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August 03, 2012

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Any major drop will impact everyone. If you think back to your basic economics class, prices are based on supply versus demand. A major drop like this will hit everyone. Buying of goods will be cut back, increasing supply and those trying to sell those goods will have to drop the prices.

I think overall, people need to look at the long term. We typically have major hits to the market every 10 years or so. We will probably hit another one in the next several years and the typical panic will ensue. Like previous hits, if you have enough money liquid, this could create another buying opportunity (just like it did for many back in 2009).

Just keep yourself diversified and have enough in emergency funds/liquid, and you can ride out the storm and perhaps profit from it.

I was under the impression that overall monetary inflation is low and well within historical norms? I keep hearing the phrase "printing money like crazy" but I have not seen any proof of this statement either in inflation or actual reporting. Am I missing something? Can someone comment and cite some real sources? I am not a econ person either, so any information would be helpful.

I had this same fear about a year ago and ended up picking up a couple of investment properties. I bought one outright and put down 50% on the second w/ a 2.99% 15 year mortgage. It took about 3 months to get them rehabbed and rented out and now they're both cash positive investments. The process has been so smooth I'm thinking about picking up a third when home prices start to drop in the fall/winter.

MonkeyMonk --

So far, this is the answer I've come up with as well. Next week I will give details on how I've started this process. I'll look forward to your comments since you're a few steps ahead of me.

It's surprisingly hard to predict the future, even for someone who has been trained in economics and finance. My rule of thumb, generally, is that investors shouldn't listen to much to someone who is trying to sell them something. This rule is particularly true imo when that person uses fear to sell their products. e.g., the Marc Fabers and Peter Schiffs of the world.

In the information age, there is so much noise out there that it is nearly impossible to figure out who knows what they are talking about and who is just talking. This is particularly true when we have no consistency or clear vision from our governments and central banks. That being said, however, the successful investors I know do three things really really well: 1) they educate themselves on what they are buying; 2) they hedge well against the downside and don't really ever try to "hit it big" on one particular investment; and 3) they remove their emotions from their investment decisions--they don't let fear, greed, or hubris drive their decisions.

And for what it's worth, the Fed isn't printing money. They are manipulating reserves and the overnight interest rate -- anyone who says otherwise, doesn't understand modern monetary operations.

PS. Love the blog--keep up the great work.

>What do you do with your money to never lose it (either to a market crash or inflation)? Do >you invest in gold, commodities, real estate, or something else? 

First there is always a risk of losing money- the real question is what is most likely to make money. My thought is that the future is too unpredictable to to try pick just one investment class. Instead have a diversified portfolio including a bit of everything. Then if the pundits are wrong, you still have some of the investment class that they claimed were oversold but really weren't.

As for buying real estate directly- Interest rates and home prices make this a good time to buy- however there are some significant down sides: Transaction costs are very high due to closing costs and commissions. Your purchase is not diversified- you are buying one particular home in a particular location, not thousands all around the country. There is a large minimum investment- I can't invest $200 in a home this month. Finally you have the management costs, and a lot of extra work and responsibility. I think there is good money to be made, but I'm not sure that I want all of that hassle. When I can invest in a REIT get diversification, low transaction costs, very low minimum investment and someone else handles the management. The big down side is I don't get the same amount of leverage.

@Money Monk how did you manage to get a 3% mortgage for a rental property? I was under the impression banks usually added a few percent on an investment property over primary residence.

-Rick Francis

I've prepared by being mostly in cash and bonds that mature within 6 months. Very little in equity, and only in companies that pay big dividends.

Is inflation beating my return? Yep. Do I care? Nope. I can make adjustments to offset my portfolio's inflation deficit, but I can't do anything to make up for half or more of my retirement nest egg going "poof."

Strong caveat here that I am not an economist and I am referencing some articles that I read a while back and don't have the source. This is a high level point just for basic understanding. (enough caveats?)

The reason that the US is not undergoing inflation follows the basics of supply and demand. Before the crash, there were loose lending standards and high investor confidence. A larger than normal portion of the available money supply was being used and invested rather than saved. After the crash, the government has been "printing money" or adding money to the available money supply but at a much smaller rate than the level of contraction among the rest of the market. As private sector liquidity shrinks, the available money supply shrinks. The US government is large but can't fully stem the tide of the shrinking money supply so we have very low inflation and if you remember there was a fear of deflation even as the government was trying to pump money into the economy.

Will the Fed get the timing right to pull back on the goverment liquidity as the private sector expands? The government will need to dial back and ultimately reverse the current policies.

As individuals and corporations work on improving their balance sheets, the available money supply goes down. (Remember I am not an economist). Summary here is that there are some very strong economists at work here so don't worry about all the sound bites.

Curt --

For now that works. But what if inflation spikes like some are saying? Doesn't your cash go "poof"?

