pull cord sooner rather than later?

[califdreamer]

I've taken a closer look at the balance sheet and budget needs for ER and wanted to run it by the group.  I've received a lot of good info and advice since first posting in Dec 05 and wanted to get feedback on most recent financial situation.  This is sort of an updated "Hello I am..." post. 

I've determined that the lowest I'd like to go in terms of after-tax cash flow is $4500/mo.  Assuming a tax rate of 18%, that would require just under 66k annually pre-tax.  I'm erring on the high side on the tax rate because the bulk of my cash flow would be from rental income.  Even with depreciation write-offs, tax rate would be higher than living off of dividends and cap gains.

Repositioned rental propty equity (after >200k in commissions/selling costs  )would be 900k.
Cash 275k
Home equity (after commisions/selling costs) 375k
401k/ESOP  355k

Here's what I would execute in a year or less:
1.  Sell rental properties and 1031 into "cash cows" yielding 6.5%
     900k * 0.065 = 58,500/yr
2.  Sell personal residence, relocate to cheaper area, buy house for 250k cash.   
     375k - 250k = 125k
3.  Invest extra 125k in diversified portfolio (this is new thinking for me, ie not putting it back into real estate, see what you've done!)
     125k * 0.04 = 5k/yr
4.  Keep 100k in cash as a buffer.  Put remaining 175k to work.
     175k * 0.04 = 6800/yr or put it in RE investmt 175k * 0.065 = 11,050/yr

Depending on how the 175k was invested annual cash flow would be 70,300/yr or 74,550/yr.  Even though the real estate might have a higher yield I do see the value in diversifying away from RE and into a portfolio with a 4% SWR.

I would prefer to roll the 401k/ESOP money into and IRA and keep hands off.  My estimate of annual withdrawals from a 72(t) is 9600/yr.

Using 18% tax rate, cash flow (w/o 72t) would be in the neighborhood of 5k/mo, slightly higher than my minimum requirement. 

Wild cards:  finding reasonable health insurance, keeping rental income ahead of inflation, relocating from San Diego to less expensive area, having a big enough buffer.

Is it time to pull the cord?

 

[macdaddy]

How/where do you propose to find relatively risk-free rental properties that will net you 6.5%?

Is 900k after you've discounted the price of your rentals so that they would sell in this market (i.e. 5%-10% under the comps)?

The two kinds of rentals I know of that can touch 6.5% returns are commercial properties and low-income houses. Commercial properties I don't consider to be risk-free. Low-income houses at less than 80k a pop means you would end up with a whole bunch (900k/80k) of them, each filled with less than desirable tenants. Under this plan it sounds like you would be a "professional land lord" but not 100% retired. What happens if you have a few months vacancy on one or more of the rentals? Tenants who cause a few thousand in damages and then skip town?

You may be able to use a 1031 from the rentals to purchase your new primary residence (as a "rental"), which would reduce your tax burden. You could 1031 some other portion of the profit into one or two easy to maintain rentals (which would probably net you 4.5%, not 6.5%). Then you could take the entire amount from the sale of the home you currently live in, tax-free, and invest it outside of RE, for diversification.

 

[donheff]

I've determined that the lowest I'd like to go in terms of after-tax cash flow is $4500/mo. Assuming a tax rate of 18%, that would require just under 66k annually pre-tax.

Here's what I would execute in a year or less:
1. Sell rental properties and 1031 into "cash cows" yielding 6.5%
900k * 0.065 = 58,500/yr

What do you mean by "cash cows" some sort of bond fund? 6.5% may give you $58,500 in today's dollars but you will be in trouble 10-15 years down the road due to inflation. You need a balanced portfolio and ~4% at start to be historically safe.

 

[brewer12345]

How/where do you propose to find relatively risk-free rental properties that will net you 6.5%?

I'd imagine you could relatively easily fine triple net leases that would yield that much.

 

[macdaddy]

I'd imagine you could relatively easily fine triple net leases that would yield that much.

