Afford Anything - Ask Paula (and Will) - How Technology is Changing the Future of Real Estate Investing

Episode Date: May 22, 2017

#78: Imagine that you're looking for a rental property. It's a warm Saturday afternoon, and you decide to cruise through a few open houses in the area. Your autonomously-driving electric vehicle pulls into the driveway. Your wifi-enabled contact lenses automatically register the property's details: square footage, year of construction, sales history, tax assessment, price-to-rent ratio, average neighborhood occupancy rates, and multiple cap rate estimates. As you walk through the property, your contact lenses display the digital history of every item -- the furnace, dishwasher, windows -- keeping you up-to-date with the full installation and service history of every home component. Welcome to the future of real estate investing. What's looming on the horizon? How will technology -- including augmented reality and 3D printing -- affect the way we analyze and purchase rental properties? I chat about this topic, and more, in today's podcast episode. This week, I feature another Ask Paula episode, answering questions that this community has submitted. This week's theme is real estate, and I've invited Will to join me as we tackle your questions about rental investing. Enjoy! For more resources, visit the website at http://affordanything.com/episode78 Learn more about your ad choices. Visit podcastchoices.com/adchoices

Hey, you can afford anything and everything. Is that the thing? That's a thing. That's a totally a thing, right? Totally a thing. You can afford avocado toast and a house and, uh, Lamborghini? Yes, although I don't necessarily recommend eating avocado toast in a Lamborghini. Ooh, can you eat a Lamborghini on top of avocado toast? If it's made of chocolate. Ooh, that sounds pretty good.

Yeah. Does chocolate and avocado go together? Everything goes with chocolate and everything goes with avocado, so yeah. Ah, by the transitive property. of everything. So anyway, for those of you who have never heard the show before and wonder what you've just tuned into, this is the show that believes that you can afford anything but not everything, which means that every decision that you make is inherently a tradeoff. You're either going to buy X or you're going to buy Y. And, you know, money is abundant, but it is also limited.

So your goal in terms of money management is to align your spending with your values. What do you want most in life and how are you going to direct your dollars there? My name is Paula Pant. I'm the host of the Afford Anything podcast. Every other week, I answer questions that you, the listeners, have submitted, and this is every other week. So I am answering your questions. If you're a long-time listener and the sound sounds weird, it's because I'm not in my podcast booth right now. Normally I record out of a closet. It's dark and depressing. But right now, I'm traveling. I'm on a lovelier mic, which is just one of those things that clips on. onto my dress, and it's great. I'm eating chocolate while I'm doing this. And I've invited to join me my partner in crime and the dude who bought a bunch of real estate with me, Will Sisk. Hello. And so, Will, the reason I invited you on is because specifically the questions that we're going to answer today are questions related to real estate. This is Ask Paula and Will, the real estate edition. Thank you for having me. Yeah. Well, you were around. So, hey.

So I want to jump right into it. Before we get into the first question, have you heard about this avocado toast thing that's been going on? I'm too old to be cool. So I only hear about things like that from you because you're cool no matter what. Oh, cue the bleh. I'm just too old for Twitter. Okay, so I haven't even been on the internet this week and somehow this is still popped up in like the newsfeed of my brain. So apparently some real estate mogul who lives in Australia.

wrote an article or maybe said in an interview that if millennials ever want to buy a home, they need to stop buying avocado toast, $19 smashed avocado toast. So first of all, a couple of comments about why this story got so big. First of all, any time you put the word millionaire in a headline, the thing automatically gets more clicks. So the headline for the story, which was millionaire to millennials, if you want to buy a home, stop buying avocado toast. The headline for the story was imminently clickable because it had the word millionaire in it. I know this because I do it all the time myself. Look at the title of some of these podcast episodes. Doug Nordman, millionaire on a military salary. Andrew Hallam,

millionaire on a school teacher's salary. Emma Patee, 26-year-old millionaire. I put the word millionaire in the title of these podcast episodes. That is not an accident. That's like, it's a hack. It's a headline hack. It's at. the hackiest hack that ever hacked a hack to hack. So that's one of the reasons the story blew up so big. The other reason is because talking about avocado toast is just another way of saying, don't buy lattes. And because don't buy lattes is so cliche, this whole avocado toast thing is avocado is the new latte. It's like they put it through, will you coin this term, if they put it through the hipster spin machine.

It is a new latte for our age indeed. For those of you who haven't heard about this, the big thing that's going around the internet right now is if you want to buy a home, stop buying avocado toast. And what I would say to that is while the general advice of don't waste your money on stupid stuff always holds true, I would also kind of add the caveat, don't scrutinize the $4 lattes or the $19, like, Sunday brunch that you have with your family. You know, don't cut that out of your life when you are overlooking the fact that you could refinance your mortgage and, you know, go from 5% down to 4%, which will save you tens of thousands of dollars over the course of your lifetime.