I think faber is one of those constant doom and gloom guys. It is pretty hard to predict the future. That said if you are worried I would hope that real estate would keep up with inflation again now that it seems to have bottomed. I am not too worried about it right now though. On the plus side savings account interest rates would go up [email protected]

First of all- nobody has a crystal ball and can predict the future. Predictions with a date attached are notorious. With hindsight, you could always find people who got the timing right. Mr. Faber is notoriously pessimistic and predicted crashes after the 2008-9 drop.

I read a great book called "Unexpected Returns" by Ed Easterling. Basically it is an analysis of stocks and bonds over the past 100+ years. Basically it looks at the statistical impact of gaining in the market over different periods of time, some as long as 20 years. At the moment we are in a secular bear market, and have been in one since 2000. You can see that the DOW has barely moved since 2000 and had a lot of volatility in the process.

Volatility and years of negative returns can compounded returns of your portfolio. There is a big difference between arithmetic (average) returns and compounded returns, and volatility and negative years can ruin the compound return rate...

The biggest impact of getting better returns is the starting P/E ratio, and compared to normal historical secular bear markets we are still pretty rich.

Interestingly enough P/E ratios tend to fall when there is a perception of high inflation or high deflation in the market. This is the opposite of monetary stability and investors sell in the face of this uncertainty. This is when I am looking to buy into the equity market- it happened a little in 2008 / 9 but not for long with all the liquidity released from co-ordinated central banks. With all the debt incurred today, it would seem difficult to repeat this in the event of another market crash so Mr. Faber may have this on his side.

I've invested in some bonds / funds that are paying distributions on residential rentals and that is the extent of my investments. I will be making investments once P/E's starting coming down across the board, and would like to invest in relatively big, stable, dividend paying stocks. That seems like a good strategy.

Of course YMMV. Continuing to work and save a lot is probably the most risk free strategy that I can think of.

-Mike

PS- looking forward to see Old Limey's comment on this.

Correction on the first sentence, 3rd paragraph above:

Volatility and years of negative returns can ruin the performance measured by the compounded returns of your portfolio.

If inflation spikes then interest rates will rise dramatically. I can remember not too terribly long ago when 1 year CD rates were around 6%.

It's all relative....

I tend to not put much faith in economists/experts etc. who make predictions that aren't backed up with an investment. Its the old put your money where your mouth is argument.

For instance, anyone can get on TV or the internet and predict that inflation is going to go through the roof, we will lose 50% of our wealth, gold is going to double in the next year, the sky is falling, and on and on and on. Generally, these people are either selling you something or trying to take the opposite position that they sell (if for some reason they think they have enough influence to move a particular market). Sometimes they are right, sometimes they are wrong. Either way, they sell their newsletters/stock picks or whatever.

Google the individual mentioned in the above article. While it does appear that he does some financial advising, he also *shock* sells a market commentary report.

If you do your OWN research and believe that inflation is a possibility in the future, you have a couple of options.

First, for the fixed income portion of your portfolio, check out Treasury Inflation Protected Securities. From the website: "Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater." They come in 5, 10 and 30 year varieties and are exempt from state income tax. You can buy them directly through treasurydirect.gov or through a broker. For those who love Vanguard, check out Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX). Had you bought this security back in 2002, you would have doubled your money in 10 years.

Note that the way TIPS operate is that inflation adjustment isn't actually paid to bond holders until the maturity of the bond. So as a taxable holder of individual TIPS directly, you are being taxed on a cash flow (inflation increase) that you haven't received and won't receive in a long time. That's a negative present value problem. A TIPS mutual fund, on the other hand, is required by the IRS to distribute virtually all of its income, and so a TIPS fund distribute both the real coupon income and the inflation increase in the value of TIPS, provided that inflation is positive.

Just know that if you buy TIPS or a TIPS fund, you will have to hold it to maturity to see the best effects. For an investor who is subject to tax, direct holdings of TIPS are somewhat inefficient, because the Treasury characterizes as ordinary income both the real coupon income that's earned and the adjustment for inflation, which is typically upward.

For the equity portion of your portfolio, the general rule is that stocks will act as a hedge because the companies will generally pass on the inflation to the consumer in terms of higher prices. Several studies have found that this is not the case. With real estate (like buying rental houses) the idea is that you can raise rents as inflation increases and hedge against it. Gold, commodities and REITs also act as a hedge against inflation. The technical term is that they are positively correlated to an increase in the Consumer Price Index (CPI). CPI is our measure of inflation - when inflation goes up, so do the returns on Gold, Commodities and REITs. If you want to see a chart of how different asset classes correlate, check out: http://blogs-images.forbes.com/greggfisher/files/2012/03/inflation-correlation-03-02-2012-v2.png.

The bottom line is to stay well diversified regardless of the market. You may have heard this advice (for free) many times before here on FMF!

I think rental properties is the way to go too. The rent will increase when we have inflation and the money owed will worth less.