I agree commercial rentals can be lucrative, however the risk is that they take longer and are harder to rent, and tenants have been known to declare bankruptcy. I'm not sure I would be comfortable depending on one or two commercial properties for the vast majority (900k * 0.065 = 58,500/yr) of my retirement income.

 

[califdreamer]

Thanks for feedback.

How/where do you propose to find relatively risk-free rental properties that will net you 6.5%?

I usually invest in Class B apartment buildings with a partner or two so we can buy a large enough propty to warrant using a professional propty mgr.  We do a little research and look for what we think are the best mkts to invest in.  For instance, there's no way we could get a 6.5% yield by buying in CA now.  Better to go elsewhere.  There are many apartment building markets that did not experience increase in values during the boom and are good investments now IMHO. 

Is 900k after you've discounted the price of your rentals so that they would sell in this market (i.e. 5%-10% under the comps)?

I keep abreast of propty values and believe I have appraised them fairly.  None of the properites are single family houses BTW.

The two kinds of rentals I know of that can touch 6.5% returns are commercial properties and low-income houses.

I do have a commercial propty in the mix.  It did fine but I would exchange it into an apt bldg rather than another propty of its type.  I have no interest in single family dwellings as investments. 

You may be able to use a 1031 from the rentals to purchase your new primary residence (as a "rental"), which would reduce your tax burden.

This is an interesting idea.  It seems in the past I've looked at ways to incorporate the use of a 1031 exchange using the residence and their was a problem with it.  I'll look into it again.

What do you mean by "cash cows" some sort of bond fund?

Bad choice of words on my part.  By "cash cow" I meant a real estate investment that would throw enough cash to give me a 6.5% yield.  One of the challenges of depending on RE rental income is making sure you keep pace w/ inflation.

I'd imagine you could relatively easily fine triple net leases that would yield that much.

I've seen some NNN real estate deals that purport to yield 7.5%, etc.  As macdaddy pointed out, there are risks involved.  I would probably keep my focus on crummy old apt bldgs.  My favorite.

How/where do you propose to find relatively risk-free rental properties that will net you 6.5%?

Back to the first question, here were my assumptions:
1.  Buy apt bldg with 50% down payment
2.  Finance 50% with 30 year loan at a rate of 7%.
3.  Buy a bldg with a 7.25 CAP rate
4.  Working thru the #s, that would yield a cash-on-cash return of 6.52%.

 

[brewer12345]

dreamer, could you talk a bit about the kind of property you usually buy and where you find them? How many units? How do you make sure you don't get killed in the deal? What does a property manager cost?

 

[Cransten]

It looks to me like you have a lot of exposure for a crappy return.  You're talking about a business, not an investment, and 6 percent and change for a business is just not worth it.  You have the worst of both worlds: huge downside risk, and very modest return.  Just stay in cash if this is the best you can come up with.

 

[brewer12345]

It looks to me like you have a lot of exposure for a crappy return.  You're talking about a business, not an investment, and 6 percent and change for a business is just not worth it.  You have the worst of both worlds: huge downside risk, and very modest return.  Just stay in cash if this is the best you can come up with.

He might have to roll it to RE or else pay some pretty crippling cap gains and depreciation recapture taxes.

 

[wabmester]

The apartment idea sounds pretty good to me as long as you find good management and have a good handle on expenses.

I looked at a REIT that specializes in class B apartment buildings (UDR), and they yield 4.6%, so you're basically getting 2% for taking on more risk.

 

[macdaddy]

It looks to me like you have a lot of exposure for a crappy return. You're talking about a business, not an investment, and 6 percent and change for a business is just not worth it. You have the worst of both worlds: huge downside risk, and very modest return. Just stay in cash if this is the best you can come up with.

Dreamer, you may have more experience in these kinds of investments than I do, but let me play devil's advocate. Let's say you sink the money into a 100-200 unit complex in the midwest, which is the kind I am familiar with. You could probably see a cash on cash return of around 7%. But what happens if vacancies increase? What happens if a tenant is injured and sues? What happens if major capital repairs are necessary and not covered by insurance? What happens if the manager quits? Or worse, steals money from the business?

