Real Estate, Trusting Stocks & Asset Allocation

[msbearkeley]

I found some posts with varying opinions on treating Real Estate investment cash flow as various asset classes or even a business, but I cant seem to find the answers on how RE investments (landlording) should be calculated when figuring out your ideal AA to maximize your SWR / cashflow after retirement.

I know I'm also really just skeptical about selling real estate (something tangible) and putting most our $s into the market (60% RE right now) because I don't know enough about the market. I tried to read the Four Pillars, but I think I need something I can trust (and maybe more practical / modern in light of the recent market issues). Can anyone suggest posts or a good book to start with? Any alternative to FIRE Calc that has RE investments included? How are the landlords out there 'planning' with their RE equity & cash flow?

Some things I'm confused about...

Seems like a 10% RE; 30% Bond; 60% Stock is what the right allocation would be for us right now. But -- if 10% is based on what our net worth is (if RE is sold today), then how do I truly decide if it's ok to have a different mix given what seems like a higher return on my RE investments.

On that note, am i calculating the return correcty? When purchasing RE, we use cash on cash returns but I don't have a mortgage on a rental now (paid off and refid a primary residence to lower rates) so is that good or bad from an asset allocation standpoint? (definitely great for taxes!)

Aside from the landlord headaches (we have several rentals now and been doing it for 8 years so we know what to expect and what's unexpected), and RE risk, what else should we consider to evaluate what our AA should really be? Based on what I've read, I know that the 4% SWR from investments are really supposed to be more reliable than monthly rent coming in - but where would it come from? Dividends enough? If we sold investments, would we know enough about what to sell at what time? I know many on this board 'shy away' from financial advisors...but is there an investing for dummies book? (I didn't see that on the FAQ section of recommended reading by the way!)

[Gone4Good]

With 8 years RE experience, including The Great Recession, you should have a pretty good idea of what cash flow your rental properties throw off (on a full-business cycle basis). I'd simply use that cash flow (net of all normalized expenses, of course) as a reduction in my expected living expenses. I'd use those net expenses to calculate my withdrawal rate. Then I'd set an AA on my liquid portfolio that matches my risk tolerance. I wouldn't try to add my real estate investments to a portfolio and worry about how it impacts my AA. But you may want to consider whether or not you're over exposed to some kind of real estate specific risk . . . like if all of your properties are in the same one-employer town, for example.

[calmloki]

This post leaves me puzzled - kind of like the posts on whether one would want one's kids to be in business for themselves or work for megacorp or de gubbermint. Seems so clear to me one wants to have faith in one's investments. Who do you have the most faith in? Uhm - yourself? If you trust the government or big business or anyone else more than yourself then why not just buy an annuity?

My Mom owned Rath Packing and Enron and we've owned GM and BofA. Hmm. Maybe we were really stupid, but those were/are pretty big companies with a whole lot of other stupid investors. We mostly own rental real estate - at this point selling it means about a 25-30% haircut by the taxman if we sell vs. a regular monthly income if we hold on. When stocks went to 7000 our rents actually went up a bit. Given that I believe massive inflation is the cure for American debt I expect property values in future dollars to be way up, so selling now seems silly. It's just the management issue that is a bit of a problem. As for firecalc - same problem here - oh well.

[haha]

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Originally Posted by msbearkeley Aside from the landlord headaches (we have several rentals now and been doing it for 8 years so we know what to expect and what's unexpected), and RE risk, what else should we consider to evaluate what our AA should really be? Based on what I've read, I know that the 4% SWR from investments are really supposed to be more reliable than monthly rent coming in - but where would it come from? Dividends enough? If we sold investments, would we know enough about what to sell at what time? I know many on this board 'shy away' from financial advisors...but is there an investing for dummies book? (I didn't see that on the FAQ section of recommended reading by the way!)

If you are happy with the job of being a landlord, and don't find that it ties you down more than you want, why quit?

It provides the regular, understandable and rising cash flow that one needs to live. Why enter into the fantasyland of SWRs, etc?

Ha

[clifp]

If you are happy with your real estate investment and they are providing positive cash flow, I agree with other no reason to switch them to what for many people is consider to be illusionary world of financial assets.

I had sort of the opposite problem. Many times my mother (who experienced California 's booming real estate market for 50 years) prodded me to buying rental properties (generally when CA prices were soaring.) I certainly watched with some jealous as lots of people made fortunes (at least on paper) in real estate.