The Inflation Chicken Little's have been warning about this ever since the 2008 crash and the loose monetary policy that followed it. So far inflation as measured by the CPI has been more mild the last 4 years than at any time in the previous 20. Some will argue that the CPI is not a valid measure but I can't really argue with people's ideas about inflation or some conspiracy theory about government shadow numbers. Others will argue that price inflation is not the real measure of inflation but that inflation by definition is the increase in the money supply which dilutes the value of each dollar. If they want to define inflation that way more power to them. If it doesn't increase my prices I don't care what they call it.

Eventually inflation will increase. How high it will go I do not know. But it could still be many years before it happens and the increase could be mild. The economy is so weak right now that any rapid price inflation is not possible.

However if inflation does start to increase significantly most assets will go up with it. Hard assets will go up (metals, real estate, etc). Stocks will also go up because they will have to raise their prices which will increase their revenue and eventually their profits. Of course in the short run of a few years things could go the opposite direction but in the long run inflation raises the nominal price/value of every single asset. Bonds are you borrowing money to someone else and that is a bad thing to do during inflation. During inflation you do not want to be a lender. So bonds will go down as interest rates rise (bonds move in opposite direction of interest rates). Cash is not an asset so its nominal value stays the same and is thus able to buy less of every other asset which has increased in price.

However as someone pointed out interest rates will rise dramatically in that environment. The last run of inflation we had was in the late 70's and early 80's. People may not realize that the fed funds rate topped out at 20% in 1980 when this inflation came. It is now 0%. So even cash will be able to be invested in an interest bearing account that will keep up with inflation. If you had long term CDs at lower rates you will lose out until you can roll them however.

Frankly, except for hyper inflation which is not something you can adjust to, I do not see the big fear with a mild increase in inflation. In fact I would welcome it.

So the worst place to be during inflation is to be a lender. that means the best place to be is a borrower. Your borrowed money is paid back with dollars worth much less. Your debt literally shrinks during inflation.

So given that where is the best place to invest if you expect inflation. I would argue real estate. Why? Because of the dreaded D word, debt. As I already discussed inflation benefits debt holders and it does so to a drastic degree. If you have a property that is worth 100K that you put 25K into and 75K of debt and then it doubles in price due to inflation, you just turned your 25K into 125K. 400% return. And that doesn't count the return you make on a cash flow basis by renting it out. As wages rise with inflation your rents will follow the same pattern (although they will likely lag appreciation). If you buy real estate with 100% cash then it is not any better of an investment during inflation than anything else. It's the debt that makes real estate the best inflation hedge.

BTW, inflation is a big benefit to the U.S. debt situation as well. If everything were to double in price over 10 years including the U.S. economy and GDP that would in effect cut the U.S. debt in half without paying down 1 dollar of it.

@retirebyforty.

We agree. You are more succinct. :)

I emigrated to America in 1958 after leaving England in 1956 and spending 2 years in Canada. I agree with Mike Hunt that the future is unpredictable, but I listen to lots of experts and read a lot of what they have to say.

I am apalled that our budget deficits and our national debt have grown so enormous. It's ironic that ordinary people like all of us cannot live that way but the government chooses to.

Wouldn't it have been great if our national government had to live by the same rules as the states, and didn't have the power to spend money they don't have, run up a big tab, and then just print more money.

Reagan was the first president to start us down the road of deficit spending with the concept of Trickle Down economics. The last president to have a budget surplus was Clinton, and he actually said that if Al Gore has succeeded him and continued his plan that the national debt could be retired by 2008. We all know what happened to Al Gore's presidential run - it was thwarted by the Supreme Court.

The next big blow to our economy started after 9/11 with the war in Iraq and the hunt for WMD that they were supposed to have but that were never found. That then led us into the war in Afghanistan which added more and more to the deficits. As if this wasn't enough, along came the greatest recession since the Great Depression. If you study the charts of this recession it is unlike all of the prior recessions we have ever had, and the recovery is still many years away. This recession bloated the deficits greatly as the government stepped in to bail out GM, AIG, Fannie Mae, Freddy Mac, and a host of banks and other large companies, as well as extending unemployment and food stamp benefits etc. As if this wasn't enough we also had the bursting of the housing bubble which has had a colossal impact of the wealth of the country, particularly those of working age.

I am almost 78 and people of my age haven't been hurt like the younger people, we also had the opportunity to benefit financially from the dot.com and real estate bubbles. I'm one of the very lucky ones, I happened to be in the right place at the right time and have no regrets on a single one of the biggest decisions I have made in my life. These days my wife of 56 years, and myself live a very tranquil, quiet, happy life, and stay home most of the time. I stay busy keeping my garden looking beautiful and growing lots of vegetables.

