Appearing live on CNBC’s Squawk Box, Buffett tells Becky Quick he’d buy up “a couple hundred thousand” single family homes if it were practical to do so. If held for a long period of time and purchased at low rates, Buffett says houses are even better than stocks. He advises buyers to take out a 30-year mortgage and refinance if rates go down.CNBC Interview I’d Buy a Couple Hundred Thousand Single Family Homes
Have you ever looked at your 401k or IRA and wondered if you could do better with a rental property?
Look no more.
I’m going to show you why a boring single family rental (purchased correctly) runs circles around your employer sponsored 401k once you include all the investment factors the financial service industry and investment media fail to include when making a proper real estate versus 401k comparison.
Things like…
Leverage
After tax cash flow
After tax ending value
Realistic return assumptions
Quick…run a Google search on “401k versus rental property. Which is the better investment?”
Did you find a anything?
I didn’t and was surprised no one took a balanced approach after you consider all the key drivers of an investment property return.
Most of the real estate sites compared the historical returns on real estate with the benefits of leverage but failed to account for items like replacing a roof, management fees, and other expenses that confront real world investors like me.
Or, they would tell you could earn 10% appreciation per year if you only buy the right kinda of deal.
Is this possible?
Yes.
Is it probable?
No.
The mainstream financial sites offered some insights but you could tell they favored stocks over real estate. They basically said real estate does worse over the long term since the stock market has averaged 10% (including dividend income) versus 3-4% appreciation for single family rentals.
Bottom line, very few articles talked about ALL 6 benefits of buy and hold residential income property.
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Income
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Depreciation
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Equity build up
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Appreciation
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Leverage
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Value add (we won’t even consider this in the analysis)
When you combine all of these benefits, there is no comparison. Real estate is the clear winner by a long shot if you can free up some time.
Let’s face it. From a time perspective, nothing is easier than buying and holding a diversified global portfolio of low cost index funds that are rebalanced each and every year. If you want a no muss, no fuss approach to building wealth, you can’t go wrong with a 401k or IRA that is properly diversified into 8-12 asset classes.
By the way, if your company offers you free money in the form of a 401k match, take it. The point of this article is not to dissuade you from investing in your 401k, but to consider real estate in addition to your 401k.
As with all projections, we need to establish the ground rules. The property we will consider offers the following.
It’s a no frills 3 bedroom in the Midwest in a neighborhood that is either stable or up-and-coming. Decent neighborhoods attract decent tenants. Good schools and close to commutes or walking distance to parks or trails are an added bonus.
We will use $150,000 for the purchase price and will rent it for $1,500 per month. This fits my minimum investment criteria where monthly rent is 1% of the purchase price. This is called the “rent to value formula.” If you are a real estate geek like me, you call this the “RV” ratio.
Remember, in order to succeed in real estate you must buy right in order to cash flow right. If you can get a higher rent to value ratio, you will make even more money. Just be careful if you buy something where monthly rents are less than 1% of the purchase price.
On the other hand, beware of properties that offer a RV ratio of 2% or higher. These properties tend to be in tough neighborhoods and most likely needs tons of rehab since the seller is offering it at a low price for a reason. If it looks too good to be true, you’re right.
Next, we are going to hire a property manager since you are too busy to self-manage and want to make a balanced comparison to investing in your IRA or 401k. This will run 10% of annual rents. In some areas of the country, it could be less.
We will also add in vacancy, maintenance and repairs plus this thing called capital expenditures (CAPEX) that budgets for replacing big ticket items like a roof, furnace, or siding. To keep things simple, I will subtract the CAPEX from the gain later on in order to adjust the tax basis. Technically, you would depreciate this expense as well in the year you spend down your CAPEX account.
Total vacancy allowance, maintenance and CAPEX will represent 20% of the rents. As long as you buy a solid property that doesn’t need lots of work, you can easily hit this number. The key is to purchase something that is not too fancy or too cheap.
Again, this rental is the classic blue collar property that you drive by each and every day on your morning commute.
Finally, we will assume the tenant pays all the utilities and takes care of the lawn care and snow removal. I’m in Minnesota, we have lots of snow plus lush green lawns. This is fairly common with single family rentals across the U.S.