Don't overlook the fact that you can negotiate your insurance rates and perhaps save $100 a month, which is $1,200 a year. Those are the unsexy things that don't make good headlines that nobody wants to talk about because negotiate your insurance rates is not clickable. But that's the stuff that will actually gain traction. I never clicked on negotiate your insurance rate stories. See? Yeah. That sounds super boring. rant over, let's get started with the first question of the day.

Before we move on, I do have to say he might have a point, though. Yeah? I've never bought avocado toast, and I own a house. What? So obviously it's true. Okay, but have you bought toast with a chocolate and borghini on top? Yes, I have. I think the French have a word for that, don't they?

the word for bread with chocolate. Oh, yeah, it's pano chocolate. There we go. So it's pano chocolate Lamborghini. Avec avocado. Let's go buy a house. All right. And brunch is at our place tonight.

Tonight. Brunch is at our place tonight. It doesn't even make sense. We can do whatever we want. We can have brunch whenever we feel like it. I'm having brunch right now, so I don't even know what time it is. I live in a permanent state of brunch. Yes. All right, here's our first question.

Hey, Paula. My name is Alexandra. I'm 27 years old and my husband just turned 30. We have two kids, one who's five and one who's four. And we purchased our first home about two years ago. We currently owe about $203,000 on the home and our neighbor recently sold for 265. We're thinking about selling the house because we'd like to dramatically change our lifestyle and stop just working and taking care of the kids and really being able to live. So we're thinking we could walk away with about $40,000 that we'd like to put down on an investment property, a multi-unit property that we would maybe live in one of the units for a while while we rent the other units and continue to repeat that process until we have enough

profit that we could cover our living expenses. and then spend some free time traveling the world. We just wanted to know what your advice is on how we can get started on this process. And what do you think about us selling the home? Thank you. All right. So the first thing I want to say is that you're doing a great job already.

You're 27 years old and you've got about $40,000 worth of equity in your house. That's like congratulations. I would clap, but it would cause an echo on my microphone. So you just imagine me clapping inside of your head. Steve, clap and post. So yeah, so kudos to you for being where you are and for wanting to take the next step and go even further with that. A couple of things that I would say right off the bat. Number one, given that you want to live in this property.

Now, normally, okay, I'm going to backtrack even before I've said the thing that I've just said, right? Normally as a general rule, I very much encourage people to buy rental properties anywhere within the state, region, country. Go where the money is, go where the returns are. If you happen to live in a very expensive area, not a big deal. Buy where the money is. Go where the money is. Now, in your particular situation, because you want to buy a multi-unit and live in one of the units, of course, there need to be properties in your area that are worth the hassle, basically. There need to be good rental properties in your area. And so that's the first question that I would ask. Are there good multi-units in the area? And so the logical follow-up question becomes, how do I know if a rental property is good or bad?

I use a formula called cap rate or capitalization rate in order to determine this. And cap rate, essentially what it is at the high level is it's a measure of what the returns on the asset are. So given the value of the asset, meaning the value of the home, what are the unleveraged cash returns on that asset? essentially cap rate is analogous to the dividend that you would get on a stock. Yeah, I mean, from a technical standpoint, I completely agree with that. I think what I would add is I would really want to think through before I did this. I think this can be a great plan. I would really want to think through it, number one, make sure you and your husband are both

on board with the same vision. It can be a little challenging to live in a house that you're also sharing with tenants, you know, sharing it in the sense that they're going to be in different units. but you know, you're going to, there is a tendency to sort of feel like you're at work at all times because your tenants live right next door to you. Right. So you got to be okay with that. And, you know, your whole family really needs to be on board with it.

And what I mean by on board with it is I think you need to both be really on the same page and it needs to be, you know, really a shared dream in terms of like why it is you're doing that because that'll make it a lot easier. Right. Also knowing kind of what your plan is, you know, I think generally speaking, I, I, I think generally speaking, you're allowed to do this once every year or two by most loan standards. You'd have to look into it. Well, generally what the rule is is that if you – so the benefit to buying your suggestion, which is buying a multi-unit property and living in one of the units, is that if the property has four or fewer units, meaning it's a duplex, triplex or fourplex.

You can qualify for a loan as a primary resident, which means that you – with a primary resident loan in conventional finance, that's typically where you'll get the best interest rates, the best financing terms. So that's one of the big advantages. It's also generally easier to qualify for a primary resident loan than it is for an investor loan. Yeah, they're not going to want to see a business plan and history of rental management and all that stuff. They're just going to... Exactly. So, yeah, in terms of financing, what you're proposing, which is living in a multi-unit is the best, like the best deal.

