high selling commissions, the ability to sell is much more difficult than selling a stock when the markets are crashing. I know plenty of people who just had to get out of the stock market in 2008-2010 because they were scared out of their minds. It’s so easy to pay a $8 commission and press click. But when you’ve got to pay a 5% commission and go through the entire process of marketing a property, you tend to just sit tight and see what happens.

7) Paying back debt with inflated dollars. For people with fixed rate mortgages, their payments never change. 10 years from now you’ll get to pay off the same amount of debt with dollars that aren’t worth as much as when you first took out the mortgage. As your net worth grows, the mortgage liability becomes a smaller part of your overall net worth, thereby reducing any feelings of stress associated with the loan.

8) Never have to move again (so long as you pay your mortgage). Moving is a painful process. What’s more painful is having to move when you don’t want to. Many long-time renters are being displaced in cities such as San Francisco because the property owners want to capitalize on the demand. I was speaking to one renter who is being asked to move after 18 years. He has no job, a daughter who is entering high school, and a wife who no longer wants to be with him. He pays $1,990 a month for a place that could easily rent out for $3,800 a month.

9) Passive income machine. Although real estate takes ongoing maintenance, rental income is one of the best passive income sources around along with dividend investing. After the hard work of finding the perfect tenant is done, one should usually expect to collect income for at least 12 months before another tenant may need to be found. The rental income is also partially or completely shielded by non-cash depreciation expense as well thanks to the government.

10) An asset to pass on to your heirs. Everybody has heard a story of some grandparent buying a home for $20,000 that is now worth hundreds of thousands or even millions of dollars. If you can buy a property to live and enjoy, and then pass it down the family to give your children a heads start, what an amazing gift you’ll provide. It’s very difficult for Millennials to buy their own property nowadays. But besides working hard, a massive generational wealth transfer should help support future generations.

BUY PROPERTY FOR THE LONG TERM

A lot of opponents say that property has only inflated at the similar rate of inflation over the long term. Even if the average property is only growing by 2% a year, that’s a 10% cash on cash return if you put 20% down. But more importantly, you’re long an asset that has a good chance of inflating. The return on rent is always -100% every single month.

If you are a renter, you are actually short the property market. You only gain if rent prices go down or if property prices go down. But if prices continue to go up, you’re losing. If you own your primary residence and nothing else, you are neutral the property market. Even if your property goes up 100%, you will only benefit if you’re willing to downgrade in price. You’re only long property if you own more than one.

Hopefully all those who have chosen to rent since the downturn have taken advantage of the stock market instead.

For those of you with property, Personal Capital has come out with a great new feature that will help you keep track of your real estate investments with Zillow. Zillow uses their proprietary algorithm and database of sold homes around your area to come up with a Zestimate. Once you press +Link on the top left, and click Add Home Value on the bottom left with your home’s details, Zillow will update the value of your home three times a week.

Be forewarned that Zestimates are sometimes off by a great deal on the upside and the downside. If your $500,000 house is suddenly worth $1 million according to Zillow, do your best to refrain from buying the latest Porsche 911 Turbo! Chances are high the estimate is wrong.

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Using the Zestimate to look at the historical pricing charts provides for good data on the direction of your market. I just wouldn’t rely on the specific Zestimate completely because a home’s true value can only be determined upon sale. You can continue to manually input a property value in your net worth calculations as well if Zillow isn’t your cup of tea. It’s always better to be conservative than aggressive.

Readers, do you think real estate or equities is a better way of building wealth? Why do you think there are so many more stories of immigrants getting wealthy with real estate vs. through the stock market? What are some of the downsides of owning real estate for the long term?

Regards,

Sam

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