I don't think the extra couple % is worth this risk. Even so, if this represented 10% of your income stream, it may be tolerable. But you want it to represent nearly 80% of your income stream. Can you sleep at night under those conditions? I know I would have trouble.

 

[Martha]

Let's say you sink the money into a 100-200 unit complex in the midwest, which is the kind I am familiar with. You could probably see a cash on cash return of around 7%. But what happens if vacancies increase? What happens if a tenant is injured and sues? What happens if major capital repairs are necessary and not covered by insurance? What happens if the manager quits? Or worse, steals money from the business?

When you buy you need to assume a certain vacancy rate. You get good insurance to cover injuries. You do your due diligence and inspections to figure out a capital budget for capital improvements needed in the next few years. You hire a professional management company that is bonded. You read the financial statements they provide you.

The worst rental property we ever invested in did not cash flow enough to do distributions to owner investors. There was a fire (covered by insurance), a number of units were out of commission for a period of time and new tenants were nervous about moving in. After repairs and getting the occupancy rate back up, our managing partner sold the property. We held the property for about three years and made about 30%. So even bad wasn't that bad. In retrospect, our managing partner probably should have held on to the property.

 

[MasterBlaster]

Martha:

Would you mind discussing the apartment deal ? Was it a tennants in common (TIC) arrangement ?

 

[Martha]

No. I don't do TICs.

We are investors in several limited liability companies where there is a managing member (another LLC) and investor members. Although we have invested in several different LLCs, basically the same people are all involved. A former lawyer in our firm decided he wanted to make a lot of money and would do so by purchasing apartment buildings for the best price possible, improving management, and then selling the properties. He is the best negotiator I have ever know. He makes CFB look like a CFB. A bunch of his lawyer friends and former clients became investors in his deals.

 

[MasterBlaster]

Martha:

From your point of view what is the upside of a LLC over a TIC deal ?

Is it knowing the management and the other players ? Or is the structure of the LLC itself ?

 

[macdaddy]

Keep in mind it's been hard to go wrong in real estate in the last 10 years. It will be much harder the next 10 years. I have done really well but wouldn't project results from the past 10 years out to the next 10. Now, I assume that appreciation will follow inflation and buy only for the cash flow.

 

[boont]

"You may be able to use a 1031 from the rentals to purchase your new primary residence (as a "rental"), which would reduce your tax burden." macdaddy

You cannot purchase any kind of primary residence with any of your 1031 exchange money. If you try it you will not only pay all the taxes but penalties besides.

boont

 

[macdaddy]

I should have been more specific. Can't he purchase a home w/ 1031 wherever he intends to move, rent it out for a year, and then turn it into his primary residence and move into it? This is legal as far as I know.

 

[honobob]

relocating from San Diego to less expensive area

Califdreamer   From your posts I think this is what you need to figure out first.  It looks like your plan would work but it would be hard to "undo".  I'm in N. CA. and faced with similar situation except I know where I'll retire (Honolulu!!!) but I'm also unsure if I want to LEAVE CA because it's HARD to come back.  I don't want to rent my single family home from long distance for a long time but recently found out that if I rent for two years to three years I can pocket my $250K capital gains (single like you) exemption and then 1031 $250-300K excess to another rental in Honolulu.  Even tho I lived in Hawaii for 5 years and plan for it to only be a base in retirement I'm not positive that I would not want to come back to the Bay area.  So this way I have up to three years of keeping my 5.25% mortgage and my LOW prop 13 tax base ( worth over $4,000 a year) and avoid paying taxes on my excess capital gains.  Have you considered what your property taxes and utilities will be in your $250K downsized home?  Could actually be more than staying in your present more expensive home.  Since I'm close to 55 I could also take my low tax base if I choose to a downsized property here in Alameda County (prop 60) or to one of the six counties that still take tax base transfers(prop 90).  If I downsized to a condo I would be more inclined to rent from a distance to keep my finger in the future crazy CA home appreciation.

