The Pros and Cons of Income Investing

This Today’s Classic post is republished from the White Coat Investor. The original post can be found here. Thought it was a fascinating discussion the first time I read it and have re-read it several times since. I consider myself a pretty balanced investor, investing in both the stock market and in real estate. However, in terms of mindset, if anything, I identify with the income investor. So it was good to hear what the other side thinks even if it can be seen as a criticism of a group I roll with. In the end, I think WCI and I are on the same page though – both sides (stock market and real estate investing) have its merits and a balanced approach is usually the best. Tell me what you think after reading this? Enjoy!

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 which 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 click-baity (and lest you think that’s bad, I’m all for click-baity 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.

1. 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.
2. 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.
3. I like the idea of having relatively high-income investments in retirement, so 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.

    

    

4. 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 is available.

Now, let’s talk about some of the problems these guys fall into.

5 Problems Income Investors Need to Consider

1. High Yield Does Not Equal High Return

The first problem is that many of them 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, then you find out your $10 shares are worth $2.70.

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 and 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 but 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 5 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 not only comes from additional risk and leverage, but 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 and 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 now sure how to tactfully put this, but I’ve been surprised by the lack of basic knowledge of the tax code and 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 on-going 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. I mean, 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 7 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 of the matter 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 that 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 his pre-retirement lifestyle on 1/4-1/2 of his 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 yourself, which is fine. But most doctors I know aren’t willing to work longer in order to allow their kids to have a larger inheritance which will probably have a negative effect on their life anyway.

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 and 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 okay 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?