Earlier in the year, I had a nice conversation with a well-known San Francisco angel investor about risk and reward. I had a chunk of money coming due from an expiring 5-year CD and I wanted to get some advice on what to do with it. I asked him whether he would be leveraging up or paying down debt in this bull market. He responded, “Sam, I always like leveraging up. It’s how I made my fortune.” This angel investor is worth between $50 – $100 million dollars.
Of course you can’t just leverage up into any old investment. The investment has to be something you know fairly well and has a good risk/reward profile. The only thing I have confidence leveraging up on is property. Everything else seems a little bit like funny money.
Although I quit my job a couple years ago to try my hand at entrepreneurship, I’m a relatively risk-averse person because I’ve seen so many fortunes made and lost over the past 15 years. If I was risk-loving, I would have done what so many brave folks do nowadays and quit as soon as I had a business idea, instead of methodically moonlight before and after work for three years before negotiating a severance. The breakfast sandwich guy I used to go to for 10 years while I was working told me he was worth $3 million dollars during the dot com boom in 2000. I went back for old times sake last month and he is still there!
Despite my risk-aversion, I do believe money should be used to increase the quality of your life and the people you care about. As a result, I did something recently that might seem financially risky, but I think the move actually lowers my financial risk profile now that I’ve had a chance to fully process the situation.
I finally found my panoramic ocean view Golden Gate Heights home! A room with a view has been on my bucket list forever. But it never occurred to me to look in San Francisco, despite being so close to the ocean because I thought such homes would be unaffordable. San Francisco already has the highest median single family home price in the nation at $1 million. To add on a panoramic ocean view would make prices outrageous, or so I thought.
It’s the same curmudgeon as never asking out a super model because you think she or he will say no. You’ve just got to ask and I’m sure you’ll be delightfully surprised once you try.
After spending months aggressively looking for my next ideal property within my budget, I found a view home for less than half the cost of my existing home on a price/square foot basis. How is this possible you might ask? The farther west you go from downtown and the established neighborhoods, the cheaper prices are in general (see the graphic I created in The Best Place To Buy Property In San Francisco Today). But the farthest away you’ll ever be is 7 miles because San Francisco is 7 X 7 miles large. Given I’m only going into a downtown office two times a week, I don’t mind the extra 15 commute. To be able to watch the sun go into the ocean every day for the rest of my life is priceless.
THE RISK OF BUYING REAL ESTATE NOW
Buying property in 2014 is not as good as buying property in 2011-2013. Prices in major cities such as Miami, Las Vegas, Phoenix, Los Angeles, New York City, and San Francisco have risen quite aggressively over the past several years. But I couldn’t have bought property in 2011-2013 because I was in the middle of leaving my job and I didn’t have a large enough downpayment for what I wanted. I needed to prove I could create wealth on my own for at least a couple years before buying another property. (See: How Much Do I Need To Make A An Entrepreneur To Replace My Day Job Income?)
Some positive things happened since I left work. First, I didn’t sink to the bottom of the deep blue sea, but caught a wave of growth in my business. I got over my fear of failure with every new minute I spent online. Second, a large chunk of change was coming due from a 5-year CD I mentioned previously. The great thing about putting your money away in a CD or long-term investment is that you get used to not seeing or needing the money – very similar to paying yourself first or maxing out your 401k. I wanted to invest the CD proceeds into something more tangible or rewarding than just trying to make more money. Finally and most importantly, my primary property’s valuation went ballistic.
I wrote a post on March 13, 2014 entitled, “Zillow Is Broken Or We Are In A Massive Housing Bubble” to get my mind straight before actually buying another property. When I wrote the post, the valuation had risen every single day for nine months in a row for a 60% gain, which didn’t make any sense. I was absolutely sure the chart would start leveling out. But that wasn’t the case at all. Its valuation actually spiked by another 30% four months later as of today!
Here is a price chart of my previous primary residence of 10 years on Zillow:
Without property price appreciation from my existing properties I purchased in 2003 and 2004, I would have a much more difficult decision buying more property in SF, even with rents skyrocketing. But by coupling the property portfolio appreciation with the fact that I was buying a home 50% cheaper than my existing home, I mustered up the courage.
I had a 30+ year real estate veteran and #1 nationwide producer for her firm come by and do a free assessment of my house the other month and she said I could get the first absurd value in the chart above “no problem.” I didn’t believe her because I know my home and I know the strategy of buttering up clients to snag a listing.
I then had to do an official appraisal on my primary residence as part of my mortgage application process for the new Golden Gate Heights home. That figure coincidentally came out to the first absurd value as well. So maybe, just MAYBE, the house is worth Zillow’s first estimate, but definitely not the latest estimate. Several houses close by recently closed for $1,500 and $2,200 per square foot, which is causing the entire neighborhood to go bonkers. But these houses are on quieter streets or are more upgraded, and Zillow can’t tell the difference.
Logic would say that when prices are going crazy, it’s a good time to sell. But I thought 2012 was a decent time to sell too (thank goodness I didn’t). Maybe I’m being absolutely stupid for not selling now, but if I sell my home, I wouldn’t know what to comfortably do with the proceeds because I already have proceeds from my 5-year CD which I have to put to work. Earning 0.1-0.2% in a money market is not an option. Furthermore, if I sold my home, I fear I will be priced out of the north end of San Francisco forever (Pac Heights, Marina, Cow Hollow, Presidio Heights).
