In Part I of this series, we laid out the 3-step overall plan for how you become an investor. This was important because “plan” is the key word. Since most folks don’t have a plan to put their capital to work for them through the power of investing, they’re almost completely in the dark about what investment is, or how to retire comfortably.
Briefly, the 3 steps are: gain control over your money, capitalize, and invest. Today, we’re going to get into some of the details of the third step ‒ investing.
Laying Some Groundwork
First, we need to get clear on two things: passive income, and the housing price cycle.
With investing, we’re looking to generate passive income. That is, we own assets that are generating cash flow without our having to work for it. We worked to “make the money,” but now we’re going to put that money to work for us.
This is the opposite of earned income, where we only make money while we’re working. And passive income has two big advantages of over earned income.
First, it’s passive ‒ it comes in whether we’re working or not. It’s a good feeling to know you’re making money even while you’re on a ski trip with your family…
Second, passive income is taxed at a lower level than earned income. In fact, earned income is taxed at the highest rate ‒ so owning assets that generate passive income really can make a big difference in your taxes.
The other issue is the housing price cycle. Often, people will argue that real estate investing doesn’t really work because the price of housing is so cyclical, with continual ups and downs. The idea is that the valleys pretty much cancel out the peaks in pricing so that there’s no real gain over time.
But this isn’t true at all…
Yes, the cycle is real. It goes something like this:
Expansion → Oversupply and Peak Prices → Recession and Falling Prices → Prices Hit Low Point → Recovery and Rising Prices → New Peak for Prices
Then rinse… and repeat.
So over a given period of time, properties may either rise or fall in price, affecting their value.
However, the data shows that the average price over time is always increasing. Even after a 10-year low point, housing prices in the 2010’s, for example, are higher than prices in the 1980’s. The average value just keeps going up.
Real estate is a good long-term investment.
So how do you do it?
It’s a Game
Do you remember playing Monopoly© as a kid? If so, you already know how to play the investment game…
In Monopoly©, you have some money and start going around the board. As long as you keep moving, you collect at least some money every time you pass “Go.” This is like working your job in real life. You just keep moving and making money to use as capital.
As you keep playing, you buy assets. These are the little green houses. You purchase them, and they produce rent money ‒ every time someone lands on your property, you get more money. This is a dividend for you, passive income. Basically, the more you build and the better you place them, the more passive income you receive.
As you build up enough of these assets, you trade them in and buy commercial properties ‒ which generate much greater passive income.
Well, that’s exactly how the real estate investment game works. Houses are a great way to get into the game. And as you assets grow, you can trade them for even better ones.
Just like the board game, you start buying assets while you’re “moving around the board”, while you’re still working. You can stop working ‒ you can retire ‒ when your assets are funding your lifestyle for you without any additional work on your part.
It’s All About Leveraging Your Assets…
You need financial assets so you can leverage them via investment. We all have assets, and there are different kinds.
Some assets are more liquid ‒ they’re easy to get to and use. These are things like money in a checking or savings account, mutual funds, and so on.
Others are static ‒ they’re more difficult to access and put to work for your investment purposes. These are assets like equity in your home, or retirement accounts like 401(k) plans and IRAs.
However, these static assets are often quite valuable. And just because they’re difficult to access doesn’t mean it’s impossible ‒ far from it.
Here’s a strategy for using your IRA to buy a property…
As you may already know, an IRA can actually purchase and own assets. You do this by using a third party administrator (TPA) to manage your IRA as a “self-directed IRA”.
One of the great things about this is that your self-directed IRA is pretty much considered to be a separate entity from you. It’s almost like it’s a person ‒ it can “own” all kinds of assets, including businesses and… real estate. (About the only things it can’t purchase are collectibles and insurance.)
Even better, like a person, your IRA can get a loan from a bank. And because it’s a separate “person” from you, the loan isn’t based on your FICO score, other assets, etc. Instead, it’s based on the financial health of the investment for which you’re getting the loan.
So in the case of using a self-directed IRA to purchase a rental property, the bank would look at the cash flow and other factors of the house your IRA is looking to purchase ‒ because it’s the IRA that’s buying the property, not you.
