by Adam Dawson
Well I hope you’re still up for suspending judgment because this is the story you’re really going to get me for. I am curious to see what everyone thinks of this, but I do anticipate some disagreement on this topic. Our second rental property was not an accident or a stroke of bad economic luck. We went into this one full speed ahead. Here’s the story.
One of the big events in the Austin area in the past year has been Michael Dell’s attempt to buy back his company from the public market via a leveraged buyout. In fact, shareholders just today voted to approve the deal. If you aren’t familiar with an LBO, it’s essentially a way to buy a company using mostly debt that is financed by the expected cash flow of the company. The buyer puts in a relatively small down payment, and over 3-5 years, uses the profits of the company to pay off the debt, and is left with ownership of the whole company free and clear. In this deal, Michael Dell is putting in about $2 billion of his own money, and will be the largest investor in a company worth approximately $20 billion. To make the debt payments, he will lay off thousands of employees to free up cash.
When I looked at this deal, it really bothered me. I was upset that Mr. Dell, simply because he could throw in a bunch of his own money and arrange a bunch of financing, could turn his $2 billion into $20 billion, essentially without adding any value to the company. If he can innovate, and grow the company, he will do even better. But the bread and butter of this deal is simply a financial transaction. If he simply maintains the status quo at Dell, he will triple or quadruple his money in a few years. Don’t get me wrong, I don’t begrudge Mr. Dell his money or his decision to use it to make more money. But I do resent the fact that so many workers will lose their jobs in the transaction, and I especially resent that the average worker/investor is more or less limited to investment options that may return somewhere between 3% and 12% instead of having access to the types of arrangements that people in Mr. Dell’s position can pull off. Maybe I’m just jealous.
So I got to thinking, how can an average investor like me use leverage to grow money the same way Michael Dell can, without having access to billions of dollars? Is there any way I can put my small retirement account to work by buying an asset worth 4-5x as much as I have, that will pay for itself in a few years from its own cash flow? The only answer I could come up with that is attainable for people like me is real estate. I know you can buy stocks on margin, you can buy an existing small business, but these options seem way too risky for me. To mimic a true LBO, you need something that is highly debt-financed, with predictable passive cash flow, and a 3-5 year payback horizon. The rulebook says investment properties require at least 25% down which leaves 75% financed. With that sort of leverage, I’m starting to feel like a tycoon after all.
That’s right. I am talking about an investment strategy that eschews the conventional wisdom of slow growth over 35 years in favor of something that throws off 30-40% and is debt-financed. I don’t expect everyone to agree with me. I do know there is a sizeable risk, but as I mentioned in a previous comment, I think I was born to be in real estate – because all the heartburn and pain that other people go through seem to be natural for me to deal with. I’ve made mistakes but I’ve learned a lot and I think it’s going ok so far. (A special note to reader Cathy C. – your comments and suggestions are NOT in vain! I’m not a perfect landlord and your experience is also instructional for us! Thank you!). There is a commercial that plays on the radio in our area that says more millionaires were made in America through real estate than any other means. I wonder if it’s true.
This spring, I started looking into additional real estate options. Austin properties didn’t make sense. Prices and taxes were too high, and the returns are all based on expected increases in value, not from predictable cash flow. I’ve tried the speculation route and I’m not interested in that kind of deal. I want cash flow. Turns out that Indianapolis is one of the best cash flow markets in the country. Not to mention, I have a fantastic property manager in Indy already. I started looking at rental properties available on the market and did some analysis in trusty old Excel. I found that many properties would rent for twice as much as your monthly expenses, given the low interest rate environment of early 2013. I settled on the 2% rule – I would only look at properties where the monthly rent is 2% of the purchase price. Many investors use a 1% rule but the 2% rule is a lot pickier and narrows the choices to high cash flow properties. I also limited my search to properties with renters already in place – which signals rental demand and also eases financing.
So I made an offer on a duplex about a mile from my previous property with a 2.2% rental rate. They countered, and I came right back with the previous offer. I wasn’t desperate. But to my surprise they accepted the offer! I couldn’t believe the offer was accepted, the inspection passed, and financing was a breeze. So in a few weeks I became the proud owner of a second house – this one a duplex.
This property, with both sides rented, brings in $1450 per month and the costs are about $650/month. This is a much better cash flow than the other property. Since this is part of our retirement strategy, we won’t be touching the money this property brings in. This time I paid 25% down out of my retirement savings and made sure we could cover expenses in case it went unrented for a while. The idea is that in 3-5 years, we will be able to either pay off this property or use the proceeds to pick up another one or two units. In a normal year, this ends up being a 56% cash-on-cash return – much better than my 401k usually does! With maintenance and vacancy figured in, I’m expecting 30-40% returns realistically.