At some point I told her. "Mom not only do I not have the skill or desire to be landlord, I just don't understand real estate. You and other folks can look at property and see how can be transformed into something much more desirable from a future buyers or renters prospective. I don't even know how to judge if something is a good deal". "Now stocks, those I understand I can read balance sheets and income statements and have pretty good idea what something is worth, a lot of people can't do that. So I'll stick with stock and leave real estate for others."

I can say that right now with bonds looking really overvalued, stocks looking somewhat overvalued (after a 50-70% increase from last year), and cash paying nothing. I wish I knew enough to invest in real estate.

As far as Asset Allocation goes. My only advice is to start thinking about economic scenarios that would screw you up. the impact of auto industry collapse on Detroit real estate. One obvious is thing is that you should do very well in a period of high inflation. Most smart money is predicting this in the fairly near future. What if the smart money is wrong and we have continued declines in real estates prices (and rents) and no inflation.

Long bonds would a good asset to own in this environment (personally I hate them but your and my financial situation are pretty opposite). There maybe some other asset classes that do well in a no inflation, stagnant growth environment.

[traineeinvestor]

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Originally Posted by clifp As far as Asset Allocation goes. My only advice is to start thinking about economic scenarios that would screw you up. the impact of auto industry collapse on Detroit real estate. One obvious is thing is that you should do very well in a period of high inflation. Most smart money is predicting this in the fairly near future. What if the smart money is wrong and we have continued declines in real estates prices (and rents) and no inflation. Long bonds would a good asset to own in this environment (personally I hate them but your and my financial situation are pretty opposite). There maybe some other asset classes that do well in a no inflation, stagnant growth environment.

That all sounds very logical but is far from being a certainty. As a real estate investor, one of my concerns with higher inflation is that it would (I expect) result in higher interest rates. Higher interest rates means higher borrowing costs and higher opportunity costs - the combination of the two may well cause real estate prices to either fall or at least lag inflation in real terms. Over time, rising rents and construction costs may overcome the problems caused by rising interest rates but the short term could be ugly.

Of course you also get a benefit from the declining real value of any outstanding mortgages - particuarly if you have access to mortgage finance at long term fixed rates.

The worst scenario for all existing investors is higher interest rates without higher inflation. (Of course, this would be a pretty good scenario for those with new money to invest.)

Needless to say, all this is very speculative and I have no idea how things will actually play out in practice. In the meantime, I'm happy to keep banking the rent payments each month.

[Nords]

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Originally Posted by msbearkeley I found some posts with varying opinions on treating Real Estate investment cash flow as various asset classes or even a business, but I cant seem to find the answers on how RE investments (landlording) should be calculated when figuring out your ideal AA to maximize your SWR / cashflow after retirement.

One of the issues is rent variability (vacancies or evictions). Another issue is unpredictable expenses (repairs & replacements). After eight years you could treat the rental as some average source of cash income. You could try to budget for the expenses from history and the expected life of things like roofs and appliances. But I'd treat a rental as a business, not part of an AA.

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Originally Posted by msbearkeley I know I'm also really just skeptical about selling real estate (something tangible) and putting most our $s into the market (60% RE right now) because I don't know enough about the market.

As other posters have mentioned, you'll probably be happier with a real estate investment under your control than some impersonal REIT or partnership. You'll probably do a better job than a manager who's more focused on their enrichment than on yours. Running your own real estate is also at least as much of an emotional decision-- and a good one-- as a financial decision. The "sleep at night" aspect of the emotional decision is more important than all the world's financial logic. If you're not comfortable with your decisions then you won't stick with them during bad markets and it won't matter how logical they were.

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Originally Posted by msbearkeley I tried to read the Four Pillars, but I think I need something I can trust (and maybe more practical / modern in light of the recent market issues). Can anyone suggest posts or a good book to start with?

Um, it's been a while since anyone's complained about Four Pillars being "too hard". Bernstein says that he's dumbed down the theory considerably. You can find lots of "practical" advice by searching for "asset allocation" on Amazon.com or this board, but it rarely offers the background leading to those results-- it just spouts "do it this way" dictums. Bernstein at least shows the logic leading to the conclusions.

As for the "modern" comment, you may want to assess AA books on more qualitative factors than their copyright dates. "Four Pillars" is based on theory, has stood the test of historical data, and its principles have been generally validated by recent research/events. Newer AA books haven't necessarily done so well with confirming research. They might be fine but it's too soon to tell.