My financial chart analysis near the end of 2007 showed me that the stockmarket was heading into really bad times. I was also wealthy enough by then that I relished the opportunity to move into the slow lane and settle for investment income rather than investment capital gains, and that's where I still am. I hold municipal bonds in our Trust account and investment grade corporate bonds in our IRAs and earn between 4.5% and 5% tax exempt and tax deferred. Unlike one of our presidential contenders I keep my money in the USA rather than in Swiss banks or offshore trusts in places like the Cayman Islands & Bermuda.

I don't let fear or outside proclamations from media dictate our investments. The financial media, whose job it is to sell magazines and advertising, will not alter our long term plan.

Regardless of what experts say, I'm confident that by saving and investing in diversified index funds, I'll be comfortable in the future. Yes, the markets will swing widely at multiple points in the future and there will be bad times ahead, but there will also be great times.

Macro-economics can be complicated, so compare it to your own personal finances (something we all enjoy):

If an individual goes deeper in debt, sooner or later the lenders will a) want their money back, b) start charging you a higher interest rate, or c) you default, impacting ability to get a future loan.

In the governement's case, they can a) repay (unlikely), b) default (unlikely), c) pay higher interest rates because the loan is riskier or d) inflate and devalue their currency. Options b-d don't sound too appealing.

This isn't a perfect example, but a directional illustration. At the end of the day, we can't continue to run trillion dollar deficits and not expect recourse.

I'm in agreement with others - tangible assets (real estate) are the way to go.

All --

Just to be clear, the guy I quote above is from the media, but the others I refer to (wealthy individuals) are not. They are "regular people" just like you and me.

Now perhaps they are influenced by the media, that could be happening. But I wanted to be clear that my questions for you above are not solely based on reactions to one guy in the media -- far from it.

Real estate assets are very popular with many people. I just have our home and a beach condo near Santa Cruz, CA which I bought many years ago. As owners we used to spend a few weekends there but rented it out to vacationers quite a bit. It used to get a little tiresome having to go down and dispose of junk that people often leave behind, as well as doing some maintenance in between renters.

The big advantage of a rental is that you can get a nice tax writeoff. Over the years the writeoffs saved me a lot in taxes. However, now it is fully depreciated tax wise but has appreciated greatly in value. It's not a problem for me, but if I really needed to sell it I would pay taxes on almost its total value. The other alternative that I have elected, is to just leave it to my son in our will. That way he will receive a completely new tax basis based upon its value when he inherits it. I also used to invest in tax shelter partnerships that also saved me a lot in taxes, however Ronald Reagan did away with these kinds of partnerships but lowered the highest tax rate.

My bottom line is that owning rentals is fine, apart from sometimes having to deal with really bad renters, but the biggest problem is the taxes you will owe if you decide to sell. You can do a 1031 exchange into "like" property but it's hard to get your money out of a rental that you have owned for 25 years or more without facing severe tax consequences.

This is a problem that doesn't exist with bond investments. If I buy some longterm bonds with a $1,000 coupon value per bond, the bond pays me half its coupon interest every 6 months and then when it finally matures it gets redeemed for $1,000/bond no matter what its bond price has been. In actual fact what happens is that as a bond gets closer and closer to the date at which it will mature, its price will move steadily, up or down, until it reaches the $1,000 coupon value.

You can also own bonds using a bond mutual fund. I recently had a lot of bonds in our IRAs called and decided to invest the proceeds back into the IRAs into a PIMCO institutional income fund earning over 6% in taxable income with a 0.40% management fee. The fund has a $100K min. purchase but there is another class of the same fund with a $2.5K min. purchase but with a 0.7% management fee. The advantage of owning a fund over owning individual bonds is "liquidity". You can sell shares in a fund any time you like but selling individual bonds can involve considerable fees and may take a lengthy time.

Bottom line - Always think about the future tax implications of any investment.

@FMF,

I don't actually find the media to be the one who usually over hypes this. You may recall there have been a few posts on your blog over the past 3-4 years either about inflation or where the comments took a turn toward inflation. In each of them I have taken the stance that inflation is currently nearly non-existent and it appears there is minimal risk of it showing up in the near future. I have taken that stance for at least 3 years and I feel the exact same way today. Of course that is just my opinion and it's worth about as much as anyone else's opinion.

However, in my comment above, I started it off with a reference to chicken little's for a reason. Someone who claims the sky is falling cannot continue to do so for an extended period without anything catastrophic happening before their credibility should be severely damaged. The Ron Paul cohorts and the ban-the-fed cohorts (that may be redundant) are prime examples of the chicken little situation I am referring to, but there are others too.

I am not sure where you are hearing "new" claims of inflation disasters. I have been hearing them for 4 years. I still see no evidence it is on the horizon.

But even if it comes, I don't see any serious disaster for those of means. Unless they are holding mostly bonds and continue to hold bonds through extended inflation or hold cash in a mattress, they should be just fine.

