By Dr. James M. Dahle, Emergency Physician, WCI Founder
Warning: Lengthy rant ahead.
I often run into people who are somewhat dogmatic about cash flow investing. The typical vehicle of choice is real estate, although occasionally it is high dividend yield stocks. By cash flow, I mean that they simply work at building a portfolio of investments that generates cash flow, and when the cash flow is equal to what they generate from their day job, they consider themselves financially independent. Seems simple and intuitively smart, right? Not so fast.
While there is no doubt that investing in this manner “works” and, in fact, is a great way to become wealthy, there are a few things that really need to be pointed out before jumping on the “Kiyosaki Bandwagon.” (By the way, there is no rich dad.)
I was originally going to title this post “Why Cash-Flow Investors Need to Get Off Their High Horse.” While that title probably would have been a lot more clickbaity (and lest you think that's bad, I'm all for clickbaity titles because it doesn't matter what you write if no one reads it), the current title sums up my thoughts and feelings on the matter a lot more. Like with my politics, my moderate position subjects me to criticism from both sides.
Before we get too far into criticizing these folks, I think it's important to point a few things out.
- I think investing in real estate is a great idea. It is a wonderful asset class with excellent returns and low correlations with other common investments such as stocks and bonds. There are many different ways to invest that allow you to decrease the active aspect of it. It is also a relatively easy and safe way to add leverage to your portfolio. I have owned real estate in many different forms and anticipate increasing my allocation to it in the future.
- I am a huge fan of entrepreneurship, which in some respects is simply adding value, work, and expertise to your investments. While it is unlikely that spending time and effort to pick stocks or mutual fund managers is going to be worthwhile, that is not the case with many other investments such as individual income properties.
- I like the idea of having relatively high-income investments in retirement, as long as the total return is acceptable. While real estate rents are not technically guaranteed income, if you are reasonably risk-tolerant, they can in some ways substitute for it. For example, if you had a cap rate six property, I would feel pretty comfortable spending 6% of its value each year rather than the more standard 4% rule.
- The real benefit of real estate investing in my view isn't the cash flow aspect of it, but the solid total returns and low correlation with stocks that are available.
First, let's talk about the basics of income investing and some of the basic problems.
The basic idea behind income investing is that you only spend the income from your investments. Seems like a great idea, right? It's easy to know when you have enough to retire—when the income from your investments replaces the income from your job (or at least your living expenses). Plus, you know you'll never run out of money if you're only spending the income.
Unfortunately, if you become an extremist in this camp, you may get burned by several issues. There are really four ways that income investors get it wrong when compared to a “total return” investor.
- Income investors are likely to underspend: Safe withdrawal rate studies, such as the Trinity Study, have demonstrated it is quite safe (although not perfectly safe) for you to spend about 4% of a traditional portfolio each year and expect your portfolio to keep up with inflation throughout a 30-year retirement. But many traditional investments, throughout history, don't yield anything close to 4%. If you're only going to be spending the yield on these investments, you're going to be spending much less than 4% per year. That means you will need to do one of three things: have a higher savings rate, work longer, or spend less in retirement. Since you are spending less, you are also likely to leave a lot more money behind at death. In short, you'll spend less than you could have if you were willing to spend some principal.
- Income investors may not hold the best portfolio: An income investor is far more likely than a total return investor to chase yield, since every little bit of extra yield increases his or her lifestyle. However, there are many investments with a high yield whose total return may not be what you would hope. The classic example is junk bonds, and the junkiest of junk bonds these days are peer-to-peer loans. A portfolio of peer-to-peer loans may yield 20%, while only having a total return of 10% due to a high rate of default. If you're spending 20%, that portfolio isn't going to last long. That doesn't mean there isn't room for higher-yielding investments in your portfolio, but you want to make sure you are holding a diversified portfolio with excellent long-term, risk-adjusted returns. Such a portfolio almost surely will include some assets that have a low-yield.