Typically, banks are going to want to see you live there for at least one year in order to qualify for a primary resident. loan. Right. But I mean, if you're going to move in there anyway, I doubt you're going to move out in less than a year. Right, right. Exactly. Because moving's a hassle. Exactly. So I think this can be a great strategy as long as you are, you and your family are very aware of the challenges and the struggles of it. It can be a bit of a sacrifice. You know, if the end goal is worth the sacrifice, then that can be very motivating. Yeah, I would say, I would agree with that. I would say you and your husband should talk about, you know, in terms of the day-to-day management of it. assuming that you're going to manage it yourself, which if you live there, I assume you probably

are at least during the time in which you are living there. Have that plan sketched out before you move in. So, you know, who is in charge of responding when a tenant comes to you with a maintenance request? Who is in charge of, even if you're going to hire contractors, who's in charge of finding those contractors and making the call and scheduling them? You know, nor if you, once you move out and you get a property manager to come take over, that property manager is going to do everything, which is why I freaking love having property managers makes my life great. But, you know, if you're going to be living in the building, I mean, when we will, when you and I lived in that triplex. We had it all worked out from the very beginning, there were never any problems. Yeah. It was, we were perfect the

first time. Uh-huh. Sure. Hashtag not. You know, but we also, we managed the triplex ourselves because it just, because we lived there. So it didn't make sense not to. But to go back to my earlier comment about calculating cap rate and calculating returns, when you are making those calculations, run those calculations as though you are outsourcing everything. So run the numbers as though all of the management, the maintenance, every single aspect of the work is getting outsourced. And you're going to do that for two reasons. Number one is because you are evaluating an investment rather than trying to buy yourself a job. And number two, the goal is to let math be math. And the only way that math can truly be math is if it is identity agnostic, meaning that math should never depend on the identity of the individual who's performing a task. So if you value your own time at zero and you value a property manager's time at 10% of gross, well, then you're changing a variable which throws off the whole equation. So in the show notes, which are available at afford anything.com slash episode 78, I'm going to link to an article

that explains exactly how to calculate cap rate. Affordanything.com slash episode 78. That's where you'll see the formula for cap rate. But right now on a podcast at just a very high level, conceptually, that's the number one thing that I would say is, you know, make sure that the property that you are looking at is a good rental property. Yeah, because if it's not a, a good rental property, then why bother? Yeah, make sure the numbers work. Make sure it works with your life and your goals. And this can be a really great thing. I mean, we wouldn't be where we are today without our first property that we bought together, which was a multifamily. Yeah, exactly. It was huge, so it can really catapult you if you get the right one. Yeah, exactly, exactly, because that's what we did.

We bought a triplex. We lived in one of the units with roommates and then rented out the other two. Yeah. And that was how we got our start. Yep. Our next question comes from Chris. Hi, Paula. This is Chris from the Washington, D.C. area. I really liked your blog post emphasizing investing rate over savings rate. It helped me realize my wife and I have about 50K and non-emergency fund, non-future allocated cash, just sitting in savings that should be working harder for us.

I'm intrigued by buy and hold rental property investing because of the strategy's differences from our current investment portfolio, which consists in two things. 401k money and the house that we live in. Our 401k assets total 155k. We bought our house a year and a half ago for $610,000 with $120,000 down, and we have a $3.875 interest rate. I like the idea of buy and hold rental properties because it diversifies us away from the stock market and gives us the prospect of passive income to be realized in early retirement. Hopefully well before we're 59. I'm currently 29 years old. The only hesitancy I have comes from recent news. Have you seen the stories about a 3D printer having built a 400 square foot home for $10,000?

What is your take on how this low-cost way of manufacturing houses will affect real estate investment returns from the perspective of a start or buy-and-hold rental property investor like me? What properties bought today will be least affected by the new technology? Will the technology-affected investment returns I'd anticipate earning in 15 to 20 years to a substantial enough degree that you'd recommend index funds as the safer investment? Thanks, Paula. I know you'll remove any potential bias from being in the process of developing a course

on real estate investing in answering this question. I'm looking forward to the course, by the way. Take care. So here's why I love this question. Fundamentally, the question is, how will new technology affect the real estate market? So if you strip the specific detail about the 3D printer away,

the broader question is, what advancements loom in the future and how will that affect real estate investing? And that is actually something I've spent a lot of time thinking about. And the time that I've spent thinking about it has been inspired by a book that I highly recommend. I'm going to also link to it in the show notes. It's called Be Inevitable by Kevin Kelly. Kevin Kelly is a founding editor of Wired Magazine. He was around to witness the birth of the internet. He was like, hey, look at this.