I don't put much of any weight in the economic talking heads on TV. Their track records are awful and I have no idea why we'd trust them to predict the future any better than anyone else. It just boils down to one economists opinion and if they could really predict the future of the economy with acuracy they'd be a billionaire not hawking a newsletter by getting on cable TV. 50% wealth loss within a few years is pretty excessive doom and gloom prediction. Even from someone who writes the 'gloom,boom,doom' report. Marc Faber is a broken record making perpetual doom and gloom predictions about the economy. I don't know why people put sooooo much weight into the negative predictions. If someone on TV in a suit said that the economy will grow 8% next year and rich peoples wealth will grow 50% in a few years would you believe that? I bet thats happend a lot more often than rich people losing 50% wealth in a few years and is historically more likely.

I follow Nouriel Roubini and Paul Krugman. Their economic models have proven themselves as time passes by. Roubini is best at telling you where the economy is headed and Krugman is best at throwing graphs at you and showing why things have happened the way that they have.

The doom and gloomers predicted inflation to occur after the start of the Fed's first quantitative easing. That period for inflation to happen has already passed and therefore their economic models would have to be flawed. Time to start seeking information from someone else.

Didn't the "super-rich" (and most middle class) lose 40-50% of their retirement in 2008? As long as you aren't planning on retiring and the economy crashes, why should anyone be concerned about theses predictions? If anything, I made money from investing when nobody else would.

If the US economy crashes, I'll be in good company and as long as my skillset and finances are in better shape than at least half of America, I'm not going to lose any sleep.

I do think interest rates are insanely low but with that comes houses that are priced about as high as they can go now without tipping the monthly rate into expensive territory. Once the interest rate does go back up (to 6-10%), expect property prices to drop as the monthly rates will likely go up by around $1K/year. If you are buying rental properties now, expect to hold onto them for a very long time.

It may not happen this year or next year or this decade or next decade, but eventually the American government (and consequently the American and world economy) will have a "day of reckoning".

For example, the ten year Treasury currently yields 1.5%. What happens when the ten year approaches a more historically normal yield of 4% or beyond? A spike in yields could easily increase the interest portion of debt payments to 100% of the federal budget. Talk about a recession. Mean while the media and our culture are more concerned about the Chick-fil-a CEO's personal beliefs than the facts about our future.

How do you prepare for this? You maintain liquidity, stay out of debt, and diversify. You want good rental property or real estate, commodities (oil or something of actual industrial value), and stocks.


"Didn't the "super-rich" (and most middle class) lose 40-50% of their retirement in 2008?"

It isn't the super rich or middle class that lost their nest egg, it was anyone who invested their retirement in the stock market. That would include the poor too my dear sir. Second point, investors lost up to 40% on the portion of their retirement that was in stocks. Now if some buffoon had all their money in stocks right before they were preparing to retire, then they certainly were not preparing for an economic meltdown.

@Noah

"with that comes houses that are priced about as high as they can go"

Except that 4 years ago they were 50% higher so how can they now be as high as they can go when they have been 50% higher?

"without tipping the monthly rate into expensive territory"

With the exception of a few local areas, house payments on a percentage of income basis are cheaper right now than they have been at almost anytime in the last 50 years. There is plenty of room for prices to move up without making houses to expensive to buy.

"Once the interest rate does go back up (to 6-10%), expect property prices to drop"

That could happen a little bit. However right now many more people want to buy than are able to because they cannot get the credit to do so. Once interest goes back up the economy will be on more sound ground. The fed will not raise until it is. That will make the banks more willing to lend and this will increase demand for housing. Prices may be uneven but from here the movement is most likely to be slowly up in price for real estate.

"If you are buying rental properties now, expect to hold onto them for a very long time."

I doubt that will be necessary at all. However if you are buying properties that create generous cash flow, why would you want to sell anyway.

Re: Inflation

Right now the severe drought in the Corn belt has devastated the crop and since corn is a commodity its prices have shot up considerably. Corn is used for feeding many animals so meat prices will also start shooting up. For the average person that is not into farming this isn't going to be a major problem. However some of the poor countries in the world that have a diet of mainly corn products, their poor will feel it more than most.

The world's population is growing steadily in some of the poorer countries, at the same time as many people in the world are finally able to buy mopeds, motorcycles, and cars and increasing the demand for gasoline (i.e. oil). This is leading the world into the era of Peak Oil. Other bad effects are being produced by severe climate change in many regions of the world.

The supply of water for drinking and irrigation is already becoming critical in some parts of the world. The USA however is blessed with having an abundance of natural resources and an abundance of smart, well educated people and a great educational system at the university level, which will help to minimize the problems that 3rd. world countries are experiencing.

