2008 marks the first year when 78 million baby-boomers born between 1946 to 1964 start retiring. This is the first time in the US history that there is so many people who will be eligible for AARP membership. As a result, federal spending on retirement and healthcare –Medicare, Medicaid and Social Security will increase dramatically. So how will this affect you when it’s your turn to retire and what should you do now? Since it has never happened before, you don’t have the benefits of learning from the history. You just have to rely on analysis, projections of experts, paying attention to all the red flags you have seen along the way, and sometimes just your own common sense. Let’s look at the big picture from 30,000 feet:
1. Uncle Sam is currently spending about $1.30 for every tax dollar he collects. As of March 2008, the US national debt is $9.38 trillion dollars or about $30,894 per citizen. Per the Government Accountability Office (GAO) this kind of fiscal policy is unsustainable. However, it does not take a rocket scientist to come up with that conclusion. Just try to do that with your checking account!
2. Government spending on health care alone could double by 2017 to more than 2 trillion dollars a year as a result of baby boom generation retiring and rising costs of drugs & medical expenses. Americans are also living longer. As they get older, they also have more medical problems: high blood pressure, cholesterol, diabetes, Alzheimer (one out of eight baby-boomers will get it), and cancers. And medicines baby boomers need are very expensive. For example, a year’s supply of Avastin to treat colorectal cancer associated with old age costs $55,000.
3. On top of that, the US consistently imports more than it exports. The trade deficit was $708 Billion dollars in 2007. So more and more our money is going to the Middle East and China to pay for our addiction to oil and imports.
So the government will have to spend more and more money that it does not have. To put it simply, the problems are so large and a financial crisis is inevitable. The question is not if but rather when the tipping point triggering the crisis will happen. So to make sure you will be least impacted by what is about to come, you will need plenty of cash aside when you are retired. If you work for Corporate America, you probably participate in the 401K plan which invests mostly in stocks and bonds. While 401k is a convenient retirement plan for many as it allows people to make a small monthly tax-deferred contribution, it may not be the solution for everyone. Some people prefer to own more tangible real estates with limited supplies that they have more control of instead of just shares of stock. In addition, most if not all financial experts agree that as you get older, you should reduce your investment in the stock market due to its volatility. This article discusses about an alternative plan to 401K and for a lack of better name the “equity-of-my-home-is-my-retirement” investment plan.
There are several reasons why commercial real estate investment is a strong candidate:
1. It is a fairly stable investment. This is an important factor as investors want to make sure their equity is also preserved throughout their retirement years. Unlike stocks, real estate investment is not sensitive to market fluctuation which seems to get worst as the internet is getting faster. Commercial real estate investment will shield people from going through the emotional roller coaster as the stock value widely fluctuates sometimes within a very short time. The stock of the Bear Stearns, the fifth biggest investment bank in the US is an example. J.P. Morgan Chase & Co. bid just $2 a share for what was selling at $150/share in March 2007. While this kind of performance is not typical, you definitely don’t want to be in that position when you are ready to retire. You don’t see this kind of dramatic volatility in commercial real estate.
2. It generates strong cash flow after paying the mortgage and all expenses. Many people simply forget the very fundamentals: if your investment generates more rental income than your mortgage payment and expenses than you are in pretty good shape! To those who invest for retirement purposes, this is another important criteria. In order to retire you need cash as you won’t be able get income from a job anymore and your social security check will most likely not sufficient. For those who are still working for corporate America, it gives you a second source of income just in case. Besides, you never know you could be the most important asset of the company one day and a dispensable asset the next. Normally the closer to retirement, the more important the higher income is to the investors. To achieve strong cash flow, investors often look for properties where “cap rate” is higher than the interest of the loan. Texas is an area where many commercial properties offer 8-9% cap rate and it is a good place to invest for strong income. Commercial properties are like a golden goose that keeps laying eggs. You can just eat the eggs, i.e. cash flow, without slaughtering the goose, i.e. your equity, for meat.
3.
It is an excellent hedge against inflation. As oil price is over $100 per barrel, you will have to pay more on almost everything. In addition, the US dollar is getting lower against most if not all foreign currencies so imports (is there anything, besides Big Macs, beverages and cigarettes, made in the US anymore?) will cost more. All these thing cause inflation to go up at least in the near future. Commercial properties tend to hold values very well for two reasons: strong cash flow and limited supplies. Besides, the leases often have either fixed or CPI-based (Consumer Price Index) annual rent increases so you should have a raise every year. As the rent increases, the property value is more likely to remain the same or to go up.
4.
It gives you a wide range of landlord responsibilities options from purely passive to active. Some single-tenant properties, e.g. restaurants or pharmacies offer 20 years absolute triple-net lease with no landlord responsibilities whatsoever. This means you don’t have to worry about looking for a new tenant for a long time. The tenants maintain your property in first-class condition while all you have to do is cash the rent check and pay the mortgage. This kind of property is ideal when you are too busy or just don’t want to do anything. Multi-tenants properties, e.g. shopping centers normally require you to at least spend time to manage the local property manager to make sure all the issues are taken care off.
5.
It also offers potential for appreciation. This may increase dramatically the overall return of the investment. It is a more prudent investment than residential real estate investment. Due to strong cash flow, you don’t have to gamble on appreciation to make money and thus are less likely to invest on pure speculation. If the property appreciates in value then your investment return is much better. However, if it does not appreciate rapidly and thus you don’t get rich quick, your rental income is more than enough to cover the loan payment. As a result, your property is less likely to be foreclosed. So it’s not a surprise that the default rate for commercial properties is only two tenths of one percent, at least ten times lower than that of residential rental properties. Of course real estate properties are more difficult to sell compared to 401k shares. This actually encourages investors to hold their properties for long term investment and discourages them to sell prematurely.
Below is a case to illustrate these principles:
The Smiths (name changed to protect privacy) had their own business and lived in the fairly nice and expensive neighborhood in the San Francisco Bay Area. They planned to sell their business and retired in the next 2-3 years. They still wanted to maintain current life style. Over the years, they had invested in real estate and had quite a bit of equities in several residential properties. However, they figured out these residential properties would not generate enough cash flow for them to retire comfortably. They decided to exchange these properties for ones with more income. They sold one of the properties and netted about $1M.
While the Smiths were looking for properties with high rental income, they wanted to make sure the investment also preserved their equity. This meant they would need to invest in a somewhat stable and/or growing area. This advisor suggested them to do a 1031 tax-deferred exchange for a $2.825M Italian restaurant located in front of a mall in the fast growing Atlanta metro. The financial information shows the tenant is doing well now and expected to do well in the future due to a good location. They applied for $1.8M 5-year fixed-rate 30-year amortization loan at 6.95% interest rate. The property generated $19,000 of net rental income a month after expenses (8% cap) while the mortgage payment was $11,915. So each month, the Smiths net $7085 of cash flow. The tenant signs a 20 years absolute triple-net lease in which there are no landlord responsibilities. Since the lease had a 2% annual rent increase, the Smiths could expect to get even more cash flow in the future. Investing in commercial real estate for retirement purposes is not a plan for everyone as it requires a large sum of down payment. This article is intended to introduce a new paradigm in retirement investment that is not promoted by Fidelity, Smith Barney, eTrade or Charles Schwab for obvious reasons. If you have always considered 401k, you may want to investigate further about commercial real estate investment. Of course you will have doubts about it as your friends, relatives, neighbors and co-workers know little or nothing about it. They all seem to know everything about residential real estate investment. Well, the problem is often worse when people don’t even know what they don’t know!
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