We are going to finance this rental with 20% down on a 30 year mortgage at a 4.5% fixed interest rate. Closing costs will run $3,000. Thus, total investment is $33,000. As an investor, you can’t get into a rental on the cheap like you do with your personal residence. This is why we are going with 20% down.
Note: Don’t get caught up in the exact numbers. The key ratios in this analysis are rent to value, expenses as percent of cash flow and loan terms. I have properties with numbers that are worse than this and it still makes sense.
Finally, we will factor in inflation for appreciation, expenses and rents. I’m using 3% for everything since we are currently in a tepid inflationary period.
For the record, inflation has been running 1.5% since the financial crisis of 2008. Since 1926, it has averaged 2.9%.
For the 401k, we will use the same $33,000 investment and assume no contributions.
Just like the real estate numbers, don’t get hung up on the $33,000. Most people blindly add to their 401k and never really question whether or not this is the best use of their money.
All you need to know is you can easily accumulate $33,000 on a $50,000 salary if you save at least 15% of your salary in a 401k. Add in an employer match and this is a no brainer over 5 years or less.
Lastly, we will give the 401k investor a generous 10% compounded annual growth rate (CAGR). This number is ludicrous (like the cool Tesla button) when you consider that the average investor in a 401k earns nowhere near 10% over 30 years.
Most studies show the average investor earning 4-6% due to chasing performance, paying excessive fees for active managers and buying high and selling low. Fees and fears rules the day for most investors.
Historically, the S&P 500 Index (excluding fees) has averaged 10% since 1926.
Here is a snapshot from my nifty software that allows me to analyze properties on the fly from my iPad. It shows all the data we need excluding the tax benefits.
First, the financial dashboard
Next, the 30 year projection excluding tax benefits
Like Graphs better?
Check out that internal rate of return in the blue bars above. It starts at a negative due to the acquisition and then starts trending up to almost 20% a year. Thereafter, it slowly declines but maintains a 17% return over 30 years.
For you non-financial peeps, this is the number that reflects both the cash flow and expenses plus the growth rate of the asset and the disposal of the asset. Just this number alone runs circle around the 10% stock market returns that the financial industry likes to trump.
In fact, a 17% annualized return would put you among Wall Street’s elite money managers.
Warren Buffet & Charlie Munger have compounded Berkshire Hathaway at 19.0% per year since inception (book value gain 1965-2016 vs 9.7% SP 500 Index with reinvested dividends). 99.9% of professionals have done worse.
Why is real estate so much higher? Due to the leverage and low volatility. The bank allows your to leverage your money by 5:1 and lets you keep all the cash flow and tax benefits. Plus, residential real estate is one of the most stable assets out there. This is why banks love residential real estate loans.
Unlike a stock portfolio that can be margined (leveraged) as well, it is much harder for the banker to make a margin call on your property than it is for your broker. Plus, you can’t leverage your stock portfolio by 5:1 with your brokerage account.
Here are the same numbers where I summed it up and then added in the tax benefits of real estate depreciation plus mortgage interest deductions and the after tax values.
401k vs Rental Before and After Tax
To help you gain an understanding of how slowly real estate wealth builds over time, I simply insert the annual number so you can get a feel for what the financials look like in year 5, 10, etc. The cumulative benefits are shown under the corresponding column after year 30.
Let’s dig into the amazing tax benefits.
Whatever you do, do not gloss over this section. This is where real estate shines as an investment. While you might not like our current President, he sure knows how to use real estate to pay little or no taxes. Just like the Kennedy’s by the way.
First up, the phantom write off called depreciation. This is an expense that doesn’t cost you any money. Basically, the IRS allows you to write off the value of the building each year to steer investors into providing housing.
For residential income properties, all you do is take the purchase price excluding the land value and divide by a factor of 27.5 years. For commercial properties, it is 39 years.
Why 27.5 years? Who knows. The IRS likes to make things complicated. Just like when they say you can take money out of your retirement at 59 1/2 and have to take some money out of your IRA or 401k at age 70 1/2.