In spite of experiencing inflation in various commodities I agree with Apex that wholesale inflation rates are still many years away, and that's also what we are hearing from Bernanke and other leaders. Also inflation is unlikely to happen overnight. You just need to be watchful and well informed and make adjustments to your investments as you feel it is necessary. It may also be a good idea to gradually make your investments more liquid over time, but your age and wealth are factors to also take into account. It's never a good time to live right on the edge where changes in the economy could prove disastrous. You need to have a large cushion between your total income and your total expenditures.

@Old Limey,

"The big advantage of a rental is that you can get a nice tax writeoff"

I do not agree with this statement. The biggest advantage of real estate is leverage. Currently the second biggest advantage is the significant cash flow that these cheap properties allow you to generate. Tax benefits accrue on top of that but that is certainly not the primary reason I would get into real estate.

"but the biggest problem is the taxes you will owe if you decide to sell."

Why is this a problem? You already received the tax benefits as write-offs that reduced your taxes in previous years. Having to pay taxes later is not a problem. It's a benefit. You just cited the tax write-offs as a benefit and then turned around and claimed that paying the taxes later was a problem. That is exactly how an IRA works too. Is paying taxes on an IRA when you withdraw it a problem? If so the best way to avoid that problem is to not put any money in an IRA. Pay the taxes up front and then you won't have this "problem" later. I do not understand this reasoning?

"This is a problem that doesn't exist with bond investments."

This just isn't true. Unless you own municipal bonds which are tax free but have a lower rate of return as a result and usually results in similar net return to a taxable bond. When you receive interest from your bond it is taxable the year you receive it. Of course there is no tax due when the bond is redeemed because you have already paid all the tax on the interest and you didn't get to deduct any of the value of the bond like you get to with real estate. If you have your bond in an IRA then that is the same situation where you are deferring the interest until later.

1. Bonds make interest which you pay taxes on when you get it.
2. Real estate has gains in value which you do not pay tax on until you sell it. You also get to deduct about 80% of the original purchase price for depreciation over 27.5 years and then if you sell it you need to pay tax on that amount that you have received extra benefit on for the last 27.5 years.

When you compare those two scenarios you want to claim that the real estate one is a tax problem and the bonds one is not? I am sorry, but that reasoning just doesn't make any sense.

@Apex

You are right, the prices probably won't be affected in most areas. Unfortunately I'm in an area where interest makes up a large part of the monthly payment. Cutting the interest rate from 6 to 3% has allowed a lot of people to still afford a home. Were it 6%, they would be defaulting as it adds almost an additional $1k/month. I'm hoping a higher interest rate calms down buyers enough for me to slip into something. We'll see, at this point my down payment isn't high enough for me to feel the pressure to buy.

I'm very jealous of 90% of the country where house prices match incomes.

Apex --

I'll be interested in your thoughts next week as I begin my posts on rental real estate. As a no-debt guy, I'm buying with cash. :)

Of course, that could change over time. We'll see.

Other than the inflation hedge we're discussing above, I got into rental real estate because of your advantage #2: income. If I can convert enough of my net worth to rental properties (at the right price, with the right rents, etc.) that make a good income, I can slowly replace my current salary. You can see where this is heading...

@Luis

Absolutely agree! Anyone within retirement age should have only lost a small portion of their wealth.

I know I'm hijacking the topic at hand, but do most parents gradually make their 529s more conservative as their child reaches 18? I know several people at work who have children in the 11-15 range who said they lost 30% of the 529's worth at the time.

@FMF

What are the current rental income interest rates? Even at 4-5%, wouldn't you be close to break even if you invested the money elsewhere? And wouldn't the interest rate tax breaks help?

I apologize if I'm jumping the gun on next week's topics :)

Noah --

We can go through all of that as the posts hit. I'm looking forward to it. ;)

@FMF,

I figured you might be an all cash buyer. My first property was actually all cash too. But then I was out of easy cash (I didn't want to liquidate other investments at the time). So I leveraged it to buy the next and so on. I now have 10 and they are about 75% leveraged. I had about 100K into the first property and I now have a little over 300K into the 10 that I have. But I don't have 1.2 million in cash just laying around so I could not get here without leverage. But that 300K in cash that I have invested in 1.2 million of real estate generates about 70K cash flow and almost 80K net profit, so it's a 25% return on my cash invested and that assumes zero appreciation which I don't expect to last for too long.

Reason #2 is the primary reason I got into real estate as well. Without #2 I don't consider #1 to be strong enough to do it. That might sound strange that I think reason #2 is more important than reason #1 but reason #1 is the biggest advantage. It's how you can build wealth much faster than anywhere else. Reference my annual guaranteed 25% return that I laid out above and it doesn't even included appreciation. But without reason #2 being there then reason #1 just doesn't work very well. Leveraging something that doesn't make you any or hardly any money is not an advantage. This is why debt for a couch is a bad idea. Couches don't make money. Debt for an investment property that doesn't make any money is also not something I consider a good idea.