Nobody's claimed McDonald's.com yet. So he was around in the very early days, and he has this incredible book about what's looming on the horizon. And one of the primary things that he says, and by the way, Chris, I will specifically address the 3D printer later in the answer, but hold that for now. So one of the specific things that Kevin Kelly talks about is AR and VR, augmented reality, virtual reality, will be the next game changer. It will be the next electricity, the next personal computing, the next internet. It will be the next thing that changes everything. And some examples that he gives, right now, if you want to learn how to weld, you have to generally find somebody who knows how to weld, watch what that person does, and then try to mimic or imitate what that person does. In the future, augmented reality slash virtual reality will allow you to.

follow that person's hands and essentially be in that person's hands as they are going through the process. When I really stopped and I visualized that, like mind equals blown. I mean, in terms of the way that that will shape, reshape everything we do. Okay, so to take this to a real estate application, right now, if you want to tour some homes that you're interested in buying, yeah, you can pull up an app on your phone that would tell you how much the home costs. And you can pull up some other apps that will give you an estimate of what that home might rent for or what comparable homes in the area might rent for. And then you can kind of like squeegee together some numbers on a spreadsheet and do a little

bit of rudimentary math and try to figure it out. Imagine a future in which we all have the future equivalent of Google Glass, whatever wearable that is, contact lenses. Imagine some type of a future in which when we look at a home, in our field of vision, we immediately see the price to rent ratio. We immediately see the cap rate. So I wouldn't have to tell somebody, here's a link to an article that has a PDF of a spreadsheet about how to calculate cap rates. I mean, how horse and buggy is that when in your field of vision, you've got that information digitally available to you right away. That is the thing. That is. the future that I see. And imagine as you walk through the property, every item within the property

has some type of a digital record of when it was installed, when it was serviced, and by whom it was serviced. So when you see the water heater, you don't have to hold a flashlight up to the water heater to look at the label and be like, oh, it says here this water heater was installed six years ago, you know, you can just scan a QR code or whatever the future version, the future analog of a QR code is, and you can see exactly who the service technician was. So you can call that person back if there's an issue. Maintenance is going to be, I think, a lot, lot easier in the future once every item within the home is tied to some type of a digital record. And analyzing properties is going to be so much easier in the future. 3D tours of properties that tenants can take

will be incredibly easier. So anyway, I'm going off on a tangent a little bit about how excited I am about the effect that new technologies are going to have on real estate generally and real estate investing 10, 20 years from now. Now, to your specific question about 3D printing, I have a few thoughts on this. Number one is that I cannot imagine the mass market living in homes that are entirely 3D printed. I can imagine that being a niche market in the same way that tiny homes are in niche market today. So like the tiny home movement or the airstream trailer movement, like that's a rapidly growing niche.

That's not something that you heard about in the 1980s. But now it's avocado toast cool. Printed on avocado toast. Yeah, exactly. And that's great. I love that people are doing that. I think that's awesome. I've got friends who live in tiny homes.

but that is not enough of a disruptor to affect the returns in the mass market. Tiny homes, I respect them fully. They are a movement, yes, but they are a niche. And they're a niche that does not affect the general overall picture. Okay. I've got two things I'd say about this. Number one, so I went to engineering school, believe it or not. And I don't.

And I don't. I will not be posting a link to my diploma online, so forget about it. So I went to engineering school. I graduated in, I think, 2003 or something like that. And even at that time, I remember there being engineer stories about 3D printed houses out of cement, basically. I mean, you know, this idea has been out there for a long time. At the time that I heard about it, it was, oh, you know, wouldn't this be great for, like, developing world applications? because what they wanted to do is they wanted to basically use some sort of cement to 3D print.

So they would have some sort of machine that would go around like a printer head and deposit cement slowly in layers over and over and over again around and around. So anyway, that idea has been out there for a while. What I'd say about it is, you know, and I didn't read this article, but what I would say is probably, you know, when they were talking about, oh, you could build a house for $10,000, you frequently see these articles and they make, you know, pretty outrageous claims like that. It might be the case that you could build the frame of the house for $10,000 with the 3D printer,

but what about the cabinets? What about the sewer line hookup? What about the roof? You know, what about the mechanicals, the hot water heater, the furnace, blah, blah, blah, the wood flooring. You know, those aren't going to be 3D printed. Well, the flooring wouldn't be wood. It would be cured cement, I would assume?

Sure. So, yeah, the materials may change. Yeah, some of the materials may change. But, I mean, at least for this foreseeable future, I imagine that. that 3D printing a house wouldn't be a complete thing. It would just be maybe the frame of it mostly. You know, you're not going to 3D print a window into place. You know, that isn't going to happen anytime soon.

It might happen someday. But so that's like one thing is like that wouldn't probably represent the entire cost of the house. So I don't know how legitimate that number really would be, even if it were available today. Right. And today the cost of framing a house is not that high. Is A, not that high. And B, it fluctuates depending on cost of wood. Right. So the second thing I would say is that I'm pretty certain that you and I have bought a house that would cost less than $10,000 for the house. So when you buy a property... For the material cost, you mean.

Right. So when you buy a property, there's kind of two components to it, if you think about it. Like you break it down. One of them is the underlying value of the land. The other one is the value of the improvements on the land. So these are broken out even in your tax record separately. The under the underlying value of the land. The underlie is the value of the improvements on the land. So these are broken out even in your tax record separately. The under underlying land goes up and down with the market. The improvements on the land go down, basically. Right. The improvements, the materials, the materials. The house itself depreciates over time. So we bought a house one time for $21,500. I think I got it down to $21 flat. They were asking 22 and I offered 20. And then we had this big long negotiation where they were like 215 and I was like, uh-uh, 20. And we kind of, that went on for a while. I do not doubt that. So anyway, we bought a house for 21 flat. And, you know, it was a three-bedroom house in Atlanta. And I'm guessing that the value of the improvements, the house on that land, if you took that as a proportion, was probably, you know, close to zero. Because it had, because it was really depreciated. It was very depreciated.