Next comes the interest expense on the mortgage. Once you own a rental property, the IRS considers you a business owner and your loan interest becomes tax deductible. This is huge. The government is basically paying you to go out and borrow money to provide housing for the masses.
Let’s look at how these two deductions help you save money on taxes today and to infinity and beyond. Well, for the next 30 years.
In year 5, you show a profit of $4,364. From a tax standpoint, you show a loss of -5,828.
How amazing is that? Better yet, you may be able to write this loss off directly against your salary or self-employment income.
This is the other reason (outside of leverage and stability) real estate excels over the 401k and other investments. You can lower your taxes on your earnings today and basically leverage the tax savings into more savings.
Warning: DO NOT buy and hold physical real estate (loans, notes and land are ok) in your 401k or IRA.
There are a bunch of real estate guru’s that recommend this and I consider it a terrible strategy due to a number of factors. All you need to know is you will strip out all tax benefits we are discussing here when your rental is sitting inside your retirement plan and you will be taxed at a higher rate if you die or sell in the future.
If you must buy real estate in your retirement plan, hire a tax attorney and do not rely on alternative asset custodians for tax advice. If you screw up , it could force the entire IRA or 401k to become disqualified and you will suffer a massive tax hit plus a 10% early withdrawal penalty.
Let’s go back to the projections in year 30. The value of the real estate is actually less than the 401k. The ending value of the house is $364,089 versus $575,830 for the 401k.
Yet, we need to add back the after tax cash flow from your rental at $261,365. Combined, this boring 3br home ends up being worth $638,083.
Here is where things get interesting.
Do you know your 401k or IRA is actually worth less than the value of your online account balance? As the ‘ole saying goes, it is not what you earn, it’s what you keep.
Most people forget this. To tap the cash from your retirement, you need to pull it out in terms of a 1099 distribution so the IRS can tax the money at your ordinary income tax rate. In other words, your retirement account is worth 15-45% less (depending on your combined Federal and State income tax rate).
What is the after tax value of these investments if you were to cash out in year 30?
While I would never advise this, if you sell out at end, the after tax value of the 401k drops to $414k (actually less since your tax would be higher on 414k in income) while the after tax value of your little 3br cash flowing ATM machine drops to $295k-excluding the costs of the sale which could easily lop off another $25k in realtor fees and sales prep.
Still, if we add back the after tax cash flow of the rental over 30 years (less the $25k in sales costs), you still come out ahead.
The difference is $141,961 for the boring 3br single family rental. That can definitely buy some extra years of retirement income.
By the way, how much does your 401k pay you each month. Can you go out to dinner with the money you gained in your 401k?
In this scenario, you cash flowed $261,365 over 30 years (after tax) on a $33,000 investment.
Can you see why so many Main Street millionaire’s are landlords?
Here’s the primary problem with a 401k/IRA once you hit age 59 1/2 and wish to retire.
If you hired me to analyze these two investments with the intention of maximum cash flow with the least amount of taxes, I would tell you to take the bare minimum from your 401k to live on since it is taxed like your salary and then sell the rental and exchange it into a bigger and better property that offers more cash flow.
By utilizing a thing called a “1031 exchange” you can transfer all your taxable gains and depreciation into a new property tax free as long as you follow certain guidelines.
This is why it is critical that you hire a savvy tax person to analyze things before you sell. Between the capital gains tax and this thing called depreciation recapture, you would be crazy to sell the property outright.
With $364,000 or so equity to deploy, you could easily purchase a couple more homes to double your annual cash flow. A small multi-family would definitely do the trick.
Sure you would have a new loan, but purchasing 1 million in real estate with 36% down is a no-brainer as long as the deal cash flows right and is in a stable market.
With the new higher value on the purchase, you can reset the depreciation clock and coupled with the mortgage interest deduction, you could create a new tax free income stream of $34,000 or more per year compared to $16,000 after tax in our hypothetical scenario.
Boom! We just doubled your inflation adjusted retirement cash flow.
You could never do this with your 401k without taking on some massive risk.
Worse, when you die, the 401k has to be paid out and taxed to your beneficiary. For real estate, the value at death would “step up” to the fair market value at your untimely demise and your heirs would inherit the real estate tax free!