The TPA comes in because you can’t legally “co-mingle” with your retirement account. It’s a retirement account, after all, not a simple savings account! So, basically, you direct your TPA on how to manage the investments your IRA makes, and that person oversees the implementation of your directions. Your TPA is like a trustee for the account.
It’s a powerful way to leverage one of your most valuable assets.
How to Double Your IRA in 45 Days
In fact, here’s a specific case study of how one of my clients used this strategy to double the value of his retirement account in just 45 days.
His name is Jon Galane, and the only figure I’ve adjusted is the initial value of his IRA. (This makes it easier to show the doubling effect.) All the other numbers, like the value of the rental property and the percentages, are his actual numbers.
Here’s how it’s worked out for Jon (and this kind of thing is pretty typical for many of our clients who adopt a similar strategy).
He started with an IRA with a current value of $100,000.
He used a TPA to have his self-directed IRA purchase a rental property worth $180,000. To do this, he used $63,000 from his IRA… and received a bank loan for the remainder of the purchase price. This left him with $37,000 cash in his IRA ‒ and an asset worth $180,000 within the same account.
So, when you add the $180,000 house and the $37,000 in cash, he now has an IRA worth $217,000.
The whole process of closing the deal on the house took about 45 days (fairly typical). So he more than doubled the amount in his IRA ‒ from $100,000 to $217,000 ‒ in about 45 days.
Here’s the breakdown so far:
Not bad for six weeks’ worth of effort…
But it gets even better. This is clear when you look at the assumptions he made for a 10-year period (which is generally a good time frame to work with for an investment like this).
Jon figured his annual appreciation at three percent. Because he bought this property in 2008, at the height of the market, this was a good figure to work with. Now for simplicity’s sake, I’m just going to give the uncompounded appreciation number here ‒ just know that this is actually a compounded interest rate in “real life”, so the projected appreciation was actually a bit higher.
A three percent annual appreciation rate on $180,000 yields $54,000 over ten years. So the ten-year appreciated value of his account is $271,000 ($217,000 plus $54,000).
And here’s another interesting thing. In fact, some of you may have noticed this… while it’s true that Jon’s house is worth $234,000 after ten years ($180,000 plus $54,000), he’s still got to pay off the loan that his IRA received from the bank. So how does that affect the numbers?
Well, he gets about $1,450 per month in rent. After expenses, he’s left with $900 per month. What Jon does is, he uses that $900 per month to pay down the principal on the loan. And remember, it’s actually his tenants who are paying off the loan for him.
So, with $900 per month cash flow coming in from rent, he will only owe about $40,000 on the house after 10 years. When it comes time to sell, you subtract that $40,000 from the account’s appreciated value of $271,000 ‒ and you get a value of $231,000 for the IRA after ten years.
Here’s how it looks:
Again, growing your account from $100,000 to $231,000 like this, in just 10 years, is… amazing.
But what about that 10-year ROI number? Where does that come from?
Well, remember: he only invested $63,000. Not all $100,000 of his IRA, and not the full $180,000 the house was worth. He just invested $63,000.
And when you divide that $63,000 into the account’s $231,000 value after 10 years, you get an ROI of 367%. Spread out over ten years, that’s an annual return of 36.7 percent!
Folks, that’s an incredible return…
(The last time I checked in with Jon, his actual numbers were tracking right along with his assumptions. His investment is paying off nicely!)
It’s good to have assets. And for our purposes, the main reason it’s so good is because there are some very real, doable, and powerful ways to leverage that money to get you a truly incredible ROI.
It’s largely a matter of identifying your assets and gaining the knowledge of how to tap into them.
The case study we walked through is just one example of the many ways you can play the real-life game of real estate investing… and play to win. Big.
In the next post in this series, we’ll dive into the rules and guidelines you should use when choosing the right properties to invest in…
Give us a call at (801) 990-5109 or schedule your free appointment here to begin your personalized Wealth Plan. We’re happy to help you clarify and reach your financial goals by investing in real estate.