Extremely depreciated. And not just in the tax sense of the word. Exactly. So would this radically change the market? I mean, not really. if that's the case because you can buy a house today that for the improvement value is probably close to zero. Right. So that can happen.

In certain markets. Sure. Sure. So that can happen. So for those reasons, I just wouldn't worry about this thing too much, this particular news story, because A, that number may not reflect the total cost of construction. I mean, there's a lot that goes into building house besides just permits. Permits. The cost of permits alone.

The cost of inspections. Anyway. Yeah. That's another tangent. There's a lot of different components that go into it. So, you know, I wouldn't worry too much about it, to be honest with you. I wouldn't let it stop me from investing. Right. That's for sure.

Right. Absolutely. Yeah. Yeah. It's the same thing is, well, you know, what if the stock market were to go down later in price? Should I buy any stock today? Well, yeah, well, you don't know what's going to happen in the future. So, sure.

Yeah, to that analogy, I mean, we do know that the stock market fluctuate. up and down. And we don't know what will happen in the future, but we do have historic data of what's happened in the past. And if we assume that over the long term, the future will generally reflect the past, I guess if we assume that history repeats itself, you know, we can make some generalized assumptions about what the stock market will do in the future. As far as how that analogy applies to housing, I mean, it is certainly true that technology has changed housing. It's much cheaper to build a house. Yeah. Well, you know what? Here's the thing. It is much cheaper to build a house now. Even in

inflation adjusted dollars, houses are larger. They have more square footage than they used to in the 1940s and 50s. But the construction cost per square foot is substantially cheaper now than it was 50, 60 years ago. Right. Because of technology. Right. We don't have to go in hand-hue slate tiles for the roof. We just get a bundle of asphalt shingles delivered onto the rooftop and a crew of guys just pounds them down in about, you know, half a day or whatever. Right. And we don't have to laugh and plaster walls. Right. Drywall. Man. Drywall technology completely changed. When, when walls were built from individual strips of, I mean, of laugh, yeah. Of laugh. That was a lot of People had to tack these little tiny strips of wood onto every square or almost every square inch of a wall onto the studs.

And then someone else had to come in and mix up some custom plasterer, you know, on site, you know, a plaster person had to come and mix it. And then they had to trowel it on really perfectly smoothly. Can you imagine how, I mean, even a very skilled person at a skilled plasterer. I mean, there's no way that that can compete with putting up a drywall. And it doesn't today. Right, exactly. But we still buy and invest in houses and people still make money investing in houses. Exactly, despite the fact that the manufacturing cost of walls has come down significantly. Right. And the manufacturing cost of roofs has come down significantly because of these technological advancements that we have.

So make a good decision today. And don't worry too much about that because this is just part of an ongoing price decrease curve that's been going on for hundreds of years in housing. Awesome question, Chris. Hey, hey, we'll be back to the show in a second, but first, I want to give a shout out to Fresh Books. They have signed on as one of our main sponsors in 2017, and they have an awesome product. It's meant for freelancers, solopreneurs, small business owners. If you have a side hustle or if you're self-employed and you need to send out invoices to your clients, yeah, it's necessary. You've got to send invoices to get paid, but it's also annoying and it's time-consuming and nobody really likes doing it.

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That's FreshBooks.com slash. We'll return to the episode in another minute, but first I wanted to let you guys know last year, and those of you who may have seen photos of me might have noticed this. So last year I lost 25 pounds, and I'm 5 foot 1. So 25 pounds on a 5 foot 1 frame is very visible. And made a big difference in terms of just what I could wear and what I couldn't, basically. like none of my clothes fit anymore. I kind of alluded to this on a previous episode. If any of you listened to the episode in which I chatted with Gretchen Rubin,

I kind of alluded to the fact that I needed to buy all of these new clothes because what I was wearing wouldn't fit anymore. The problem was that I'd buy new clothes and then I would lose five or ten more pounds and then that stuff wouldn't fit anymore because on a 5'1 frame, that's like fairly significant in terms of sizing. That was one of the many reasons that when the sponsor, La Tote, approached me, I was drawn to the service that they offered because they are a service that they're a subscription box that sends clothing and accessories to your door for one low monthly fee. And you can get as many totes as you want per month and you just simply wear it and return it and repeat it. And it's a particularly useful service for people whose bodies are changing frequently, like you.