Don’t want to double your cash flow by taking on a new mortgage and buying more properties? Fine, place a new loan at 50% loan to value and walk away with $180,000 tax free.
Can you take $180,000 out tax free from your 401k? Unless it is inside a Roth 401k, forget about it.
There you have it. The boring single family rental offers a higher return, monthly cash in your pocket and unique tax benefits to both you and your heirs. Plus, more flexibility to enhance your wealth through 1031 exchange or refinance.
What are you waiting for? Go out and buy a bread and butter 3br today.
Further reading:
Why The Oracle of Omaha Likes a 30 Year Mortgage Versus Paying Cash for a House
plain and simple , Best written Article ever,! real estate it is
Glad ya liked it!
Great comparison
Question: I do both now but should I not max out 401k after my match and use the difference to pay off loans on my loans faster?
It all depends on your goals and tax bracket.
If you are looking to minimize taxes, keep maxing out 401k for tax breaks and keep the mortgages. However, if you are looking to reach early financial independence, you could easily make the case to contribute to 401k up to the maximum match and then take extra cash to pay down mortgage.
Or, keep mortgages and use excess funds to save for next rental. If you can get ten rentals in ten years, then you would be set for life assuming you buy and manage right.
Great article! My husband and I both contribute up to our company match and use Roth IRAs to store our emergency fund. Plus my company has a 6% of salary profit share that is added to my 401K once a year.
Between the two of us we are able to save about $15,000 + (extra cash) a year and have been researching how to invest our savings. There is a shortage of rentals in my area and after reading your article, this may be the way to go. My husband is extremely handy, so we would be able to care for the properties our selves.
Nice! All ya need to do now is buy one cash flowing property a year and you will easily hit a million in ten years or less.
What software is that you are using on your ipad for deal analysis??
I bought the pro version of Property Evaluator. It’s an amazing value. Plus, it helps me breeze through commercial bank underwriting. Here is the link http://www.propertyevaluator.com/ or you can download on the Apple App store.
I’m curious how you would calculate rent to value ratios for a home that you have lived in for 10 years and are now converting to a rental. Purchased home for $300k, now worth $600k. $230k left on the mortgage. Only rents for $2500/month. If I took all the equity out of the house (sold it), I would net $335k cash after selling fees. Should I consider this the “Value”?
I would use the $600,000 value to calculate the rent to value ratio. Ideally, it should rent for $6,000 per month or higher.
This is common among higher value properties where it becomes impossible to cash flow since you can only demand rent that the market dictates.
In your scenario, I’d sell the house (assuming you wish to expand your portfolio) and use the equity to purchase more properties.
Or, if your goal is to simply keep the house, recognize that it’s not a good rental but a nice appreciation play.
I’m dealing with a similar issue right now as I analyze some coastal properties. The current rents do no support the deal, but from an appreciation standpoint, it may make sense.
Thank you! Yes, it is tricky. This is a very hot housing market, and even though rents are low compared to value, there is a very low rental supply, so vacancies aren’t much of an issue. One plus for me is that I know the house and the market well. For me to find a property with a 1% RV ratio, I would have to look out of state, and I’m not sure I have the energy to deal with that!
I agree. Sometimes, you can find better deals in the 5 unit+ space. I’d consider looking there since small multi family deals are appraised based upon cash flow versus comparable sales comps for 4 units or less. You could tap the equity in the current house for the multi down payment. Plus, there is less competition in the 5 to 25 unit space.
When you say tap the equity to use as a down payment on a multi unit property, are you referring to a cash out refinance or a HELOC? Which one do you recommend?
I prefer the HELOC if it’s available. Way easier than a cash out refi
Thanks for this timely article! I am obsessed with trying to max out my 401k, mainly to lower my taxes for the year, but I already own 5 rental properties and am looking for more. My gut tells me that I should drop my 401k contributions down to enough just to get the match from my employer, and focus on using the extra cash to get more properties. Do you think that is the best route to go? From what I just read, the answer is yes.
That’s a tough call. For tax purposes, it makes more sense for me to keep buying rentals since I’m considered a real estate professional and can achieve higher tax deductions compared to maxing out my 401k. In the perfect world, you do both.
