WHY DID MY FINANCIAL PLANNER SAY THAT?
I’m writing this week while we are on a trip to Europe. We started in Germany and stayed in a small town near Oberammergau. After checking in at the hotel my mother had trouble opening the door to the balcony and asked me for help. The top had fallen in toward her about a foot, then stopped.
It had been a long time since I had been to Europe. I had never seen a door like this.
I asked about this at the front desk.
It turns out the door has a 3-position handle. When the handle points down the door is locked shut. Rotate the handle 90 degrees and the door will swing open as you would expect. Push the door closed and rotate the handle another 90 degrees and the top of the door will tilt toward you.
Hmmm. I thought this was strange and wondered why the Germans would make a door like that. But then it made sense.
The hotel did not have air conditioning. By creating a gap at the top you could get more fresh and cooler air flowing in from outside.
At another hotel we found that the windows work the same way.
That is one of the benefits of traveling. It sometimes forces me to see something from a different perspective.
Sometimes it is good to challenge some of our beliefs. We might realize something that we did not know before. Or find new possibilities.
We can start by asking “Why?”.
STOCK MARKET HISTORY
Before investing in real estate I had studied and invested in the stock market.
I figured out that if the market provides an average return of about ten percent per year, and inflation averages four percent, then eventually I could withdraw five percent of the portfolio per year with a one percent buffer.
I would want the principal to keep growing and keep up with inflation.
Later I learned that many financial planners recommend a withdrawal rate of 4-5 percent per year so that you never run out of money.
Is this a coincidence?
I don’t think so. I believe it provides a basis for the suggested withdrawal rate not exceeding five percent.
The financial planners even run what they call Monte-Carlo simulations that show you have a very high likelihood of never running out of money.
This leads to the next question.
So how much do you need?
Let’s do just a little simple math assuming a 5-percent withdrawal rate.
Suppose you want $100,000 per year cash flow from your portfolio. Divide $100,000 by 0.05 and you get $2,000,000. That would be the size of your target nest egg. Just scale the numbers if your target is larger or smaller.
To get the same $100,000 per year as your cash flow, but only withdrawing 4% each year, then you would need a $2,500,000 nest egg.
Does that make sense?
All of this is based on several assumptions.
ONE. You are fully invested in the stock market. Certificates of deposit or investments in bonds will dilute your returns.
TWO. The market continues to provide a 10-percent return on your investment.
THREE. Inflation remains below 4%.
FOUR. You sell 5 percent of the portfolio each year for the cash desired.
FIVE. You don’t want to spend down your principal.
But what if the market is down 20% and you need to get cash?
What if inflation surges well above 4%?
What happened to the buying power of your nest egg?
Do you have to reduce your spending plans? And your standard of living? Or will you have to go back to working?
Where does real estate fit into the equation?
BENEFITS OF REAL ESTATE
It is known that real estate can be a great tool for diversification. You have probably seen the huge increase in property values over the last couple of years.
We have written previously about five reasons why real estate is the IDEAL investment: Income, Depreciation, Equity buildup, Appreciation, and Leverage. You can read about those five reasons here.
This week I want to focus on another reason to use real estate as a primary tool in your portfolio. Return on investment.
Some people have found real estate to be far superior to the stock market. Not only does it provide a hedge during inflation, but it can be used to significantly boost total returns. I’ve found it to provide total returns consistently above 10%. It is often significantly higher.
Does it always produce great cash flow? No.
Does it always appreciate rapidly? No.
But there is an element of control that is not available in the stock market.
You can choose your specific investment. That may be a single family house, a multi-family property, or a larger multi-family property acquired through a syndication.
In each case you or the syndicator has control over how the property is managed. That includes choosing a property manager if you so desire. A syndicator hires a property manager and decides how to improve the property to increase cash flow and market value.
Using leverage enables higher gains. This is a primary advantage of real estate, particularly during times of high inflation.
Real estate produces a combination of cash flow and long-term gains in equity. Lower leverage produces more cash flow. Higher leverage decreases cash flow but can magnify gains from appreciation. This appreciation may be market based, due to inflation, or forced appreciation from improvements to the property or management.
You can also tap equity in a property through a sale of the property or refinancing.
There are multiple ways to invest and provide diversification. To keep things simple, let’s consider a passive investment strategy.
Suppose one were to diversify a portfolio over ten syndication investments. Each may have a 5-7 year investment time frame. They may or may not have a preferred return during the investment.
Syndications typically invest in properties that have more than one tenant, so a single vacancy is not critical. For example, an apartment complex frequently has over 100 units.
Let’s use an example of a syndication with a minimum $50,000 investment. The syndication did not pay a preferred return, but instead reinvested income to improve the property. After 5 years the property was sold and each member received back $100,000. You would then have a couple of options.
Option ONE: Take the $50,000 profit to spend that year and invest the rest in another syndication. This gives you some of the income for the year and reinvests the principal.
Option TWO: Decide to reinvest the entire proceeds in one or two other syndications.
Option THREE: Mix the two options such as taking $40,000 profit to use, then reinvest the remaining $60,000. This keeps growing your principal.
How much can I take out? That is a personal decision dependent on risk tolerance and current inflation, and how much you want to keep growing the nest egg. If a portfolio is consistently producing returns over 15-percent then going above the 5-percent withdrawal rate seems very reasonable.
I also think it is important to keep growing the portfolio to at least keep up with inflation after withdrawals are made.
The door is waiting for us to open it. Sometimes the door is not what we expected. When we limit our investment options to what we learned when we first invested, then our long-term growth will reflect our original choices. When we learn new techniques it is possible to learn and build from those previous experiences. Real estate investments can provide returns that allow us to accumulate wealth faster and enjoy larger disbursements later from the same size portfolio.
HELP US GET TO KNOW YOU BETTER
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.