As to where "this is heading", I know exactly where it's heading. Hopefully I will see you there cause that's where I'm going too. :)

Apex --

Time will tell if I ever begin funding properties with debt. Once I learn more and get some experience under my belt, I may do so. But I have had ZERO debt for 15 years now, so it could take me a while...if ever.

@FMF

I'm looking forward to reading about your journey into rental properties. I've heard from many that it's either the best idea ever or a complete nightmare.

I think it would also be interesting to read about "Reader Rental Property Adventures" where some of your readers, like Apex, give some advice based on an situation they had to handle and overcome.

@Noah,

What part of the country do you live in?

I am in Minnesota.

I have some money borrowed at 5%, some at 5.5% locked up for 30 years. I also have some short term lines of credit borrowed at under 3% that can float. They are all tied to prime so if interest moves up, my interest costs will move up. I have been using these lines for 2-3 years and plan to continue for quite a while. I don't expect interest to get too crazy anytime soon which you could probably guess from my opinion on where inflation is going. After all expenses I have more than 1/3 of the total rent left as profit.

Rent on these properties is about $1,400 per month.
For the 5.5% interest properties I cash flow about $400 per month.
For the sub 3% interest properties I cash flow about $700 per month but since they are lines of credit they are interest only so it's not really fair to compare those numbers. If they were not interest only they would cash flow about $525 per month on a 30 year amortized loan.

So you can see that the difference between 5.5% and interest that is basically half that is about $125 per month in extra interest expense. Interest can go to 10% and I can still easily make money doing this at these prices. It would be a lot smaller but still profitable.

As far as whether you would be better off if you invested the money elsewhere, see my post above to FMF to see my returns. Using leverage you can get returns that vastly exceed anything you can get anywhere else.

Quite the debate.

Read John Mauldin, he has some interesting thoughts about this, as do many others. We could experience massive deflation, or deflation then inflation (his bet), or just inflation. The future is incredibly hard to predict, as any person with any wisdom knows. But it's hard to miss all the extremely dark clouds on the horizon, at least for the global and specifically U.S. economy. We're not in some normal business cycle. Large shifts of wealth (destruction, likely) are probable, as are economic and civil unrest. Europe's a step ahead of us, and it will be interesting to see that unfold. Reminds me of that old curse, allegedly of Chinese origin (though its origins are now doubtful): May you live in interesting times. For better or worse, we're headed into interesting times.

@FMF,

As far as using debt I think it depends on if you goals require it or not. Yours may not. You probably have a pretty good amount of accessible cash available to you. You are also further along in your career than I with more of your net worth setup than I. You may simply want to pick up a few properties with zero leverage to supplement 50K per year in income or something. If you want to turn it into a business that both provides all your financial needs and has enough left over to cover market risk and future expansion, and don't want to wait for 30 years for it to happen you probably have to use debt or be cash rich.

I need to get my properties to the point of producing about 200K per year cash flow before I can switch to that and feel comfortable. That requires about 3 million dollars of properties the way I am going which I cannot do with cash anytime soon.

However it will be interesting as you go down this journey to see if you get comfortable with business debt. Most people who are debt weary just cannot bring themselves to accept any debt as positive but once you see it working and get a sense of the safety of doing it properly, it's kind of like breathing. It's just part of the business life cycle.

My lines of credit have been drawn on and then paid back down and then drawn on again more than once. It truly is like an organic life cycle. Draw money from my line to buy a property (plant seeds), Get property ready and find a tenant (cultivate field), collect income from property and pay the debt back down (harvest). Find another property and repeat.

@Apex,

I'm in Southern California. I think for most rental properties, the interest rate increase would not shake anyone, especially in areas with reasonable prices, but for new buyers, it's something to consider. Most decent houses in my area are near $500k. The price jumps to around $3700 from $2700/month when interest rates go from 3.6 to 6.6. Who knows how long it will be when that happens, but $1K month is a lot for anyone in the area who is already strapped (most of my area, as I live in the land of vanity). I know several professionals at my work who will admit to living paycheck to paycheck. These are very intelligent people, mind you, but their concept of money management is completely insane. I also don't think they are in the minority for my locale.

Apex,

I'm very interested to know more about the way in which you've financed your properties. I've financed my 3 properties with traditional 30-year mortgages, 80% of purchase price. The rates are 5%, 4.5%, and 4.375% and obviously I have no interest in paying those down or off...probably ever. The problem, as my mortgage broker has indicated, is that Fannie and Freddie limit the number of mortgages they will purchase for a given buyer. My understanding is that Fannie's limit is 4 and Freddie's is 10. I am interested to know more about alternative financing options. I'd really love to find seller-carry financing, but that is not common for 7-year old homes in a recession-hit area!

FMF, I definitely agree with Apex on leverage. Buying with cash provides greater overall returns per property, but the return on capital is much lower. And from a risk perspective, more properties (as can be purchased with leverage for the same capital expenditure) provide less risk - the whole "don't put all your eggs in one basket" mantra. One property can go bad for a while without upsetting your whole strategy.