- Income investors may pay too much in taxes: As a general rule, income tends not to be very tax efficient. There are exceptions, of course, as muni bonds are usually federal (and sometimes state) income tax-free. Plus, some of the income from real estate can be shielded by depreciation, especially early on in the life of a property. Bond dividends, REIT dividends, and CD interest are taxed at your regular marginal tax rates instead of the lower dividend and capital gains rates available with stocks. To make matters worse, you have to pay those taxes even if you didn't really want to spend that income yet. There is no way to defer the income until you actually want it in the future.
- Income investors may get burned by inflation: Higher-yielding investments, such as CDs and bonds, tend not to keep up with inflation nearly as well as traditional lower-yielding investments such as stocks. If you focus too much just on income, you may forget that your real opponent in the investing game is your personal rate of inflation. If your income is steady, or only increasing slowly, and your expenses are increasing at a moderate rate, it won't take long before you will be faced with an unsavory choice: Cut your lifestyle or sell your investments. A total return investor spending 4% of his portfolio each year has an inflation adjustment built into his plan.
Now, let's talk about some of the other problems income investors could face.
5 Other Problems Income Investors Need to Consider
#1 High Yield Does Not Equal High Return
The first problem is that many income investors do not realize that a high yield does not necessarily equal a high return. You want cash flow? I can give you 10% cash flow. Give me $100 and I'll give you $10 a year for the next 10 years. If you didn't get anything back after 10 years, you wouldn't think that was a very good investment, would you? You always need to look at the total return, even if you're an “income investor.” The classic example is a privately traded REIT that gives you “guaranteed” 8% returns a year for a decade, and then you find out your $10 shares are worth $2.70.
In reality, high returns come from higher risk, higher leverage, additional work, and additional expertise.
The historical return for publicly traded companies is about 7% real per year. However, it is not only possible but common for a real estate investor to have returns that are far higher than that. There's no sense in denying it, but it is important to realize what it takes to get those higher returns. One source of higher returns is taking on additional risk. I mean, which is a more stable, impressive business to own—a piece of Amazon or that duplex on the corner? Amazon, of course. That duplex only has a single source of income—rents—and is subject to serious risks such as vacancy, competition, excessive maintenance costs, general decline in rents or property appreciation in the area, etc. And that's only comparing it to Amazon, not an investment that owns pieces of thousands of companies. So you're taking on significant additional risk. Of course, you expect to have higher returns as a reward for doing that.
Your expected nominal return from an unleveraged real estate property is the cap rate, which is typically between 4-10% plus the rate of appreciation, which generally tracks inflation (technically the land goes up faster than inflation and the building depreciates,) so perhaps 9-10% total. However, once you apply leverage, the expected return goes up.
A pretty typical loan-to-value ratio for an income property is about 2/3, so if your unleveraged return is 9%, then your leveraged return would be higher. How much higher depends on your cost of credit. If your loan on 2/3 of the value is 5%, then your leveraged return would be 16.5%, ignoring transaction costs. If you had a 15% round-trip transaction cost and spread that out over five years, that would reduce that return by about 3% a year, reducing your return to 13.5%—still a great return.
The increased return available on real estate comes from additional risk and leverage and also from the additional work you must put into the process. Obviously, that can vary from a ton of work if you are maintaining and managing the property yourself to a relatively small amount of work if you are investing in syndicated shares where all the work is done by someone else to almost nothing if investing in the Vanguard REIT Index Fund.
However, no matter who actually does that work, it must be done. You, as the owner, are paying for it. The additional work inputted into the process adds value to it and that value shows up as a higher return. However, even if you are paying someone else to do almost everything on an individual property, at a minimum you still have to do the due diligence on the purchase.