If your income goes past a certain threshold, I think it’s 150k adjusted gross income? You can’t write off all passive income losses against active income. I would definitely run the numbers with your CPA.
On the other hand, if you are looking to buy more rental properties, I’d lower the contribution to your 401k to hit your goal for at least 10 rentals or higher. I find 10 rentals to be the sweet spot for financial independence.
I’m all for real estate over 401k as I’ve been preaching to my little brother but don’t you have to include your ” what-if” 401k contributions to get a fair even analysis. If I have 30k in my 401k that I’m contributing just enough to get the company match (5%) and I keep doing that for 30 yrs the amount in my 401k will be way over a million if I’m 30 now. I understand I lose if I take a lump sum out plus there is the taxes but the numbers favor a 401k if you only have this one property.
Ideally though once I had equity in the rental property or saved up enough cash flow, I would repeat this over and over again or as I have done move on to duplexes and then multi-family to come out way ahead in 30 yrs but the 401k with contributions beats your 1 rental. I tell people that if your company matches your 401k at the minimum pay enough to get the free 100% match then put the rest in real estate.
Martin, thanks for the comment.
I’d definitely contributed to the 401k up to the match. It’s a no brainer. Never turn down free money.
In terms of comparing monthly contributions to a 401k versus a rental property, the math is the math. The rental property wins.
Cash flowing rentals offer a higher return with less risk (from a strictly return standpoint due to lower volatility/higher sharpe ratio) versus equities. Check out this post for details https://www.tentomillion.com/archives/684
Wow. I just stumbled across this article on a google search and this is fantastic! It confirms what I have always suspected, which is that my rental properties will out perform my employer sponsored 401k. I am a Real Estate Broker in Phoenix, AZ and have the added benefit of being paid a 3% commission for every rental property that I purchase! This is not factored into your formula above, but is a huge plus for those of us in the real estate business. I also self manage my 4 rental properties, so I can subtract all management fees. In addition to owning my own real estate firm, I also work for an employer FT. I save 13% of my salary and they contribute a 5% match. I’ve been with the company for 6 years and have saved $70,000 so far. Here is my current dilemma. I just turned 50. I plan to retire at 62, so best case scenario, in another 12 years I may have 200k in my 401k. However, our company was recently acquired and starting in January of 2021 our 401k company match is dropping to a lousy 2%! The Cares Act for the first time ever, allows me to withdraw my entire 401k balance without paying the 10% penalty and I can pay the income tax over a 3 year period. I am really feeling like I should pull out the 70k in December and buy a 5th rental property. Keep in mind that even if I withdraw the 70k, I can still participate in the 401k plan and start over again and just contribute enough to get the 2% match. I would love to hear your opinion on this!
Nick,
Thanks for the comment and questions!
I would run the 401k distribution idea by your CPA to make sure this works.
From what I have read on the IRS website, you need to show a COVID related hardship to pull money out of your plan without incurring penalties.
Also, If you don’t pay the money back, this will be treated as taxable income. While the tax would be spread out over three years, it would still be a sizable hit.
Here is what I pulled from irs.gov
A3. You are a qualified individual if –
1. You are diagnosed with the virus SARS-CoV-2 or with coronavirus disease 2019 (COVID-19) by a test approved by the Centers for Disease Control and Prevention;
2. Your spouse or dependent is diagnosed with SARS-CoV-2 or with COVID-19 by a test approved by the Centers for Disease Control and Prevention;
3. You experience adverse financial consequences as a result of being quarantined, being furloughed or laid off, or having work hours reduced due to SARS-CoV-2 or COVID-19;
4. You experience adverse financial consequences as a result of being unable to work due to lack of child care due to SARS-CoV-2 or COVID-19; or
5. You experience adverse financial consequences as a result of closing or reducing hours of a business that you own or operate due to SARS-CoV-2 or COVID-19.
Under section 2202 of the CARES Act, the Treasury Department and the IRS may issue guidance that expands the list of factors taken into account to determine whether an individual is a qualified individual as a result of experiencing adverse financial consequences. The Treasury Department and the IRS have received and are reviewing comments from the public requesting that the list of factors be expanded.