Like in my case, I was losing quite a bit of weight. Like I bought a pair of yoga pants and then within three months, the yoga pants were baggy. So I went through a lot of clothing waste as a result of those body changes. And they have maternity totes as well. So for those of you who are expecting, you know, your size is going to be ever changing for nine months. And so you don't have to buy maternity clothes that you'll never wear again. So that is part of the reason that I like Letot. And frankly, the other part of the reason is the fact that they deliver.

And I don't like spending all day running errands. I would, on balance, I'd rather get something delivered to me than I would have to go out and get it. So that's another reason that I'm into them. If you want to check them out, go to Litote.com. That's L-E-O-T-O-T-E dot com to get started for as low as $39 a month. and enter promo code Paula at checkout to get 50% off your first month. So again, that's L-E-O-T-O-T-E dot com. If you enter promo code Paula, you'll get half off.

Once you sign up, you'll receive a customized tote within days. You can wear what you want, return everything in the mail when you're done, and repeat. So, L-E-O-T-O-T-E dot com, intercode Paula. Let's move on to the next question. Hi, Paula. I'm calling to ask you for your thoughts on where I should save the cash for my first investment property. I've been maxing out my 401k, Roth IRA and HSA for some time now, and would like to continue maxing out these savings goals.

My overall goal is to retire early. I'd like to purchase rental properties for the purpose of increasing my monthly cash flow. If I continue to max out my 401k, Roth IRA, and HSA, it would be really difficult to save anything in a regular money market account. Should I stop contributing to my 401k and just pay taxes on the $18,000 so I could speed up my savings for my first rental property? Thanks. So I love this question. Now, fundamentally, this is a question of should I save money in retirement accounts or should I save money for? a rental property. That's a question, Will, that you and I grapple with like every day,

basically. Yeah. Here's some money. What should we do with it? Exactly. I mean, because there's so many options that you could take and, you know, everything has a positive future benefit that you're talking about here. Exactly. And what I love about this question is that it is fundamentally a question about prioritizing because the deepest money questions, I suppose, are the ones in which you are asking about priorities? Is it more important to do X or to do Y? What do I want in my life, basically? Exactly. And since this person wants to retire early, I very much believe in the numbers, assuming that you buy the right rental properties, and believe me, that's a big if, assuming that you buy the right rental properties, if your goal is early retirement, rental properties can help you get there

faster than index fund investing. And I say that as somebody who loves index funds. I am the biggest index fund fan. Like, I need a hat. I need like a trucker hat. Like number one index fund. No, I don't have any friends. Be careful what you wish for. Your listeners might send one to you. I'm not hinting at anyone here, by the way. You know, I think that, you know, yeah, exactly what you say. It's a question of priority. It's a question of, of, you know, what you're trying to accelerate toward. The thing about rental properties very broadly when you're using loan money to buy them is that does add an element of leverage and leverage can help accelerate, you know, the growth of a portfolio. It's a, yeah,

it's a lever. It's a lever. It's a lever. So it works both ways. A lever can, like, propel you up faster. A lever can also put you under faster. Right. That's why I think leverage in moderation for rental properties is fine, but like absolute moderation to a degree, you know, most- We use leverage and we use it very, in my opinion, in a moderate way. Yeah. Like we don't want to go all cash necessarily, but we have a kind of a ratio range that-

Of about 50%. About 50%. Our overall portfolio, we hold a- about a 50% equity position among all of our houses together. So we have some houses that we own free and clear and some houses that we don't own free and clear, some houses that we have mortgages on. If you take the entire basket, and this is just us, I'm not saying this is what you should do, but for just us personally, we've decided that we want to hold at least 50% equity and the other 50% leverage. And we're not comfortable having a

any more leverage exposure than that. And in the eyes of many real estate investors, that makes us incredibly conservative. And I often get made fun of by like the really hardcore real estate investors, you know, who will leave comments like, well, if you hate risk so much, why don't you just put your money in a CD? In your sock drawer. Yeah, exactly. It's usually, I think, younger investors who haven't been burned yet, because I think that older investors, even if they continue to do a high leverage thing, they understand why someone would choose that. Yeah. Yeah. Yeah, they understand the risks. So anyway. Yeah, anyway, but to get back to, I feel like we're going off track a little bit, to get back to your question, one thing that I noticed when you asked your question was that you

asked, if by virtue of not putting that money into a 401k, HSA, IRA, should you just pay the taxes on it? Don't let taxes drive your investing decisions. Make an investing decision first based on the qualities that you use in order to make investment decisions, which are risk, reward, lifestyle goals. So make an investing decision first. And once you make that choice, then figure out how to tax optimize that choice. But if you make decisions based purely on the tax structure, you're letting the tail wag the dog. Exactly. Yeah. Yeah. You don't want to let taxes run your life. life like that. Yeah, exactly. It's not a good, it's not a good strategy. Because every, because every investment you can make has some sort of tax consequence. And by virtue of the fact

that there are many different investment strategies, we can kind of ascertain that there's no perfect tax situation. You know, with real estate, you can depreciate the asset. And that gives you some tax advantage. Whereas if you put your money into an IRA or a 401k, it's tax advantage today. Whereas if you put it in a Roth IRA, it's tax advantage for the future. But, you know, you can't let that tax implication be the deciding factor. Right, exactly. And yet, so you bring up a couple of good points. So number one, yeah, real estate itself also has a whole bucket of tax advantages.

