There was recently this really amazing article by Tony Wright and ensuing discussion on Hacker News about founders of startups who think they’re going to retire at 30 after taking home $4.3mm or so. The gist of the article was that with $4.3mm, you can’t expect to live indefinitely on an inflation-adjusted salary of $200k / yr without working. This is nonsense, as we’ll see in a minute.
The article makes the really good point that you should be in the startup game primarily for the love of what you’re doing, not the money. But this is true for almost any endeavor, because the reality of almost anything where you can get rich is that it’s definitely not a sure thing. So if you’re going to spend years of your life slaving away at something without a good chance of a big payoff at the end, you better be enjoying the journey itself or you might get to the end of your life and find that you wasted it on something you hated for nothing.
I can’t deny that the math of the piece is solid, but I really do question the assumption that you should take that money that you made creating value by running a business and invest it in the stock market, where you have zero input or control over the outcome. There are lots of other paths you can take, but I’ll focus on the one that I know best: multifamily real estate.
I know, I know: real estate is such a risky proposition right now! Am I crazy?!? Let me run through the numbers with you, and you can tell me.
Let’s take our hypothetical entrepreneur who just cashed out for $4.3mm and see if we can retire her within a year or two. And to be more conservative, let’s just use $1.3mm of the money for real estate. She can put the rest in stocks, bonds, or Uncle Morgan’s ice cream truck business.
Our goal is to purchase a nice, class B apartment complex in a good market with solid fundamentals. For the sake of this example, let’s use the Dallas market. I jumped on LoopNet.com for a few minutes to look for good prospects, which is also conservative, as the best deals don’t ever make it to LoopNet. You’d be better off retaining an experienced multifamily broker in the market, but this will suit our purposes for now. We’re going to take our $1.3mm and put a 20% down payment on an apartment complex, obtaining financing for the remaining 80%, either through a traditional bank loan, seller financing, or some combination. This will give us the ability to purchase a property valued at around $6.5mm. Let’s be conservative and limit to $6mm, so we can keep some cash in reserves and pay for any deferred maintenance on the property. So a perusal of LoopNet turns up this potential investment:
Asking price is $5.5mm, it looks like a solid class B place, it’s got 151 units, mostly 1 bedrooms, it’s 80% occupied (more on this in a bit), and it was built in 1985, so hopefully it’s not falling apart yet. The effective gross income on the property is $920k / year. Now, obviously this would require a LOT more due diligence, but this is one of several properties like this that I found with a few minutes of searching in one market in the US, so it’s not terribly unlikely to find a similar deal even if the numbers didn’t pan out on this one.
Operating expenses on properties like this vary, but 50% of the gross income is a good rule of thumb. The listing for this property says $500k, so that’s about right. Let’s use $500k as the number for the operating expenses, which includes maintenance, taxes, insurance, management, etc, basically everything except for debt service.
So our hypothetical entrepreneur does her due diligence and decides to buy the property. Let’s assume that she pays the asking price, puts down her $1.2mm (holding $100k in reserve) and gets a 6% loan for the remaining $4.3mm. With a 30 year amortization, that’s an annual debt service of about $310k. Her net pre-tax cashflow is therefore $920k – $500k – $310k = $110k / yr. This represents a cash-on-cash return of just over 9%. So not quite $200k / yr, but we’ve also only invested about 1/4th of our total cash to get that annual cashflow. And there are some other big benefits here as well:
First, our entrepreneur is in control, unlike the stock market. If things change with her property, she can be proactive and adjust her strategy, having a direct impact on the management of the asset.
Second, there are other potential sources of return beyond just the annual cashflow. She’s amortizing the loan every year, building up equity in the property. And there may be appreciation as well, though you don’t want to count on this. Still, it’s a nice bonus if it happens.
Third, real estate is a natural hedge against inflation. The rents can be raised annually to keep pace with inflation. (Bonus: your mortgage payments do not increase annually.)
Fourth, this particular property may offer some attractive options for adding value. The occupancy rate of 80% could be improved, for example. Improving the condition of the property, putting in new management, cutting expenses where possible, raising rents, and getting the property leased up to 95% could easily double the pre-tax cashflow on the property, and seriously increase the overall value.
Finally, we should take tax benefits into account. You’re allowed to write off a portion of the value of the property (excluding the value of the land) each year as depreciation. And thanks to this write-off, it’s very likely that this property would show a paper loss for the first few years, which means our intrepid entrepreneur would pay zero income taxes on that cashflow. Zip, zilch, nada. No federal income tax, no state income tax, no FICA, nothing.
Is this an easy or risk-free investment? No, it’s really not. You’ll need to learn a lot about real estate before you head down this road. Buying an apartment complex like this is buying a business, and you should treat it accordingly. But you should also learn a lot about the stock market before you head down that road. If you turn your money over to some wealth manager and have no idea what they’re doing with it, you’re putting yourself in a bad position. And it’s definitely true that real estate is a lot more work than just pulling up etrade.com and buying some shares. But then, that’s the difference between growing your net worth from $4m to $400m, or running out of money at 50. In the end, which approach is really riskier?
Update: if I could recommend just one book on the type of investing I’m describing above, it would be this one: The Complete Guide to Buying and Selling Apartment Buildings