Recently I posted on the subject of how to most effectively answer a client’s or prospect’s questions. Then, as the universe sometimes does, I was asked a question by a brand new client that is pretty common. On its surface the question might seem facetious, but trust me, its been asked so many times in my office, I know that’s not the case. It usually goes something like this:
We’ve now banked the $100K from the refinance on our home. But Jeff, we were thinking. How much could it hurt to take just $20K out in order to get (fill in the blank) a new boat, truck, home landscaping?
These days, since I’ve heard variations of that question so many times, I begin by answering with a question, hoping to inject a little humor. I might ask — Will you be able to sell that (fill in the blank) for a million bucks 15-20 years from now?
When I pause to enjoy the RCA Dog look on their faces, I then begin to give them a very complete and substantive answer in rich detail. Though I posted it on my blog today, I’ll give you the short answer here.
In 15-20 years that $20K will likely be directly responsible for an extra $80,000 a year or so in retirement income. If you retire at 60 and live another 20 years, that’s $1,600,000 of retirement income — over and above what the rest of your initial investment capital produced over that same period.
Less than half of my clients will ever earn $80K a year on their job. And now they can have that much extra every year in retirement.
Unless of course, 20 years earlier they decided their new boat was worth $1.6Mil in extra retirement income.
Final note — I sent the link to my blog’s post to the client who most recently asked that question. His response? One word — Awesome!
And that’s how you answer questions.
Austin says:
Point well taken, but at the end of the day, none of us can save ALL of our discretionary income for retirement. All of us spend money on things -every day- that we could really do without.
I suspect the question your clients really meant to ask is ‘What is the biggest bang for the buck we can get with this $20k if we spend it on a home improvement.’ You’ve answered the general question. It’s harder to answer the specific. Good post.
April 26, 2007 — 12:22 pm
Jeff Brown says:
Austin – >but at the end of the day, none of us can save ALL of our discretionary income for retirement. All of us spend money on things -every day- that we could really do without.
I know what you mean, but read my response to your next observation.
>I suspect the question your clients really meant to ask is ‘What is the biggest bang for the buck we can get with this $20k if we spend it on a home improvement.’ You’ve answered the general question.
Here’s what my son said: If you can find the home improvement that, on it’s own merit will increase the home’s value in 20 years by a million bucks – do it. 🙂
There’s nothing general about it. $20K spent on hedges, sod, and rose bushes, or an extra $80K a year in retirement income.
This is where you put you hands in front of you, palms up, while weighing this imaginary decision in your head. You do this by saying “Let’s see, $20K for new lawns and bushes, or $80K extra retirement income every year.” 🙂
April 26, 2007 — 2:24 pm
Brian Brady says:
Delaying gratification is the number one way to increase your net worth.
April 26, 2007 — 4:56 pm
Chuchundra says:
Wait…what?
You’re saying that $20K invested today will appreciate enough in 20 years to net me $80K a year in income? I think you need to show your work here.
April 26, 2007 — 5:31 pm
Jeff Brown says:
Chuckundra – No, I don’t. 🙂
That said, a few of my clients have turned just over three times that $20K (one of them started with $68.5K) and are now already worth far more than it takes to generate that $80K. The $68.5K client? They started with me in 2001 and have been retired since 2005.
If you don’t know how $20K can be invested into real estate over a 20 year period and grow to a million bucks, I can show you, but I’d have to kill you. 🙂 But the essence of the numbers is this.
To achieve a 20-22% annual capital growth rate the following needs to be in place.
If you put 10% down on a 100K property and it goes up 2%, your capital grew by 20% that year. In order to grow 20K to 1Mil over 20 years you must average around 20.5% for the twenty years.
But remember, that’s not 20.5% appreciation on your properties. Generally speaking, if you are able to stay on top of where the growth is, (which is my job) you’ll do far better than 2% a year in appreciation, to say the least. Growth regions like Boise for example, have for years and years trundled along at 3-6%, which would have done what the post said.
Throw in a few flat years, and a few boom years and instead of 20 years it could very well take a lot less time.