For example, you might sit through a one-hour webinar about a syndicated real estate property and spend another hour going through the paperwork. Those two hours of time, at your hourly rate, should be added in to make a fair comparison to buying an index fund which takes me approximately 30 seconds. Also, when you are talking about exchanging your time for money, it is a good idea to consider if that is the highest rate at which you can do so—and also how much you enjoy the activity, especially for a high-income professional. Many doctors not only have a higher hourly rate practicing medicine but enjoy it more. Besides, most of us have learned there are other ways to make more money than being a doctor, and most of those involve working in the financial services industry. It isn't that we don't work there because we're not smart enough to do so nor because we are not willing to work hard enough to do so.
Alpha is a concept well understood by stock investors but poorly understood by real estate investors. Alpha is a zero-sum game. For every dollar of alpha that I get, someone else loses one. Real estate investors often tell me that they earn 20-30% returns, and I don't doubt them, because I have earned returns like that on some of my real estate investments. But I have also earned 3% and lost > 100% of my investment on other deals. Some of that may be luck (good or bad) and some may be skill (or lack of it) and often it is difficult to tell which it is. But there is no doubt that alpha is a lot more accessible in real estate than it is in highly analyzed public securities. But that includes negative alpha, and when amplified by the effects of leverage, far more investors have been wiped out by real estate losses than stock losses.
#2 You Can Leverage Other Investments
While a mortgage loan has significant benefits over a margin loan, there are many different ways to leverage up your stock market investment. In fact, you can even borrow against real estate to do so. To be truthful, it really isn't fair to compare a leveraged real estate return to an unleveraged stock market investment, even if what we usually do is invest in real estate with leverage and stocks without.
#3 Lack of Basic Investing Knowledge
I'm not sure how to tactfully put this, but I've been surprised by the lack of basic knowledge of the tax code and the principles of investing among even relatively sophisticated real estate investors. For example, two guys who run an extremely popular real estate investing podcast (Bigger Pockets) revealed in a podcast with Clark Howard a while back that they not only weren't using Roth IRAs but didn't even really understand how they work. I had a discussion a few months ago with a surgeon who has had great success with real estate and even spends time teaching others how to do it but didn't know of the existence of no-load mutual funds.
There is always a heavy denigration of the “Wall Street Casino” and “paper assets” but I wonder if the fear of these things is, in large part, simply ignorance. I mean, an index fund investor is obviously very wary of “Wall Street” and realizes that the fewer trips into “the casino” (where the house always gets its cut) you make, the better off you will be. But the transaction and ongoing expenses in real estate are an order of magnitude (or two) higher than in stock investing, and cost always matters.
In addition, real estate investors are notorious for not really knowing what their actual return is. Part of it is they don't know how to calculate the return and part of it is they never add in all the expenses, especially the value of their time. I hear lots of bragging about 20% returns, but no one seems to acknowledge what a 20% return really means. If you can make 20% a year every year and you save my recommended 20% of gross, you can retire on 50% of your pre-retirement income after seven years and on 100% of it after 10 years. Yet these docs who advocate this style of investing to me and brag about their high returns are almost invariably 45+ and still practicing because they have to. Serious disconnect there somewhere.
#4 Lack of Using Retirement Accounts
One of the greatest gifts given to high-income professional investors is the ability to invest inside retirement accounts like 401(k)s and Roth IRAs. Real estate investors routinely ignore these benefits. Retirement accounts simplify your estate planning, boost your investment return (by lowering your tax bill), and, in most states, provide a very high level of asset protection, even higher than that available through an LLC (which is still a good idea for an income property in a taxable account). You can certainly still invest in the asset class of real estate inside a retirement account, typically a self-directed IRA, although it is a little more complicated and expensive to do so unless you are buying publicly traded REITs.
A real estate investor will often claim their income is tax-free since they have “paper losses” to cover it. However, the truth is that paper losses are actually real losses. That's why the IRS lets you use them. The value of your structure really does decrease each year, so you are allowed to depreciate it at a reasonable rate. That's also why you have to pour money into the structure as you go along. Remember the new roof and water heater? That's what happens when something is fully depreciated—you buy another one because it is worn out. That depreciation is recaptured when you sell the property. You can put off the day of reckoning by exchanging the property, over and over again, until your death at which time you get the step-up in basis, but that is difficult to do with anything but direct ownership of the property. And those “expenses” you get to deduct? Those are real expenses too. Paying $1 to get a $0.45 deduction isn't exactly a winning formula. And it's not like your stocks (which are real companies with real expenses) don't get to claim depreciation and expenses and pass those savings on to you.