We’d like to eventually have 5-7 properties with similar characteristics, which should provide enough cash flow to live off of in case I lose my job or we want to retire early. We have 2 so far, plus our guest house. Just to be clear, we won’t be tracking the property debt on this blog. I am ridiculously debt averse when it comes to personal debt, but I have a completely different opinion of debt for business purposes. When it comes to business/investing, debt is just a tool that figures into the cash flow equation.
So that’s the story of our 2nd rental property. There are many other personal factors that figure into this plan of ours. One has to do with being geographically mobile, another is our desire to be free from the corporate rat race. We may talk more about those in the future, but for us, a few investment properties seemed right as part of our retirement plan.
Hi Adam-
Great to hear your investment property strategy. My mother is in her 60’s and was divorced from my father a few years ago. Because of it, she’s had to go back to work and is busting her butt to make ends meet. But, she’s doing it. I’m in my early 30’s and living in Hawaii… where our median home price is $600K. Even buying a barely decent condo in Hawaii would set me back at least $200K. One of my female coworkers in her late 50’s gave me Robert Kiyosaki’s wife’s book on real estate investing, a strategy she’s followed. Divorced like my mother, this coworker now owns 3 rental properties (on the mainland) in addition to her own home (in Hawaii). This book wasn’t the best read, but what she did make clear was that buying investment properties at this age is a great way to build retirement in addition to a 401K/pension/Roth IRA. So, my mom and I took the plunge a couple of months ago and bought a condo in downtown Portland, where she now lives and owns her own studio condo. If I could buy in Hawaii, I would. But Portland worked out to be the best opportunity. The value of the condo has already gone up 30% and the purchase price was so low that I’m able to afford the mortgage and HOA on my own in addition to my own rent and expenses in Hawaii. We’ve had a great renter in and have had no problems. So far, it’s working out. We completely understand the risks involved, but, like you, in this economy, I just can’t think of a faster and (somewhat) more conservative way to build wealth off debt.
Hope this strategy works out for the both of us!
Cheers, T.
Me too! thanks for sharing your story too! check out http://hipsterinvestments.com/ for a little info on good markets for additional properties. the info there is good. (but be warned, they do work with brokers to sell properties on that site and i think the prices are too high)
Interesting. I don’t think I have the stomach for this, but I come from boom-bust California so I may be jaded. I’m not super comfortable renting out a place so far geographically from where I’m at, but it is something to think about. I love my “rat race” job so I’m not quickly trying to be at a point of leaving it and surviving off passive income.
You said: “Just to be clear, we won’t be tracking the property debt on this blog”
Fair enough, but in fairness to us, there should be a net retirement fund line in your assets so that people coming to this blog after the next few weeks are aware that you are saving for your retirement. You don’t need to itemize what they are, etc, but just leave the line there so people can see you have retirement planning in hand, separate from your debt reduction.
As well, if the property debt isn’t considered part of your debt reduction journey then we don’t need to be receiving comments like this one, “Grateful to take care of the washer, alarm, and the other renter’s leaky dishwasher.” All expenses related to the rental properties are separate, and self-financed through the rents so do not have a place in your blog entries since they just confuse the readers.
You’ve also made it clear that any income from the properties in Indy (but not the guest house) do not form part of your budget.
You have compartmentalized the debt, so it is only fair to us to compartmentalize the debt servicing (in the form of time acting as a landlord) and not comment on it since we aren’t encouraged to comment on your retirement strategy.
I think it’s fine to see comments like we saw about the renter’s dishwasher. I think you’re being a little too picky. Emily’s post gave insight into her approach to money and life, which is useful. Also, I think it makes sense to include info about the guesthouse since it is part of the their primary residence. It would seema bit much to carve out the part of their home’s mortgage that covers the main house but not the guest house.
As I understand it, I’m to think of the rentals as his retirement portfolio, and the retirement portfolio is not tracked as an asset in their financial situation. I wouldn’t expect to see posts talking about the ups and downs if that portfolio was a mutual fund since it has nothing to do with their debt repayment. So I’d prefer not to see posts commenting on expenses regarding the rental properties. It muddies an already muddled picture of their financial situation.
I still feel we have a very incomplete picture of their financial situation. In fact, they could be net millionaires but because they are not giving us the full picture, we can’t see that. I know that isn’t likely at all, but it is a possible the equity in the rental properties and their home is greater than their total debt.
Showing tidbits of a financial situation isn’t sufficient for me; I feel like I’m being strung along by, rather than journeying with Adam and Emily
We don’t know income (although they may not know it either since Emily’s business is not steady.) We get posts talking about how working at something you love is important but we don’t know if that is financially sound. I agree. I work at what I love but the absolute, theoretical max I can make is $150 a week so I’m dang lucky my dh subsidizes me and if I was not living within my means, I had have to change that situation. We don’t know if Emily and Adam are living within their means so we can’t really comment on their career choices. Once again, we are struggling with bits and pieces.