Once you buy a property, as we mentioned earlier, that property depreciates, which means that you can depreciate the thing that you bought immediately, starting with that first tax return that you file. When you make improvements, you can, and this is a little bit of a double-edged sword, if you make a a repair, like a short-term repair, that whole thing is a tax write-off in the year that you make it. If you make an improvement, such as a new roof or you put in new windows, that gets depreciated over the life of the roof or the life of the windows, which is kind of a double-edgedged sword. It sucks in the year that you do it because you've spent all of this money and yet you can only write off a fraction of the money that you spent.

So it sucks that year. But it's great for the following 26 years, or however long the depreciation of that. material is because in all of those years, you're not spending the money and yet you're still getting the tax advantage. In addition to that, normal business expenses that are associated with the operation of your business, those are all tax write-offs. I think it was the interview earlier on this podcast that we did with Joshua Sheets. I think it was the Joshua Sheets interview. he mentioned that he believes that the tax write-offs of traditional retirement accounts, 401Ks, IRAs, HSAs, are kind of overblown. I'd have to go back and re-listen to the podcast to make sure that it was actually him who said that.

But he or somebody that I interviewed in one of the past episodes brought up the point that, you know, there are a lot of people, and this is a little bit of a different topic because this was the topic of should I invest in a 401k versus use the money to start my own company. like my own actively managed business. And this guest made the point that when you make a contribution into a 401k or any other type of traditional retirement account, the tax benefit is clear. If it's a traditional account, then you can deduct that money from this year's earnings, plus that money will grow tax deferred while it's in the account. If it's a Roth account, then that money grows tax exempt. And when you take out that money, you get that money without pay. any taxes on the capital gains and the dividends. So the tax advantage there is clear. It's the tax advantages of a business are not quite as clear. They don't make quite as good of a sound

bite. But when you have a business, there's so much that you can write off. And granted, if the conversation is actively managed business, I mean, we're talking plane tickets. We're talking meals. We're talking, going to conferences. Your laptop, if you use it for business purposes, exclusively for business purposes, that's something you can depreciate. your internet connection, your cell phone. I mean, there's expense after expense that you can legitimately claim on your taxes with the help of a CPA. Yeah, it's super nice owning a business.

Yeah, that's pretty great. You've got to be honest. And now, granted, the tax structure for a rental property is not the same because the IRS views rental properties as passive income. So it's not just me who's sitting around saying, oh, this is passive income. Like, the actual tax designation of a rental property in the IRS's eyes is that it's passive income. And that means that you can't write off the same type of business expenses on a rental as you could for an actively managed business. But there's still a whole bunch that you can do.

But that being said, all of this is going off course to the original point, which is don't let the tail wag the dog. Yeah, yeah. You know, if you want to start building cash flows today, then for the most part, and there's some, you know, caveats and whatever that Joe could chime in with on and has chimed in with on some other Ask Paul episodes. But for the most part, putting money into retirement accounts has kind of a, you know, a time. A limited upside. A limited upside and a time component to it. Whereas investing in, you know, it isn't going to help you maybe as much for early retirement because that money you mostly can't access it. Again, there's a big old asterisk there and I don't want to

go into that. But with building a passive business or an active business like, you know, rental property, then you can start benefiting from that immediately. Yeah. Well, I mean, going back to our earlier conversation about cap rates, how cap rates are analogous to the dividend on a stock. So if you have a property that is an eight cap, then you have an unleveraged 8% cash return relative to the value of the asset, which is analogous to getting an 8% dividend payout on a stable blue chip stock, which is awesome. You can say that again. Well, I will. So here's what I mean by that.

An unleveraged cash return relative to the value of the asset. That's a lot of big words. Here's the breakdown of that. The asset is a fancy person term for saying house, for a lack of a better. All right. So you have a house. It costs $100,000. For the sake of simplicity, we assume that you don't have a mortgage on it. We can get into that in a minute as to why we assume that. For the sake of simplicity, let's assume that you own this $100,000 house free and clear. And then let's assume. And so the way that a cap rate is calculated is that first you take the potential gross rent, which is how much would it rent for at full occupancy. Then you add in any additional money that you would collect, such as pet fees, laundry fees, parking fees, anything else like that, storage fees that you might collect. Then you subtract out a reasonable estimate for vacancies. And then what you have left is what's called the effective gross rent.

And then from that, and this is all going to be in an article that I linked to in the show notes at afford anything.com slash episode 78. So from the effective gross rent, you then subtract out your operating costs. So those operating costs include management, maintenance, repairs, literally any cost that is relevant to the operation of that property. And then you're left with X amount of money. And that X amount of money divided by the $100,000 that the house cost equals your unleveraged cash return relative to the cost of the property. So it's your net operating income divided by the cost of the property. I can't believe I can do that like off off the cuff.