I hope this is what you were looking for.
April 26, 2007 — 5:58 pm
Jeff Brown says:
Brian – That IS the answer to a lot of life’s dilemmas isn’t it? That principle sure would have made my late teens and early 20’s a lot easier. 🙂
April 26, 2007 — 6:21 pm
sean carr says:
Jeff,
Hmmmm… I’m having a little trouble understanding the math as well. 100K compounded at 2% for 20 years is 146K. So 46 k profit on 10K over 20 years is 8% compounded. What about cost of the loan on 90K, taxes, insurance, etc.?
April 26, 2007 — 9:25 pm
Jeff Brown says:
Hmmmmmmmm…I’d be having a problem too if someone told me that. Of course, that’s not what I said.
Please read my response again, because I’m too tired to repeat the whole thing. Your mistake is that you’re applying the 2% to the invested capital, when I said it was what the property’s appreciation was.
It’s a common mistake.
April 26, 2007 — 11:55 pm
sean carr says:
Jeff,
I didn’t apply 2% to the 10K invested capital. I applied 2% to the 100K over 20 years which is 146K. Or 46K profit before loan and transaction costs. You stated:
“If you put 10% down on a 100K property and it goes up 2%, your capital grew by 20% that year. In order to grow 20K to 1Mil over 20 years you must average around 20.5% for the twenty years”
The gain on the 10K is 20% the first year but compounding the 20% gain on the 10K over 20 years is not correct else we end up at 319.5K. The value of the underlying asset is 146K after 20 years compounding at 2% so it’s not possible to that we made 309.5K from the 10K from this leveraged investment. After all the property needs to be sold to realize the gain. We can’t sell at 146K and make 309K profit on the origonal 10K investment. Also in this exercise we’ve left out the cost of the 90K loan.
April 27, 2007 — 6:05 am
Chuchundra says:
The question is, who’s paying the mortgage? Assuming these are investment properties, are you planning to make enough in rent to cover PITI plus maintenance and etc or are you expecting to deal with negative cash flow or what?
I imagine that there are a lot of people who made a lot of money using this risky, heavily leveraged, real estate investment strategy, especially if they started before or near the beginning of the current boom. How about people who jumped in in the last year or so and are now holding assets that are current worth less than when they bought them?
April 27, 2007 — 7:55 am
Jeff Brown says:
Sean – I’m going to assume you’re a newbie to real estate investment, and not being intentionally obtuse.
You stay in the investment as long as you’re making the minimum required capital growth.
My point in illustrating how the 20k can go to a mil (and without too much difficulty at that) is that the appreciation of the property itself does not need to be that high at all. With 10% down, if you had an initial year appreciation rate of 8%, your capital growth would be 80%. Your equity position has now gone, in dollar terms, from 20k to 36k.
I’m not going to take you through 20 years of exchanging, but the principle is this: As soon as your initial property has grown enough in value such that your capital growth has begun to lose velocity, you exchange up to more property which instantly re-energizes your capital growth rate.
If you use a conservative annual appreciation rate (average for the 20 years) of only 6.5%, and allow for 8% sales costs on a tax deferred exchange every five years or so, you’ll end up with a net equity of over $1,250,000.
The bottom line is you need to know what you’re doing. If a pro, over a two decade period can’t find areas in which a conservative appreciation rate of 6.5% can be enjoyed, he needs to change professions. This doesn’t take into account that in the nearly 40 years I’ve been doing this, the down cycles are eclipsed manifold by the up cycles. Folks who began investing in 1985 with a 20 year plan would have had to go through the crippling S & L crisis period in the early 90’s. Still, they would have massively out performed the above scenerio by at least 500k to 1mil.
The key? I like what Warren Buffet said when asked about what he thought of the principle of diversification. His answer?
“Diversification is for people who don’t know what they’re doing.”
Find a pro you trust, make a plan with them, and collect your million bucks in 20 years.
April 27, 2007 — 8:35 am
Jeff Brown says:
Chuckundra – >The question is, who’s paying the mortgage? Assuming these are investment properties, are you planning to make enough in rent to cover PITI plus maintenance and etc or are you expecting to deal with negative cash flow or what?