Only now, after this second post on rentals, do we know that the income from the rental property does not count as income for Emily and Adam to live on. So the responses to the first rental post saying that the rental was a good thing because it increased their income aren’t really accurate. The rental income is good but only because it is going to build savings, it does nothing to reduce the tuition debt.
I have a $22K balance on my credit card and you might jump on me for having such a high credit card balance. But it is offset by an asset (my bank balance) and will be paid off in full when the bill comes in. I charge very large amounts to my credit cards each month but I never pay a penny in interest (and haven’t paid interest on anything for almost 10 years now.)
In this post I’ve shared that my max income is $150 a week and my current credit card balance (on only one of my 5 credit cards) is over $22K. But there is no need to react to that, this is a perfectly fine financial situation.
Are Emily and Adam overreacting to their tuition debt? That debt could very well be totally reasonable given the rest of their assets and their income level. We don’t know because we don’t have a complete picture of assets, liabilities and income.
I have to say, your previous posts came across a little aggressive, but you make some really good valid points here. I’m left feeling very confused about their real financial picture. I really appreciated the way the previous blogger Claire laid everything out, her income, debts, assets and monthly snowball. Although a lot of people couldn’t relate to her high income and ability to pay large amounts when she dug her heels in, she kept it real and had a much more simplified approach. I’m a decade older than these bloggers and quite honestly, feel like a lot of this investment talk is way over my head. I have a diversified portfolio that’s handled by someone else and I just stick money in it every month. I’m thankful I have a retirement savings at all. I’m starting to feel like I’m reading Money magazine. I visit PF blogs as a source of motivation and validation, to some degree. This one is giving me neither at this point. They’re the bloggers and they can handle this however they want, but I find myself checking in here less and less.
Hi Cathy,
I understand some of the comments like this we’ve received in the past. But at this point, we’ve posted our monthly budget, our debt minimums, our snowball payment, our payoff schedule, and the rental property cash flow including both the payment amounts and rental amounts.
Although I do think we’ll share more in time, I’m starting to feel confused about what is left that creates so much mystery. Since you’ve been a regular here from the first day, maybe you can help us. I know that we haven’t posted our income (but I’m not sure Claire did either, or at least not for a long time), or the rest of our retirement stuff (believe me it’s nothing to write home about).
The income question aside, what’s still missing from our picture that is helpful for readers as we pay off debt? I’m not trying to be defensive or argumentative, I’m just trying to understand a little better.
Regarding CanadianKate’s comment – there are other comments on this post and the previous one that find this information relevant. So it’s tough to find the balance on what people want to see. If we were to track our mortgage and our rental property debt on this blog, we would be blogging here for many many years. Some readers are ALREADY tired of us! Imagine how you’d feel if we were still around 9 years from now! So it’s a practical decision. The rental properties are very relevant to our life and our finances, but it’s not really practical to track the debt as part of this blog, and the debt doesn’t add to our subtract from our monthly expenses. So we are trying to balance it all. Not as easy as it looks.
Hi Adam,
Thanks so much for responding and let me first say, I really like both of your writing styles and attitude! I guess it’s still unclear as to what your monthly budget is, monthly income, and what your snowball amount is. You say you’ve disclosed it, but I’m still having a hard time figuring it out. I think, at some point, Claire posted her actual monthly take home pay and how much of that was a part of her budget and how much was free for the debt snowball. I’m sure your actual monthly take home pay fluctuates as does ours because of Emily’s business, but I still have questions about that. We base our budget on my husband’s income because it’s steady and reliable. Anything I make is “gravy” and not anticipated or factored into our monthly budget. I’d like to hear more about if you handle things in a similar way? I hope you didn’t take offense to my comments. I didn’t mean to be rude or harsh. I think your readers just want to be able to make comments based on finite information, especially when it comes to suggestions for cutting expenses.
Quick answer is yes, we budget our monthly income the same as you and your husband. What I make is gravy. 🙂
Um…wow. I applaud you for taking the risk. I’m very very conservative and trust that our Roth IRAs and 401k will suffice in the future. I envy you guys your youth and ability to take chances. My husband and I have been burned on the real estate market and want nothing more to do with it than owning the house we reside in.
That said, more power to you and I hope it works out for you tenfold!! Millionaires(Billionaires) are not careful or risk averse people and I know we will {hopefully} be comfortable in retirement, but we will not be the extremely wealthy. I just can’t stick my neck out there to make it happen, nor do I trust my judgment.
Did you take the money out of your retirement as a 401(k) loan or as a lump sum? If you took it out as a 401(k) loan then I assume your using part of the rental income to pay yourself back. If not, then did you figure in the 30% penalty on the early withdrawal as part of your purchase expenses?