You could look at "Four Pillars"' sample portfolios in the back for some sort of assessment of your personal risk tolerance. You could also read a library copy of Bob Clyatt's "Work Less, Live More" and focus on the asset-allocation section. I put more suggestions at the end of this post.

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Originally Posted by msbearkeley Any alternative to FIRE Calc that has RE investments included?

One approach would be to include RE as a monthly income source and its expenses as part of your spending budget. But I'd see that income as salary, not interest or dividends.

FIRECalc is "under new management" with Andy R, so you might want to PM him or suggest the improvement in the board's FIRECalc forum.

You could build your own AA somewhere else on portfolio-management websites like FinancialEngines or Morningstar, determine the portfolio's average return, and use that instead of FIRECalc's returns numbers.

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Originally Posted by msbearkeley How are the landlords out there 'planning' with their RE equity & cash flow? Seems like a 10% RE; 30% Bond; 60% Stock is what the right allocation would be for us right now. But -- if 10% is based on what our net worth is (if RE is sold today), then how do I truly decide if it's ok to have a different mix given what seems like a higher return on my RE investments.

We use our real estate's gross worth to determine how much liability insurance to carry. Litigious lawyers don't have to make allowances for mortgages or net worth, only assets.

There are probably more asset allocations than investors, and they're endlessly debated. There are many successful paths to the same result. So if it "seems right", and you can sleep at night with it, then you might as well set yourself up with that and see how you like it.

We have a small mortgage on our rental (20% LTV) because we had a chance to get a 30-year fixed at 4.625%. Seemed like a prudent long-term way to leverage dead equity in the stock market. We looked at higher mortgage amounts and decided not to beat up our cash flow. If we had tenant (rental income) problems or hurricane damage we'd still be on the hook for the mortgage payment.

Otherwise we have rock-solid tenants (so far) and very low vacancy rates-- so we forecast a year's gross rent, subtract known expenses like mortgage/taxes/insurance, subtract historical estimates of repairs/maintenance, and try to estimate how much to budget for replacements. We consider the net result to be part of our annual income (like a salary for a business), which reduces the demand on our ER portfolio.

We don't consider the property to be part of our asset allocation. For starters it'd make our ER portfolio's AA pretty lopsided-- Hawaii real estate ties up a lot of dead equity. If the property's value skyrocketed or plunged then I'd hate to have to make rebalancing decisions based on a psychotic RE market. (We try not to make rebalancing decisions on a psychotic stock market, either, but at least those assets are a lot more liquid than RE.) Finally, we've recently come to view our RE as our eventual age-in-place home in 30-40 years. We'll ride the rent as hard as we can but the property is no longer just a fungible investment. Besides landlording is not what I'd view as "passive" income-- it's definitely feels like work income.

You could consider your RE to be in an "other" asset category that lets you be more aggressive in your equity holdings. Or you could consider it to be a junk bond with a high dividend in exchange for a higher risk. But I don't think either of these works as well as considering it to be business income.

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Originally Posted by msbearkeley On that note, am i calculating the return correcty? When purchasing RE, we use cash on cash returns but I don't have a mortgage on a rental now (paid off and refid a primary residence to lower rates) so is that good or bad from an asset allocation standpoint? (definitely great for taxes!)

Cash-on-cash seems like a generally-accepted way to view returns for comparison against CDs or other interest/dividend income. Instead of using the RE's equity you might want to use its net value after taxes-- the money you'd put in your bank account after the closing and after paying the cap gains & depreciation-recapture taxes. We use that after-tax amount when we look at our cash-on-cash returns to make a realistic comparison to CD rates. That comparison feels pretty good right now, but when CDs were paying over 6% they didn't call us at 3 AM to complain about roof leaks, either.

I wouldn't make a real estate decision on tax rates or anticipated legislation. Lots of people got hammered in 1986 when the laws were changed, and some got hammered again recently on cap gains vs the two-year primary-residence rule. It's nice to wipe out Schedule E income by deducting mortgage interest, but it's probably not adequate compensation for the extra risk. I'd make a real estate decision based on whether I had the aptitude, personality, motivation, and desire to work that hard. Otherwise I'd sell, pay the taxes, and put the cash in CDs.

