My friend Soren is breaking up with his partner, who he lives with, and can’t move out. Why? Soren’s entire net worth is consumed by a company 401(k) plan and a vacation rental with a large mortgage that he bought with his partner. By the standards of the average person, Soren is wealthy, but because his wealth is all untouchable, Soren won’t have the cash he needs for a security deposit and moving expenses until he and his partner sell the rental property. Was he lured into the real estate investing market way too soon? Yep. So what might he have done differently?
Savings Plan Hierarchy
Soren would have benefited by building up some liquid cash and investments first. I encourage clients to go in this order when it comes to investing surplus income:
- Cash reserves (to fund your Emergency Plan)
- Employer-sponsored retirement plans, such as a 401(k), 403(b), or SEP IRA
- Investments like mutual funds that can be sold to cover expenses
- Privately held income-producing real estate
Soren should have had an emergency plan in place to provide some runway for personal expenses in case something like a job change or disability happened (or in his case, a sudden breakup where he was living in his partner’s home).
Employer-Sponsored Retirement Plans
Soren gets an A in this category because he makes the maximum contribution to his company 401(k) every year. Even if he gets the urge to buy more real estate in the future, this account will ensure that some portion of his portfolio owns businesses (stocks) instead of private real estate. If he makes big mistakes or has some bad luck with real estate, he’ll still have this long-term account that will be available when he’s older. And let’s not forget that 401(k) accounts can get you a big tax deduction. If Soren becomes self-employed, he’ll be able to reduce his taxable income by as much as $60,000 a year.
How Much Real Estate?
Now comes the hard part. Once Soren sells the rental and builds up his cash reserves, will he put all of his excess cash (after maxing out to his retirement account) back into real estate? Or will he invest his surplus income into a good old fashioned investment account?
Personally, I think keeping 30% or less of one’s net worth in real estate is reasonable. Your number may be different, but whatever your magic number is, lock in on it and then make sure your real estate holdings stay below that number. For example, if 30% is your magic number, then after maxing out to your retirement plans you should invest your surplus take-home pay and rental income into a regular brokerage account. Periodically check to see how much of your total net worth is consumed by real estate. If down the road private real estate only makes up, say, 20% of your net worth, then you can buy another income-producing property.
I’ve heard the real estate addict’s case that “they” aren’t making more land and interest rates have nowhere to go but up. Perhaps that’s true. Still, it’s safer to round up when budgeting for your real estate expenses and round down when you’re guessing at the appreciation you’ll enjoy in the long term. You also need to ensure that you have sufficient cash reserves set aside for those periods where your rental is cash flow negative (when costs exceed income, often because of unexpected expenses and unexpected periods of vacancy).
I challenge you to track the number of hours that you spend each year dealing with tenants, repairs, paperwork, tax returns, etc. If you want to learn more about income producing real estate, my good friend Craig (a fantastic realtor and author of Destination Perpetuity) and I love to spar on the topic. Stay tuned at our Abacus events page if you want to watch us debate the role of investment real estate in one’s portfolio.