#5 Income Investors Work Too Long and Die With Too Much
Perhaps the biggest problem with being an income investor is simply that you work too long, and because of that, you die with too much. For example, in a recent conversation with a real estate investor, he noted that he wanted to maintain or even increase his income in retirement compared to what he was making now as a surgical subspecialist. This is despite the obvious mathematical fact that a typical physician investor can maintain their pre-retirement lifestyle on 1/4-1/2 of their pre-retirement income because of all of the expenses that go away or decrease at retirement (20% to retirement, 5% to health insurance/HSA, 5% to payroll taxes, 10% to income taxes, 4% to disability/life insurance, 4% to work expenses/transportation, 10% to child-related expenses/college savings, etc.).
Don't get me wrong, more retirement income is great, but the truth is that it isn't free. You exchange something for it. And what you are exchanging is your time and labor working longer than you have to or spending less than you might otherwise. That is not up for debate, it is a mathematical fact.
Total return = appreciation of the asset + income from the asset
So not only do you have to work longer, perhaps doing something you hate, but you also spend less in retirement than you could and leave more for your heirs. Now, maybe that is what you want because you love your job and you would rather leave money behind than spend it on yourself, which is fine. But most doctors I know aren't willing to work longer to allow their kids to have a larger inheritance which will probably have a negative effect on their life anyway.
Pros and Cons of the Income Approach to Financial Independence
There are two schools of thought about the figure for financial independence. The first method has the advantage of being theoretically more correct. The second, however, is not without its advantages.
The first school says financial independence is a level of assets. For ease of discussion, we'll call it 25 times what you spend in accordance with the 4%
rule guideline. So if you spend $100,000 a year, you are financially independent when your nest egg is equal to $2.5 million. You can now spend 4% a year adjusted upward with inflation each year. More or less. Probably.
The second school of thought says that financial independence is a level of income. When the income being produced by your investments is equal to your spending, then you are financially independent. So, if you spend $10,000 a month when your investments produce $10,000 a month, you are financially independent. More or less. Probably. We'll call this school the “Income Approach to Financial Independence.” Let's go through its pros and cons.
The pros of the income approach on FI
- It's easy to know when you've reached financial independence: This is really straightforward. If you spend $100,000 a year, when your investments produce $100,000 a year, you know you're there. There's no dickering around arguing about safe withdrawal rates—$100,000 goes into the checking account and $100,000 comes out. You can even break it down to the month and week if you want.
- You tend to leave more to your heirs: Since you never spend principal, you are likely to leave more money behind to your favorite heirs and charities. At least you know you'll leave something—which, although unlikely with the other approach, is not impossible.
- You can reach financial independence faster: Many of those who endorse the income approach to financial independence are big fans of leverage, real estate, and entrepreneurship. Done well, all three of these generally lead to earlier financial independence than a traditional portfolio asset-based approach combined with a standard J-O-B.
- Behaviorally, it's easier to spend money: The biggest advantage of the income approach is behavioral, not theoretical. Most retirees struggle to spend the assets they have spent a lifetime acquiring. Every year I beg my parents to spend more money on anything they think could even possibly provide them more happiness. I was so proud to see them fly first-class recently, probably for the first time in their life. I think many people are like that. After a lifetime of carefully shepherding assets, saving, investing, shopping carefully, and watching expenses, it's difficult to sell assets even when you know it's the right thing to do. It is hard to remember that building wealth isn't the end goal. You save money not to swim in it a la Scrooge McDuck, but to spend more money later. I think pension holders have much less difficulty spending than others, and the income approach is much more like a pension.