@Noah,

Yeah that area is a different animal. There are areas of California where housing supply is not able to meet housing demand due to limited real estate. I don't think any of these formulas work in those areas. Houses are too expensive to buy and they don't rent for enough some times to justify buying a rental even in this type of a market.

My understanding is that has always been the case in those areas though. Supply/Demand dislocations can cause those markets to swing wildly and as such investing there can be riskier. Can turn out great if you get in and out at the right times but I don't like to invest in that fashion. I certainly don't understand enough about the CA market to try to invest in it but then I would never suggest anyone invest remotely. You just don't have enough local knowledge to know what you don't know.

Yes I do expect inflation to increase. Currently its at historic lows, and everything in cyclical. Also I think the government will have to encourage inflation at some point in the next 10 years, as a way to help pay off the national debt.
Anyhooo....I'm not too worried because of course worrying wouldn't help anyway. I keep my $ diversified because that's sensible to do no matter what you think will happen in the future.

One thing I am looking to do however is to take out a mortgage again & upgrade to a nicer house. Nothing wrong with taking advantage of such low interest rates! And the houses are back to their non-bubble prices. And if inflation happens, and it probably will, there's nothing better to have than a mortgage.

@Apex

Do you have a rule for how far from your residence you will buy a house? My boss's rule was an hour drive.

I need to stop responding as this is probably good conversation for next week's topics :)

@FMF

I think you should enlist Apex as a regular contributor about rental properties. One article a month would be awesome!

@Jonathan,

I don't think there is a difference between fannie and freddie on their limits.

Both allow up to 4 properties with one set of rules and up to 10 with a second set of rules. The second set of rules is much more restrictive and much more paper work and scrutiny for the bank providing the loan. As such hardly any bank will write a loan for more than 4 properties. The first key is to find a bank or broker who will write one of those. The search can be long and exhaustive. Leverage any contacts you have to try to find one. My guy had 4 banks who would fund these kinds of loans and this spring he lost 3 of them. If he loses #4 then I have to find a new guy which I may or may not be able to do.

This just makes things a mess. I wish fannie and freddie would get out of this business. Because the govt is in there backing loans no bank will write a mortage without them behind it. If they were gone eventually banks would come in and write mortgages for good risks but why should they take any risk if they don't have to, let the govt take it. And as such they have to follow the fannie and freddie rules and there are not enough people going after more than 4 properties to make it worth it for most to try to meet the higher requirements to write those mortgages. You will need to be familiar with those rules if you try to get more than 4 because it will be harder to qualify. You can google it to find the rules for fannie mortgages for more than 4 properties. Some rules include higher credit score requirement, 6 months expenses in cash for all properties you have, 75% LTV instead of 80%. Can't count your rental income on properties that have not been on your taxes for at least 2 years when figuring your debt ratios.

Beyond that I have borrowed a little money from my dad and pay him far better interest than he can get anywhere else and then I have 400K in lines of credit on my personal residence and on one of my rental properties that are good for about 12 years but the interest floats at about prime.

I have a few properties that have no mortgage on them since I am leveraging some personal borrowed money and some lines of credit so I have talked with multiple private banks about taking out commercial loans on those properties and I could do that but it will probably cost about 6% to do it.

Once you get past 4 properties getting money gets harder and the rates go up. Once you get past 10 commercial money is your only option.

You need to be talking to brokers and bankers as much as possible to try to find financing. It's the number one hindrance to expanding a real estate business.

However be aware that every mortgage or line of credit that you have counts towards your 10 so try to get as many fannie or freddie loans as you can because once you have 10 loans total you cannot get a fannie or freddie loan.

Noah --

I've tried! But he and Old Limey are holdouts!!!!! :)

@Noah,

I don't have any rule but most of my properties are actually about 1 hour from my house. 30 minutes from my work. I have found some really good properties in that area and I now prefer that area. I know it really well and feel really comfortable buying in there. I look in that area almost exclusively now. I would like to consolidate my properties there.

It would certainly be handier if that area was 10 minutes away instead of 60 but I would say that the area you buy in and the type of property you buy and the type of tenants you can get and the type of profit you can make on similar properties in an area is more important than how close it is to your house. I have 10 properties, 9 in the same area 1 hour away. I am only at my properties about twice a month so it's not like its overly burdensome (I was just there yesterday to deal with an issue).

I think it depends on if you view this as a business or a hobby. If its a hobby, you probably want them closer. I view it as a business so I do what makes the most sense for the business and yet something that I can still manage and this is what has worked for me.

It just turns out that the area that I live in doesn't have the right kind of properties at the right kind of price to make this work as well. I could still make money closer to home but less and probably with properties that might not attract quite as good of tenants. Quality of tenants is everything. Nothing else will really matter if you have problem tenants.


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