From an asset-allocation perspective I guess the RE equity (before taxes) would be the equivalent to the rest of a portfolio (which is also assessed at its before-tax value). But again I wouldn't consider RE to be apart of a portfolio's AA.

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Originally Posted by msbearkeley ... what else should we consider to evaluate what our AA should really be? Based on what I've read, I know that the 4% SWR from investments are really supposed to be more reliable than monthly rent coming in - but where would it come from? Dividends enough? If we sold investments, would we know enough about what to sell at what time?

First I'd consider the RE to be a salary. You can probably predict your salary income, and maybe you can even predict your "job security". But more realistically you'd base your plans on your salary and then make a new plan if you got laid off. Same for real estate vacancies/evictions.

The 4% SWR number comes from the Trinity Study, and part of that assumes that the portfolio is consumed over the next 30 years. So at the beginning of the first year of ER, you'd cash in a 4% portion of your portfolio (keeping it within your chosen AA) for that years' living expenses and put it into a checking account. The rest of the ER account would start the year at its desired AA and then accumulate dividends (paid in cash) and whatever other interest/cap gains happen during the year. At the end of the first year you'd cash in "4% plus inflation" for the beginning of year #2. Some of that cash would come from the cash that had piled up during the year while the rest of it would come from selling portfolio assets to remain within its desired AA.

If you're trying to "live off the dividends" then you'd never touch the principal and your concern is yield, not SWR. You'd want a portfolio of assets that throws off enough income to exceed your expenses, or else you'd throttle back your spending to live within the portfolio's income. There's a lot of debate about what should be in a dividend portfolio, from TIPS to blue-chip stocks.

There are dozens of variations on the 4% SWR, including in Bob's book. There are also other withdrawal schemes that allow for variability instead of assuming inflation increases or living within dividends.

If you're trying to do some mix of SWR & dividend income then you'd forecast your rental income, forecast your dividend income, and cash in enough of your ER portfolio to make up the expense gap.

As for the timing of the sales, you could sell assets at a certain time (1 January or quarterly or when your checking account runs low) or you could cash in assets as part of rebalancing (annually or whenever you want to). You probably know as much about "when to sell" as any other Wall Street guru... or rather your prediction record would be just as good.

In our case we forecast our pension income, forecast our rental income, and predict our budget from history. Once we know our expenses for that year, we start the year with two years' expenses in cash (CDs or money markets). After a good stock-market year we replenish the cash stash, after a bad year we draw it down another year.

During the year, our ER portfolio accumulates dividends in cash. If an asset gets more than five percentage points out of its desired AA then we rebalance it (usually just by selling it back to the original point) and leave the cash in the money market account. If cash gets beyond two years' expenses then we might take some off the table or buy whatever asset is lagging the rest of the portfolio's AA.

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Originally Posted by msbearkeley I know many on this board 'shy away' from financial advisors...but is there an investing for dummies book? (I didn't see that on the FAQ section of recommended reading by the way!)

It's here:
http://www.early-retirement.org/foru...ist-22300.html
and another one is here:
http://www.early-retirement.org/foru...ist-46732.html

You could also try the Bogleheads' Wiki on various topics:
Category:Asset Allocation - Bogleheads
Category:Asset Classes - Bogleheads
Category:Portfolio Withdrawals - Bogleheads
Category:Portfolios - Bogleheads
Category:Indexing - Bogleheads
Category:Books and Authors - Bogleheads

... and then chase down the authors/books mentioned in the articles.

[msbearkeley]

Wow! What a GREAT post, Nords! Thank you! I admit I could never stay awake long enough to get through Four Pillars - even tried to try tutorial that was on this board awhile back and didn't make it.... but I sure learned a lot from your post!

Thanks to all that gave feedback too -- I really expected folks to push me to the financial markets! Comments here really opened my eyes to looking at things differently....at least figuring out a little more about the financial market to see how much RE I would want to hang on to.

You're right Nords...CDs don't call at 3am with leaky roofs, or in my case, plumbing issues! Landlording IS work, but I just REALLY LOVE owning houses. My friends are into shopping for clothes, shoes and purses that cost 2 or 3 months mortgage....I like to shop for houses. In fact, Clifp, if you can send me the cliffnotes for Nords' reading list, I'll help you buy and manage your real estate! There's this one rental right next to mine that would just be a steal -- it's in foreclosure but since we have 3 identical properties just like it next door, I know how to make it work! Tempting......