I like where you are going with this idea. I have pulled money from my Roth IRA in the past to pick up down payments on income properties. However, you just want to make sure you are not breaking any rules and then get the “Oh Sh***t” letter from the IRS stating you owe a bunch of taxes coupled with back interest and penalties.
How much would the potential property cash flow each month?
A good rule of thumb to follow for retirement income planning is to take the account balance and multiply by 4%. In your case, you could expect to pull $2,8000 per year from the $70,000 you have in your 401k as long as you invest it correctly.
Note: You would need to invest at least 60% in stocks and the remainders in government bonds and cash.
As long as the property cash flows more, you would be in great shape.
Keep crushing it in the real estate game!
Yes, I plan to talk to my CPA to figure out approximately what my tax burden for each year would be, if I paid equal installments over the three year period. As for qualifying. I easily meet the test. My corporate job has us doing 1 week of unpaid furlough each month and my real estate biz died back in March. AZ is having a major outbreak, so no telling when things will start to pick back up again.
So, I believe I will have no issues qualifying for the 401k withdraw under #3. “You experience adverse financial consequences as a result of being quarantined, being furloughed or laid off, or having work hours reduced due to SARS-CoV-2 or COVID-19.”
As for cash flow, all of my current rentals are generating a gross income of approx. $23,256 annually per property and after the mortgage, taxes and hazard insurance is paid, a net of almost $11,000 annually per home. So if you are telling me that my 401k is only earning me about $2,800 a year on a $70,000k balance then clearly $11k for another rental runs circles around that!
Awesome cash flow!
I agree, rentals run circles around the stock market from a cash flow standpoint. I like to focus on cash flow versus equity. For instance, if you had 1 million in a 401k, the most you could draw from the account to last a 30+ year retirement would be $40,000 per year.
You could accomplish the same goal with your current cash flow on rentals with only 4 properties.
Update: So, after my company announced in August that they were suspending the 5% 401k match until mid to late 2021, I yanked it all out penalty free under the Cares Act. I’ve bought another rental! I also stopped contributing 13% of my salary to my 401k and will not start it up again unless the match returns. Best decision ever! The Phoenix rental market is on fire!
Man, I wish I were buying and holding in your market! You may want to contribute the max to a Roth IRA since your employer is no longer matching contributions. The Roth is one of the most tax-favored vehicles in our tax code. Nice job of taking advantage of a crisis. We only get these periods every ten years or so.
Do you have experience with rentals in Canada? Following your advice I shouldn’t go with something that doesn’t cash flow. But in Canada it’s really hard, even imposible to find something that meets the 1% rule…
I’m not familiar with Canada. You may wish to expand your search for a market within your country that cash flows. Or, find something that most people miss and create new cash flow.
For example, imagine finding a large 2 bedroom house. You may be able to add a 3rd bedroom and make it cash flow.
Another approach is to find a distressed property and turn it around. My best deals like this were never advertised. I would bike, walk or drive through neighborhoods and contact the seller directly to see if they would sell. The signs of distress are easy to spot. Overgrown lawn, tenants destroying the place, etc.
On bigger pockets, I heard a podcast interview with investor girl Britt. She is in Canada and makes it work. Maybe check out what she is doing?
I know you said to still contribute to my 401k up to my employer’s free money match. However, I have seen other real estate investment advisors say that even with the employer match, it is better to not do that and move all 401k money to invest in rentals.
If I save 6% of my salary in my 401k and my employer matches 50% of that, how can real estate rentals beat that 50% return? Thx!
Your math makes more sense to me and offers a higher guaranteed return (employer match plus tax deductions). I prefer to see my clients with both rentals and retirement plans. Putting all of your net worth in rentals is not a calculated risk.
Better yet, a fat 401k allows you to qualify for loans. Bankers like to see retirement plans, strong w-2 earnings, and a solid equity position when they present your file to the loan committee.
In terms of other real estate advisors, I believe most of them preach you can get a higher return with rentals. While this is true for the right deal, it is not true for all deals. I’m looking at a distressed deal next week and I can guarantee you that the seller lost his shirt on this one.
In my opinion. keep doing what you are doing.