It depends on what part of the country we’re in. If we’re in Boise you’ll have a break even from day one, give or take. If you add in tax savings through depreciation it’s probably a slight yearly positive. In Twin Falls you’d have a positive before tax benefits fairly easily, because their rent to price ratio is a little better than Boise. In Kansas City you probably wouldn’t be bothered with doing the numbers, as their rents are so high relative to their values. Of course, they may not get the appreciation you’re looking for either.
Ogden works with this approach also, as has Phoenix. Denver is emerging as a candidate also.
Even if the numbers show a break even, you can’t possibly rely on that happening. This is why I refuse to work with an investor if they don’t agree to establish a stand alone cash reserve account in the amount I specify. With very rare exceptions, (none this year so far) I simply won’t take an investor into a known negative cash flow situation unless it’s obvious it will be offset, and soon. Again, very rare.
I recommend you go to my blog at bawldguy.com and search the word Sominex.
>I imagine that there are a lot of people who made a lot of money using this risky, heavily leveraged, real estate investment strategy, especially if they started before or near the beginning of the current boom. How about people who jumped in in the last year or so and are now holding assets that are current worth less than when they bought them?
It depends where the property is located. Phoenix is, for the time being, dead in the water. However, nobody has told the massive number of people who keep migrating to that city. At some point, and relatively soon, property there will again start moving up in value. So as long as investors don’t panic, they’ll be fine.
If they got into investments now worth less than they paid, AND they have a negative cash flow, AND they don’t have a generous cash reserve account, they could be up the creek without a paddle. Of course, those who find themselves in that position are either rank amateurs, or were advised by same.
What makes me laugh out loud is how this approach is often characterized as ‘risky’, then tie that immediately to ‘heavily leveraged’.
For the last 30 years the bedrock principle driving everything we do is Purposeful Planning. Sounds too simple, but not when you take a look at how you invested in what may now be a problem property.
My clients will have massive cash reserves. They’ll have excellent professional property management. The down payment, loan types, geographic area, and all other factors are dealt with in a highly focused, purposeful manner. They do things on purpose.
This is how pros can take what, to an amateur looks speculative or risky, and turn it into a reasonable proposition.
For every property I recommend to clients my son and I have turned down many, many more.
Allow me a short story here.
A couple who began with us several years ago, had been incredibly successful. In fact, they had turned modest initial capital (way less than 100k) into more than a million, while retiring before the wife hit 40.
They decided one day, that they’d seen how I operated and could do it themselves. So that’s exactly what they did. I told them that of course, they could do whatever suited them, but they were making a mistake. That was about three years ago.
Fast forward to today. The properties they bought, in a great growth area, are now sitting with little increase in value, some vacant, and many with negative cash flows. Why? They didn’t know nearly as much as they had assumed they did.
In literal terms, their move has cost them $1Mil-1.5Mil in actual lost appreciation due to their poor purchase choices. This doesn’t include another $500k-1Mil they’ve lost because they couldn’t use that lost appreciation to move to another growth area, like Boise.
Oh, and did I mention the home they bought in yet another state – with 100% financing? It was apparently a sure thing, a no-brainer. Right. When they came back to us, we had to solve that problem too. Meanwhile, it had cost them almost a year of $2k monthly negative cash flow. (You can’t make this stuff up, folks.)
The Plan I devised for them has now been totally trashed beyond recognition. They did all this damage in roughly 15 months.
About six months ago they called, wanting me to help fix the devastation. I agreed, because I genuinely like this couple, and the parting was totally friendly.
This story’s point? Investing with a Purposeful Plan in and of itself doesn’t mean you’ll succeed if it was crafted by amateurs.
I hope this has not only answered your questions, but helped a little.
If it makes you feel any better, we find ourselves more and more lately, having to fix problems for investors who had no idea what they were doing. For many, it’ll take a year or more to get them back to square one.
Chuchundra, find a solid pro, create a Plan, and your future will be better than you ever imagined.
April 27, 2007 — 9:20 am