Dear Thoughtful Investor,
If I’ve sized you up correctly, you are at an important stage in your personal and professional life. With your carefree 20’s receding ever quicker into your rear view mirror, you now face a raft of sobering questions: “How will I create a good life (and lifestyle) for my family? Pay for college? Pay for retirement? Perhaps all at the same time.
Your anxiety around these issues is not unwarranted. But I would submit to you that some of that anxiety stems from the fact that you are not using all of the tools available to you to meet these challenges.
To be clear, I am not about to suggest that becoming a real estate investor is the answer to all your financial woes. I’m not even going to suggest that real estate should be the primary asset class in your portfolio. However, I am going to suggest that if you’re willing to get your hands a little dirty and consider investments beyond the tidy stocks, bonds and managed accounts you can get from your financial advisor, there are meaningful rewards in it for you.
A word about stocks and bonds:
Of the major asset classes, stocks and bonds are the most popular among individual investors. They are easy to trade and easy to understand. Because of their familiarity, these securities have come to be viewed as the default building blocks for one’s investment portfolio.
But consider this, the long-term average return of the stock market is around 8% annually. Some will quibble over the definition of “long term” or which stock index we’re evaluating. But most will agree that 8% is directionally correct.
Think of rule of 72, which means that money invested in the stock market doubles just about every nine years. Obviously, there are periods, like the recent recession, where this trend does not hold, to be sure there are stocks that perform much better than average. Facebook stock has more than tripled in the five years since its IPO. But for every FB there are much more stocks that perform at or below the long-term trend. So the likelihood is that you will get broad market returns, not FB returns.
What does all that mean for you in your day to day life? If you invest say, $100k in a broad basket of stocks today, does that mean you could extract $8,000 in cash each year? Of course not. Stock returns are a mix of dividends and capital gains (mostly appreciation rather than dividends in recent decades). That means you basically have to sit tight, reinvest your dividends and let the market do what it does in order to have total returns hit that trend line.
The good: (i) As long as your investment horizon is long enough, it’s reasonably certain that you’ll hit that expected return. (ii) If, at any point along the way, you need to access that money, you can. Within a few days, you can have cash in your hand. (iii) Knowing the status of your portfolio is never more than a few mouse clicks away. Monthly statements will chart the exact course your portfolio took to reach its fairly predictable destination.
The bad: (i) During this time that your money is working for you, it’s out of service, meaning you can’t spend or invest it elsewhere. (ii) there is no current income unless you decide not to reinvest all the dividends and of course doing that takes a big bite out of your ability to hit that 8% return target.
So that’s stocks. Familiar. Very liquid. Fairly predictable, with the possibility of significant outperformance (emphasis on “possibility”).
*As an aside, if you haven’t read Warren Buffet’s most recent letter to Berkshire Hathaway shareholders, you should. In it, he goes out of his way to lambast hedge fund managers for so woefully over-promising and yet under-delivering for investors. Mr. Buffet’s contempt for high cost, low performing fund managers is well known. He has even put his money where his mouth is on this topic by making the now famous wager on Long Bets, pitting a passive index fund against any hedge manager willing to accept the challenge. Nine years into the bet, he is winning handily. So before you assume that you can beat these long-term averages stated above, I encourage you to read Buffet’s letter.
Interestingly, in the wake of the Snapchat IPO a few days ago, many are wondering if that company can recreate the stellar performance of FB’s stock. FB is an example of a tech unicorn that can actually turn a profit. And to be sure FB is an amazing company, literally world dominant, with nearly 2 billion users globally. Not to put too fine a point on it, but analysts estimate that close to 45% of All new online ad spending in 2016 went to Facebook. Let that sink in for a second. The stock market has rewarded the company for this dominance by more than tripling its market value in just 5 years (3.6 x to be exact).
With the financial press aflutter about Snap and gushing over Facebook again, it got me to thinking. How do REI returns stack up to stock market returns, particularly the unicorns?
