Many of my old school clients, though keenly interested in the concept of discounted notes secured by real estate, wonder why I counsel them to add notes to their overall Purposeful Plan.
It’s entertaining to watch them slowly transition into complete discounted note evangelists, at which point they wonder why they even own as much income property as they do.
I usually tell ‘em to pull back on that throttle a bit.
Here’s an incomplete list of reasons why I would advise clients to stay invested in both real estate AND notes.
4 Arguments for Investing in Real Estate AND Notes for Retirement Income
1. Multiple sources of income is rarely a bad idea because it is more secure — and more fun.
The vast majority of those I advise arrive at retirement with two or more income sources.
Sometimes the same vehicle is wrapped in more than one ownership “envelope.” For example, you might own notes in both your name and a qualified retirement plan like an IRA or 401k, be it traditional or Roth in nature.
Related: How Has Your Retirement Plan Been Workin’ Out For You Lately?
The only practical differences between the notes you and your plans own are tax issues and when the income becomes available. When you own them, the income is available from the first payment on. You’ll pay taxes on the received interest at the income tax rate you pay at work.
If your plan(s) own notes, the payments aren’t taxed as long as they remain inside the 401k/IRA. If any of them are Roth, they’re not taxed as they come out either, as long as you didn’t take the income out before the regs allowed it. That’s almost always 59.5 years old, with rare exception.
NOTE: The infamous 70.5 year birthday on which the government then begins forcing you into taking more income (read: your principal) doesn’t apply to Roth IRAs. It applies to other Roth plans, and yeah, I know it makes no sense.
But that’s why I have investors transfer from say, a Solo 401k (Roth) to a Roth IRA before they reach that “deadly” age. As a rule I like to have them do it annually or at least every couple years. It’d truly suck like a Dyson if they’d waited ’til the last date only to find the government had changed the rules in the middle of the game. Would they do that?
By having more than one source of retirement income – each source independent of the others – the investor can afford to feel a bit more secure if Murphy visits the economy (or you personally). Typically the various sources provide their own solutions to acquiring cash, dealing with downturns or outright emergencies. Having multiple income sources allows more options when dealing with urgent cash needs or taking advantage of new opportunities.
Keep in mind the BawldGuy Axiom: The one with the most options wins.
2. Though note profits are built in, they don’t tend to appreciate the same way real estate does.
They can, and I’ve seen their value increase over the price I’ve paid, which allows for a profit merely by reselling the note. I know, cause I’ve seen them do it. Generally though, that’s the exception and not the rule.
The built in profits created when buying discounted notes secured by real estate aren’t the same as profits generated while investing in real estate. That is, the appreciation of real estate value can far exceed the built-in value “appreciation” of discounted notes.
Here’s what I mean.
If you buy a note with an unpaid balance of $100k for a price of $75,000, you’ve made a total of $25,000 profit, when the note eventually pays off in full. VERY simply put, you made just over 33% profit, when only principal in and principal out is measured in terms of yield.
However, if you put that same $75,000 into an income property valued at $300,000, there’s no “built in” profit. If over time the property experiences some consistent rise in value due to market appreciation, profits materialize. Furthermore, due to your 25% down payment, every 1% of value appreciation is really 4% capital growth for you. 1% of $300,000 = $3,000. $3,000/$75,000 = 4%.
For example, if that property rises in value for 3 consecutive years at the annual rate of 8%, the value would then be around $378,000. Even with selling costs of roughly 8%, your profit remains nearly twice that of the note. That doesn’t even take into account the fact that the note is far more likely to take longer than 3 years to pay off.
Notes will generally have a higher cash on cash return than will real estate. This assumes the investor hasn’t compromised location quality for the mirage of higher cap rates, a common mistake.
3. If significant inflation rears its ugly head, having real estate makes you less vulnerable to the lost purchasing power of the dollar.
This is owing to the fact that both real estate prices and rents have shown a propensity to “track” inflation. Put more simply, property values and rents tend to rise along with inflation. We like that, right?
When inflation strikes, our buying power weakens.
When in the 1970s we saw double digit inflation for several years, we were all forced to batten down the hatches. Our family budgets suffered big time.
Related: Investing In Real Estate Is Better For Retirement – PERIOD!
The silver lining, though, came from income property values and rents. Since they’ve historically tended to track inflation, more or less, real estate investors were able to increase their overall cash flow per month. For example, San Diego duplexes sported values in the mid 70s of around $30-45k, give or take. By 1981 duplexes were selling at $100,000 and more. Inflation had been the real estate investor’s friend. Since the interest rates were fixed, the increase in rents over those inflationary …read more