The cons of the income approach on FI
- You might oversave: The truth is that we are not a pension fund or a university endowment. We will all die eventually, and none of our wealth will go with us. It is entirely reasonable to spend principal during retirement. You don't want to spend so much that you run out before you die, but if you don't spend any at all, it just means you oversaved. It's the flip side of leaving more to heirs. It might even mean you worked longer than you otherwise needed to, especially if most of your investments have a relatively low income/return ratio like stock mutual funds. Working longer than you needed to when you didn't want to is a real tragedy.
- It's tax inefficient: If you are building an income portfolio, you are by definition generating more income than you need from the time you start until the time you quit your job. From a tax perspective, you don't want to ever have more taxable income than you actually need to spend. It's tax-inefficient. On the eve of retirement, you are generating twice the income you actually need—and you're paying taxes on all of it. That's a lot of waste (even if your fellow citizens are very grateful for the largesse).
- You can make funny investment choices: If you're not careful, focusing too much on income can result in a portfolio full of lousy investments. The higher the ratio of income/return, the more attractive an investment becomes to an income-focused investor. If you compare an investment that pays out 8% of its 10% return each year as income to an investment that pays out 2% of its 10% return, then the income guy is going to go with the first investment every day of the week and twice on Sunday. However, what happens with some investments is that the investment pays out 8% of its 5% return, i.e. some of the income being paid to you is not income at all, but principal. An investment that returns 5% a year is not superior to one that pays out 10% a year, even if its income is higher. Over decades, that sort of thing can make a huge difference.
- The highest income “investments” require more activity: The biggest issue with the income approach, however, is that the things that provide you the highest income are not necessarily investments at all. While considered “passive income,” they are more like second jobs. It's not “financial freedom.” It's really only freedom from practicing medicine. It isn't freedom from working. Whether you are coaching, teaching courses, doing medicolegal work, or running a successful physician finance blog, it's really all the same. It's hard to argue that is true financial independence, even if you like the work you are now doing more than what you used to do. Real estate can be pretty similar. It's really a spectrum. If you are managing 100 doors, you've got a full-time job. So you hire property management but discover you've still got a part-time job managing the manager. Even if you're only investing in very passive real estate syndications, somebody still has to select and evaluate the syndications as you go along. That's work. So you shouldn't be surprised that an investment you are actively working in has higher returns than an investment that does not require ongoing work.
Money Is Fungible
As mentioned at the beginning, I like the idea of having the higher income available with an income property investment in retirement for the higher reliable (but not guaranteed) withdrawal rate, even though I really don't need that income now. I have more taxable income than I want right now from my earned income. I would defer even more of that until I need to spend it if I could. The tax deferment (and lower tax rates) available from being a “capital gains investor” is not trivial. But the point is that money is fungible. I can sell mutual funds anytime I want and buy an income property, and I can sell an income property any time I want and buy mutual funds. While there are obviously transaction costs, money is fungible. You are not locked into one way to invest and to be honest, there are huge benefits in doing both types of investing.
Investors Should Take the Best From Both Worlds
To sum up, real estate is a great asset class. Investing in it has real advantages due to high returns; low correlation with stocks and bonds; and, particularly in retirement, relatively high reliable (though not guaranteed) income. But there are important concepts that an index fund investor can learn from a real estate investor and that a real estate investor can learn from an index fund investor.
Perhaps the most important one is that the intelligent investor takes the best of both worlds rather than confining himself to just one.
What do you think? Why are 100% mutual fund investors OK with being blissfully ignorant of the advantages of real estate investing and afraid to put a little work into their investments? Why are so many 100% real estate investors afraid of the stock market, ignorant of basic investing principles, and unwilling to take advantage of retirement accounts and a truly passive investment? Are you, like me, a moderate on this issue, and if so, how have you decided to blend these two schools of thought in your own portfolio? Comment below!
This post was updated in October 2021.