The REI alternative:
To put things in perspective, consider a very typical return profile on a piece of investment real estate. And to keep things truly comparable, let’s try to keep time frames consistent. In 2012, just before FB IPO’d, I bought a small duplex in Houston. The purchase price was $125k– a little more than the amount in the hypothetical stock portfolio above. But the important thing is actually not the value of the asset. But how much I had to put down to control the asset. In this case, it was $35,000. I put down $35k and borrowed $90k more to complete the purchase.
Results
I collect $2,400 per month in total rent between the two units. I don’t get to pocket all of that because I have expenses — property tax, insurance, repairs, management and don’t forget, I also have to service that loan. All of those expenses together add up to about $1300 each month. So my net operating income is just over $1,000 per month. Let’s put that in perspective.
For $35k outlaid, I net $1,000 per month or $12,000 per year in cash. From a cash on cash perspective, that’s a 34% yield on my money, substantially higher than any stock dividend I’ve ever seen. But let’s keep going. This particular house, which happens to be in Houston, has had modest capital appreciation during this time. My realtor ran a CMA recently and estimated I could get $175k for it on the open market today. So, in addition to the cash flows, I have also benefited from general appreciation in the market to the tune of $50,000. Taken together, $60,000 ($12,000/yr x 5 years) of cash flows plus $50,000 of new equity puts me ~ $110,000 to the good. The true impact is actually better still because even if my property stops appreciating tomorrow, my tenants are still building my equity by paying down my mortgage.
Since I only put down $35k, my total return (cash flows plus appreciation) is 3.14x my money. Not quite as well as FB stock, but pretty darn close. Keep in mind though, that I didn’t have to find the absolute best in class deal. I didn’t have to dominate my competition. This is just a middle of the road type of deal, not even the best deal I’ve done. Certainly not as strong as some of the deals I’ve seen other investors put together.
Now, here’s the rub. I wasn’t able to buy this little duplex from my E-trade account. It took some fairly detailed research to find it and to diligence it. I had to screen tenants. I had to hire a property manager. From time to time I have to take phone calls from my property manager when we have an issue in one of the units. Heck, one of my tenants’ kids let the tub overflow and wrecked a bunch of my carpet! That was really annoying, not so much bc of the money–my insurance covered all but a very small deductible–but because it was something I had to devote brain space to. I share all of that because I wanted to paint an accurate picture of what owning investment real estate really looks like. It is not as simple as owning stocks. You will have to get your hands dirty, figuratively (and maybe literally). But the impact of having these types of assets in your portfolio can be tremendous. So while I still own stocks, I have a substantial allocation to REI as well.
So, returning to my opening comments, asking how much of a difference it would make to your financial future if some piece of your portfolio could reliably generate 30% cash on cash yields? If you took some piece of your portfolio and allocated it to buying a few rental properties, how much would it boost the returns of your overall portfolio? Said differently, how much pressure would it take off of your stocks and bonds if you had this other engine firing?
The deal described above, along with a few other rentals like it, were a big part of what sustained me as I built my house flipping business and eventually decided to start the Hoozip platform with my partner, Justin Winthers. Being able to find deals like this has given me the confidence to take risks on other ventures, and also the confidence to know I can create income for myself. It ain’t easy, and I’ve definitely got the dirty fingernails to prove it. But man, is it worth it.
A final note and a bit more praise for Mr. Buffet. In this most recent Berkshire Hathaway letter, Buffet recounts the company’s shift from “obtaining most of its gains from investment activities to one that grows in value by owning businesses.” That shift began in earnest nearly twenty years ago and has been well documented by financial writers. To me, the statement validates the premise of this note. Securities need not be the only building blocks in your investment portfolio. While you may never buy a large operating company, you can participate in what finance types call “direct” investing — which is direct ownership of an asset or a piece of an operating business, rather than a security that represents a bundle of such assets. The extent of your direct investment may never extend beyond one or two rental properties. But if done right, even a small allocation can offer substantial rewards.
This, of course, begs the question: How does one find such opportunities? The MLS is one source, but there are many others. And this is why we talk so much about becoming a great deal finder. Crack that code and there’s gold in them thar hills!
If you ever have questions on any of this or want to learn more about how we use data based marketing to find the best deals, don’t hesitate to reach out. Also, be on the lookout for some in-depth training from Justin about how you can harness data science to spot the best deals in your market.