I have 5 properties in 3 states and my plan now is to sell 3 over the next 10+ years investing the equity in the stock market if I can figure it out or possibly 1031 to a commercial property.  I'll always have my retirement condo and 1 rental that will supplement my small pension.

 

[califdreamer]

Thanks again for feed back.  

dreamer, could you talk a bit about the kind of property you usually buy and where you find them? How many units? How do you make sure you don't get killed in the deal? What does a property manager cost?

I usually invest in apt bldgs that are 25+ yrs old with a blue collar tenant base.  I don't necessarily look for bldgs that are that old, it usually turns out the Class B propties that make financial sense are that age or older.  I've been involved in everything from fourlplexes (when I started) to 150 units (w/ ptrs).  Doing your due diligence, hiring good and experienced management, researching the city and neighborhood you're investing in and being properly insured are all critical elements in making it work.  I stay away from new Class A buildings.  The rents are so high they compete with home mortgages and they compete directly w/ new construction whereas a homely Class B is essentially an irreplacable asset.  I've had different deals w/ mgrs but generally you're looking at 6% of gross rental income plus a free unit and some extra dollars for an on-site manager.

It looks to me like you have a lot of exposure for a crappy return.  You're talking about a business, not an investment, and 6 percent and change for a business is just not worth it.  You have the worst of both worlds: huge downside risk, and very modest return.  Just stay in cash if this is the best you can come up with.

Had I stayed in cash the last ten years instead of invsting in RE I'd be a pauper today.  Instead I am a multimillionaire after having an empty wallet in the early 90s.  To be less flippant, I understand this is not for everybody.  I happen to enjoy it.  I'd absolutely love to retire from my 9-to-5 job and be able to research deals all day... well part of the day anyway  

Macdaddy, your devil's advocate points are all valid concerns and must be dealt with.  Martha did a good job of summarizing what needs to be done (eg adequate reserves for capital improvements, vacancy factor built into pro forma P&L, etc.).  I've been sued for slip and fall, insurance took care of it.  I've had a meth lab in a unit that exploded and was out of commission for a while (one unit of fifty in that propty) and fire insurance took care of it.

Keep in mind it's been hard to go wrong in real estate in the last 10 years. It will be much harder the next 10 years. I have done really well but wouldn't project results from the past 10 years out to the next 10. Now, I assume that appreciation will follow inflation and buy only for the cash flow.

This is a good point.  Some are of the opinion that cash yields will become more important as rising interest rates put downward pressure on CAP rates.  Appreciation will be tougher to come by.  Keep in mind, though, even in CA our apt bldgs appreciated extremely well but were somewhat anchored by rental income (unlike SFRs).  And in some regions, apt bldgs did terribly due tenants being able to go buy a cheap home with low interest rates (think Texas).  Rising home prices and interest rates are resulting in increasing rents in these areas.  That's one reason the CPI is increasing.

Brewer, feel free to PM if I can provide more details on some criteria for apt investing.

 

[califdreamer]

Califdreamer From your posts I think this is what you need to figure out first. It looks like your plan would work but it would be hard to "undo". I'm in N. CA. and faced with similar situation except I know where I'll retire (Honolulu!!!) but I'm also unsure if I want to LEAVE CA because it's HARD to come back. I don't want to rent my single family home from long distance for a long time but recently found out that if I rent for two years to three years I can pocket my $250K capital gains (single like you) exemption and then 1031 $250-300K excess to another rental in Honolulu. Even tho I lived in Hawaii for 5 years and plan for it to only be a base in retirement I'm not positive that I would not want to come back to the Bay area. So this way I have up to three years of keeping my 5.25% mortgage and my LOW prop 13 tax base ( worth over $4,000 a year) and avoid paying taxes on my excess capital gains. Have you considered what your property taxes and utilities will be in your $250K downsized home? Could actually be more than staying in your present more expensive home. Since I'm close to 55 I could also take my low tax base if I choose to a downsized property here in Alameda County (prop 60) or to one of the six counties that still take tax base transfers(prop 90). If I downsized to a condo I would be more inclined to rent from a distance to keep my finger in the future crazy CA home appreciation.