The best time to buy property is when you can afford it, because long-term price appreciation is generally always up and to the right due to inflation. Because the property price point is multiple times higher than your salary, it’s hard for individuals to catch up e.g. a 10% appreciation on a $1,000,000 home requires a 100% appreciation on a $100,000 salary just to stay even.
Note: I decided not to highlight the specific valuation of my home, even though it would make the illustration easier to understand because there are readers from all over the country and the world who would find doing so to be poor taste. Percentages should be able to make the point. But because I have already publicly stated in prior posts my desire to make $200,000 in passive income, I am highlighting the debt and rental numbers in the next section.
INCREASING PASSIVE INCOME BY LEVERAGING UP
The ideal mortgage amount is $1 million dollars if you can generate a ~$200,000 income. The interest on a $1 million mortgage is the maximum mortgage indebtedness you can deduct from your income excluding $100,000 in HELOC money for home improvements. I’m not really down with individuals taking out a HELOC because the interest rates are always higher, and I’ve found people to get in trouble by spending money on unnecessary things e.g. cars, vacations, etc.
You might think I’m crazy for taking on a lot more mortgage debt after already having a $1 million dollar mortgage for my other residence in the chart above, but hear me out. The interest I currently pay on my old primary residence is $2,200 a month at 2.65%. Add on property taxes and insurance, and the total cost is roughly $4,000 a month, all of which is deductible.
But the rent I locked down was $8,700 a month, for a $4,700 a month profit for a two year lease. The incredible thing is that I had multiple sets of people who were interested in renting at this price or higher. One rental agent actually e-mailed me asking how come I was charging too little. I’ve essentially extracted $56,400 a year in relatively passive income while still controlling an asset that has the potential to continue appreciating over the next 30 years. In the short-term, I have no doubt the asset could correct by 15%. In fact, I’m counting on it to eventually correct because trees don’t grow to the sky forever.
I have a fundamental problem with paying a 5% or greater selling commission in this internet age. It is amazing that the internet has cut costs for every single industry except for the real estate industry. I encourage sellers to go on strike and never sell their property until such costs are lowered to a flat rate or more reasonable rate. Selling a property now means you are automatically losing 5%-6% to fees. Furthermore, if my return on equity can beat the 4% per annum ownership cost, I’ll essentially be able to live in my home for free all these years.
PAYING DOWN MORE EXPENSIVE DEBT
The other reason why I decided to take on a $1 million mortgage at 2.5% was to conduct debt arbitrage. I was originally going to put down $200,000 more for the home as stated in my no financing contingency offer. But the bank said that all I needed to do was put down 20% since the loan was already approved by the underwriter. And given the bank makes more money the more they lend, they were happy to lend me at a 80% LTV once my finances were approved.
Originally I was a little wary of the bank giving me more money than I assumed. But I took them up on the offer by only putting 20% down. I used the extra money to pay down my other rental property mortgage at 3.375% for an annual savings of $1,750.
Always maximize your financial arbitrage opportunities when you see them. They don’t come around very often.
PASSIVE INCOME DETERMINATION
In 2012, I set out a goal to build a $200,000 passive income stream by June 2015. Year one produced roughly $78,000 a year in passive income. Year two produced roughly $110,000 a year in passive income. With the move to rent out my long time primary residence, passive income is now +$56,400 – $16,000 lost from annual CD income for a total passive income stream of ~$150,000, assuming I do nothing else.
I’m shooting for $200,000 year in passive income because I believe $200,000 is the ideal income for maximum happiness. The government starts going after you if you make much more than $200,000 with higher taxes, AMT, credit eliminations, and deduction phaseouts. $200,000 keeps you in the respected and not-hated mass affluent crowd. $200,000 is also a level where one should be able to comfortably raise a family of three in almost any expensive city around the world.
A $50,000 a year passive income gap is going to be very hard to overcome in one year, but I’m definitely going to try. There is something about writing out goals and making them known that really helps keep people accountable. Even if I fail, I always think about an old Chinese saying, “If the direction is correct, sooner or later you will get there.”
The older I get, the more aggressively I’m going after my bucket list items. I know several people who’ve died at the age of 50, and that’s only 13 years away for me. I’ve always wanted a room with a view of the ocean and I’ve finally found it. Hopefully the real estate market won’t crash tomorrow. But if it does, I’ll work hard to make sure I don’t exacerbate the decline and I’ll remind myself that a forever home is never to be sold.
Recommendations For Building Wealth
* Manage Your Finances In One Place: The more passive income streams the more you have to keep track. I aggregate all 32 of my accounts with Personal Capital so I can easily stay on top of my finances. Not only is it free, Personal Capital tracks my net worth automatically, allows me to manage my cash flow month-to-month, and has a fantastic Investment Checkup tool that highlights how much you are paying in portfolio fees and how you can optimize your investments. They also recently launched an amazing Retirement Planning Calculator that pulls in your real data and produces realistic financial outcomes using Monte Carlo simulation. I’d definitely give it a try to see how you’re doing. It’s the best free financial tool on the web today.
* Shop Around For A Mortgage: LendingTree Mortgage offers some of the lowest refinance rates today because they have a huge network of lenders to pull from. I always spend the time to shop around online in order to get the lowest rate with the best terms. When banks compete, you win as they say and it’s the truth.
Updated for 2016 and beyond