Threw that one down. Nice. Boom. Drop the mic. No, don't drop the mic. This is an expensive mic. It's also a clip to you.

Oh, well, that would, I do some push-ups. Do some push-ups and then fall face first into the floor. That would be how I would drop this mic. Drop the host. All right.

So, anyway, my point is if you, if after running that calculation, you have an eight-cap property, then you are effectively getting, getting an 8% dividend on that $100,000 house. And that $100,000 house, I mean, it's not a perfect analogy,

but it's kind of analogous to a stable blue chip stock in that the value of it isn't going to swing wildly in the way that, you know, some small cap stock might. The value of it is going to be relatively stable. And even if we assume that it doesn't appreciate it, even if we assume that it merely keeps pace with inflation and nothing more, or who the F cares because you're getting an 8% return. That's why I love the cap rate equation so much. We aren't making any assumptions about whether or not the property might rise in value in the future.

Because you know what? We can't control that. We cannot control what the market's going to do in the future. And that's why focusing purely on the cash return that we are getting today. And by cash return, what I mean is cap rate, because of course, if you finance into a property that's going to affect the actual cash in pocket that you get today. But if you separate out the financing and you look at how good of an investment is this property itself, then you know, hey, this is a property that produces an 8% dividend or a 7% dividend or a 9% dividend. And if the property produces that kind of a dividend plus keeps space with inflation, which is like another generally over the long term roughly 3% if you look at historic averages, well, that's a pretty effing good deal. Yeah, I'd buy those all day.

Yeah. So now drop the mic. I think we got way off track. Yeah. Yeah. So what do you want with your life if you want to retire? Oh, so yeah. So early retirement.

So that is the reason that I believe that rental properties are a better path to early retirement. than index fund investing. Now, that being said, I love index fund investing, and I understand that rental properties aren't for everybody. Some people just aren't interested or don't want to do it. And so I'm never ever going to say, hey, you, I'm never going to like stand there and wag a finger and be like, well, you have to invest in rental properties if you want to retire early. Also eat your vegetables.

I'm never going to say that because I get it. Some people don't want to invest in real estate. Cool. But if that's something that you're interested in doing, and if you're interested in early retirement, well, then do it. Cool. So, wow, that all being said, afford anything.com slash episode 78 is where you're going to find all of these links. And I think we're running low on time. So I think this is going to be a three episode question, a three episode, a three question episode.

Want to go eat some avocado toast? Yeah. How much does that cost? I think $19. Sounds reasonable. Four bucks for a latte. Well, we should definitely buy a lot. latte too.

Ooh, buy two lattes. You can get two for eight. Whoa. How many would four be, though? Not sure. We may need a spreadsheet for that one. Yeah. Yeah.

Thank you so much for tuning in. My name is Paula Pant, host of the Afford Anything podcast. If you enjoyed this, please do me a favor. Number one, head to iTunes. Leave us a review. Those reviews are really helpful in helping me make the show better and helping us book awesome guests. Speaking of awesome guests, coming up next week,

Laura Roder. She is the CEO and founder of a company that does $4 million in annual revenue. It's a software company, which I think is awesome because I, and Laura and I chat about this, I don't meet many, frankly, I don't meet many women who are at the helm of multimillion dollar software companies. So we chat about that for a while. She bootstrapped the whole company. So we chat about that. We walk through her entire history, starting with when she was 22 and working a like a 9 to 5 job and we talk about how she left that to go become a freelancer and then a consultant and then start a software company that blew up into the big success that is today. So that's coming up on the next episode.

Please also, if you are a fan of the show, head to afford anything.com slash who are you? Who are you? Who are you? And fill out a survey telling us who you are. That survey is super helpful in helping us land sponsors and those sponsors, key. the editor Steve paid. Give yourself a round of applause, Steve. Can I make those requests of Steve yet? I'm not sure I'm really that in the podcast yet, but okay. I will mail him an avocado.

Oh, yeah. Finally, a couple of completely, if you want more of me, here's where you can find me. I've started a YouTube channel, which is a lot of fun, actually. I'm really enjoying it. So YouTube.com slash afford anything. You can hear previous episodes. We've got the audio of most of the previous episodes on YouTube. And I've also started creating videos with my face.

And they've got turtles and they've got frogs. And we talk about real estate too. Those are like four of my favorite things. Aww. Aw. So YouTube.com slash Afford Anything. Check it out. All right.

This is Paula Pant, a host of the Afford Anything podcast. I'm Will Sisk. I'll catch you next week. Bye bye. New York Times has an entire article called FACTS. checking mogul's claims about avocado toast. Avocado toast is blowing up. And there's comment on it.

Hello, it is me, Token Millennial, and I love avocado toast more than I love the idea of buying a home and filling a garage with junk.