I have 5 properties in 3 states and my plan now is to sell 3 over the next 10+ years investing the equity in the stock market if I can figure it out or possibly 1031 to a commercial property. I'll always have my retirement condo and 1 rental that will supplement my small pension.

Hi honobob,

Your post popped up while I was busy writing the last post. I think the most difficult part of this decision is whether I value retiring earlier or delaying it a bit and staying in San Diego. I like it here as much as anyplace I've ever lived... and I've moved around quite a bit. Yesterday, a number of things prompted me to re-examine my situation and seriously look at the idea of relocating and bailing sooner rather than later. Today, as I look over the numbers and think about how good life is here, I have second thoughts. And so it's gone for a while.

Interesting point about keeping your Bay Area home and renting it out just to keep a foot in the market. Predicting what will happen to real estate in CA is really difficult. I just read an article in Sunday's LA Times with an "expert" citing a price decline of 7% as a "worst case scenario." Others believe the market must revert to the mean and predict price declines of 30 or even 40%. I believe we'll see declines between 10 and 20%, but that's just a wild ass guess when it comes down to it.

I bought my current home in 2002 so I do have a pretty good deal on propty taxes though others who have owned their current home longer obviously have it better. It does seem propty taxes are generally higher in other states. Of course the home value could be low enough to more than make up the difference.

You know, I've left CA in the past and I always seem to find my way back. If the market heats up in a few years it would be hard to return. It would be a shame to lose the option to come back some day. If I had to pick a place to be "stuck" Honolulu would do just fine 8)

Good luck maneuvering your real esate equity... watch out for those cap gains!

 

[boont]

"Can't he purchase a home w/ 1031 wherever he intends to move, rent it out for a year, and then turn it into his primary residence and move into it? This is legal as far as I know."

No not exactly.

The IRS says that a 1031 turns on intent. You have to prove that you intended to trade it for a rental property. To do that you have to jump through some hoops.

It can be done but it takes some doing.

First you must rent the property to establish it as a replacement rental. Then you must keep it as a rental for say two years to establish intent. There is no specific guide line from the IRS on this but most CPA's will tell you two years. (I have heard one but I wouldn't do it).

Now you can live in it.

But if you sell it you will have to pay all the tax originally due.

To sell it tax free you still must meet the two out of five year rule AND you must have owned it for a total of five years.

Not to sound like a no-it-all but I've been through this.

boont

 

[califdreamer]

"Can't he purchase a home w/ 1031 wherever he intends to move, rent it out for a year, and then turn it into his primary residence and move into it? This is legal as far as I know."

No not exactly.

The IRS says that a 1031 turns on intent. You have to prove that you intended to trade it for a rental property. To do that you have to jump through some hoops.

It can be done but it takes some doing.

First you must rent the property to establish it as a replacement rental. Then you must keep it as a rental for say two years to establish intent. There is no specific guide line from the IRS on this but most CPA's will tell you two years. (I have heard one but I wouldn't do it).

Now you can live in it.

But if you sell it you will have to pay all the tax originally due.

To sell it tax free you still must meet the two out of five year rule AND you must have owned it for a total of five years.

Not to sound like a no-it-all but I've been through this.

boont

If I understand this correctly, someone could sell a rental propty and do a 1031 into, let's say, a single family home as long as that home was going to be used as a rental and not the residence of the new owner. Two years after the exchange, the owner could experience a "change of heart", remove the tenants and move into the home. Let's say the owner stays in the home for three years. Can the owner then sell the property and take $250k (assuming single not married) tax free?

As a practical matter, this would be a pain to do. But it's an interesting way to extract equity from rental propty tax free. I wonder how this would stand up in an audit.

 

[honobob]

 

To sell it tax free you still must meet the two out of five year rule AND you must have owned it for a total of five years.



boont

Califdreamer

 

[honobob]

oops

I think it's like boont said,  but I was under the impression that in addition to owning for a 5 year period and living in it for 2 you could only do this type of transaction once every 5 years.