If you’re counting the Indy rental as part of your retirement portfolio then I wouldn’t hold it against you to use part of your retirement funds for its purchase. I took a 401(k) loan to add to my down payment when I bought my condo. I view being mortgage free as a part of my retirement plan, so money I put towards reducing any mortgage I consider as part of my retirement savings.
I don’t know much at all about real estate investment, but it sounds like you’ve thought about it and have a disciplined plan. And you’re lucky to have a good real estate manager. I know someone who has rental property in another part of the country and it’s a real pain in the neck for him.
such an interesting article, really enjoyed this one. Thanks so much
I think as a whole this blog has always been “narrow focus” and not “big picture” – so it is what it is. It’s a blog about getting out of debt. As a “big picture” type person, I’ve never been a fan of the focus. But I like the bloggers so I read it. (I think being debt-free is a noble goal, but isn’t necessarily of highest importance if you have worse financial problems!).
That said, I don’t think we really have to know *everything*, and this is a case where the compartmentalization is probably okay. I can see that maybe this never would have come up except for Emily mentioning it. 😀
Actually, your explanation was not at all what I expected. In fact, our gut reaction was great concern for your residence rental, but it came across as kind of random and not well-thought-out (in that you were scrambling to even find a renter). Now, I feel like it was probably a more solid strategy than initially perceived (if you have put this much thought into rental #2 and have turned around rental #1).
The problem with one rental versus some other investment portfolio is that the risk is very concentrated. (What if house washes away in a flood?). But, big risk comes with big rewards, and as long as you are careful and have your eyes open… You have probably learned some lessons from rental #1 that will help you with #2 and #3. (I’d be more concerned if you said you put 100% of retirement in one house. !!).
I do have one question: Were you able to buy the property inside of your retirement accounts? I did not assume that you took a taxable distribution, but I work in the tax field. Just curious.
Sounds like a sound, well-considered, financial decision. Seems especially shrewd to purchase a property nearby your first rental property to leverage the existing property manager. Real estate transactions, like most endeavors, can be done both very well and very badly. From what you’ve written, this one definitely seems to fall into the former category!
I don’t understand all the financial secrecy in your PF blog. Have you posted a full budget or net worth statement? What surprise do we find out next?
I really like your posts and the website. However, amassing a set of rental properties when you are heavily in debt is a very risky proposition. I think one of the previous posts mentioned an issue with not receiving the rent for one month. What if you have a vacant property for six months, or if you have a foundation issue etc? Anyway, thanks for the detailed and interesting posts about your debts and lifestyle. I’m definitely on-board for the need to simplify and live a life based more on minimalism and less consumerism. Good luck paying off your debts!
I think this is partly the reason I can’t consider the retirement fund discrete. I understand Adam’s logic (it is separate from ‘my debts’ because it is untouchable and income won’t be used to pay off debts just used to increase my retirement portfolio.) If his retirement funds were invested in shares in one or two companies, that would be fair enough because the shares could go to zero and his retirement fund would be empty but that will not increase his other debts.
In the case of the houses, should their value go to zero or near zero (i.e. flood or natural disaster or a Detroit-like meltdown of the neighbourhood), he would still owe the money on mortgages so the amount that he owes after the meltdown of the asset *would* be added to his debt.
I agree this isn’t a likely possibility and his keeping the income to pay down the property further secures the asset (and protects against minor damage by tenants, or time without a tenant) but this asset is also a liability and cannot be discrete unless Adam has the properties held by a limited company.
Since it is a liability, there should be mention of the liability portion in his net worth statement and it should be considered part of his debt. It is acceptable to break down date into four categories, student debt, housing debt, retirement debt (mortgages on the rental properties), and consumer debt (apparently currently nil but if they have to dig a well and don’t add the expense to their house mortgage, then that would be where I’d pop that liability.) I’d also have a retirement expense line that covers all expenses for the rental houses (property management, taxes, upkeep) and a retirement income line (rent from the two rental houses.) For the guest house, I’d have another rental income line. Breaking these expenses out allow Adam and Emily to see if the strategy is working for them. Of course the value of the rental properties will listed as an asset, just as the value of their current home is an asset.
In order to see the big picture, they need to see inflow-outflow from all sources and their net worth.
I would expect them to share this information because they have chosen to be blogging away debt bloggers but even if they don’t share all details, I would like assurances that someone has helped them create these reports so that they have a detailed picture of their financial situation. Without it, it is harder to travel the road out of debt because although you know where you want to go, you have no idea where you are now so choosing the correct direction to walk is a shot in the dark. It is like saying I want to go to Africa but I don’t know where in the world I am now so I have no idea if I need to travel east, west or south to get there, and once I get to Africa, I may still not be at my exact goal because Africa is a big place and if I’m in Egypt and my goal is Ghana, I still have a way to travel.