I’ve been dreading this day for the past five years. First Republic Bank sent me a letter in the mail stating that one of my 5-year CDs is coming due and that I have a seven day grace period to withdraw my funds before they renew for another 5-year term. I would be fine with renewing except for the fact that the renewal interest rate is only 2.2% vs. the 4.2% I’ve been receiving. I’m not locking my money up five years for a lousy 2.2% a year, no way.
The post “CD Investment Alternatives: Why I’m No Longer Investing In CDs” provides a longer explanation of why buying a CD now is suboptimal. But curiously enough, it doesn’t highlight the one investment that I’ve been gravitating towards since I received the letter from the bank: real estate.
Real estate is my favorite asset class, even though I’ve discussed selling my rental properties in the past due to the headache of dealing with tenant issues. I just love being able to live in my investment, do things to improve the value of my investment, and wake up 10 years later with a high probability of holding an appreciated asset with a lower mortgage. The tax benefits aren’t bad either.
A deep dive assessment of all my assets shows that real estate has provided the highest return on capital invested with the least amount of stress. I have a tendency to speculate in stocks in order to find that multi-bagger return that has eluded me since 2000. Many of my speculative bets have turned sour and I don’t want the temptation to speculate with larger amounts of money. The last thing I want to do is use my risk-free money to invest in stocks. I absolutely hate losing money and I’ve already got 25% of my net worth in the stock market. (See: Net Worth Allocation Recommendation By Age)
ONLY TWO CHOICES: PAY DOWN DEBT OR BUY MORE REAL ESTATE
I know it seems funny to narrow the use of my CD proceeds to paying down debt or getting into more debt, but that’s what I’ve decided unless you can convince me otherwise. The second safest asset to holding cash under the FDIC guarantee limit of $250,000 for singles and $500,000 for couples is paying down debt. Going into debt is not safe, but I’ll explain my position soon enough.
The Case For Paying Down Debt
The only debt I have and don’t mind is mortgage debt because it’s deductible and is tied to an asset which has a high probability of appreciating over time. Leverage is a wonderful thing on the way up, but not so much on the way down as we’ve seen most recently in 2008-2011. My main rental property has a mortgage rate of 3.35% that is fixed for the next three years (5/1 ARM). 3.35% is not quite the 4.2% I was receiving from my CD (interest rate arbitrage), but its sure better than the 2.2% being offered for another 5 years.
1) Increase cash flow. The rental mortgage amount is $277,000, therefore, I would increase my cash flow by roughly $774 a month, equivalent to the interest portion of my mortgage ($277,000 X 3.35%). I would actually free up more cash flow because my mortgage is amortizing, which means I would also pay down roughly $540 in principal with each mortgage payment for a total payment of $1314.
Even though I would no longer have to pay $774 a month in interest, I’m losing about $196 a month in cash flow because this money was making 4.25% in a CD instead. I just don’t see any other risk-free assets that can provide 3.35% given the 10-year yield is under 3% and volatile. The only thing that comes close to buying Treasuries is perhaps muni bonds, which are tax free and can yield 4%.
2) Slay the annoyance. Besides no longer having to pay a $1,314 a month mortgage, the other great benefit of paying off debt is that it simply feels wonderful having no debt. When I decided to pay off my business school loans, it felt magical – like a snuggling with a fluffy golden retriever puppy. It’s nice to know that a bank is no longer making money off me, even though the money is relatively cheap at 3.35%. I’ve noticed that the older I get, the more annoyed I am with having debt.
3) Lower tax payments. Finally, I’m no longer making as much as I once was. Therefore, the income earned from my rental property is being taxed at a 11.6% lower marginal tax bracket (39.6% vs. 28%). I’ve still got amortization to shield me from paying taxes on most of my income as well.
The Case For Buying More Property
Although property is becoming outrageously expensive in San Francisco, I believe just like every other international city in the world with a thriving economy (London, NYC, Hong Kong), prices will just keep on getting more expensive. Just one look at the job listings on Angel.co/jobs and you’ll see that basically every single startup job is between $80,000 – $200,000, and there are thousands.
1) Higher Return On Equity. If I decide to pay down the $277,000 mortgage the return on my equity goes down. The property is currently valued by Zillow at $1,045,000. Let’s cut that value down by 15% because Zillow is often wrong to get a value of $888,250. If the property appreciates by 10% ($88,825), the return on my $611,250 in equity is $88,825 / $611,250 = 14.5%. If I decide to pay down the mortgage, then my return on equity declines to 10% ($88,825 / $888,250). On the other hand, if I only had 10% equity in the property, my return on equity would be 100% ($88,825 / $88,825).
Let’s say I utilize $200,000 of the $277,000 for a 20% downpayment on a $1 million property instead of paying down debt. If the property appreciates by just 3% ($30,000), I make a 15% return on my down payment ($30,000 / $200,000). A 3% appreciation rate in San Francisco does not seem unreasonable given the robustness of the technology and internet sector in the area. AirBnB will go public. So will Dropbox and a host of other companies in the near future. Too bad the 5% selling commission rate still exists. Ridiculous, really.
2) New Adventure. I’ve lived in my current home for a little over nine years now. It would be fun to purchase a new property in a new neighborhood in San Francisco to live. Some places such as Telegraph Hill or The Mission come to mind for their different restaurants, parks, and night life. I don’t plan to buy a rental property for the main purpose of renting it out. I’m also not just going to buy any property. The property has to be something I really enjoy where rent can immediately cover the mortgage and taxes just in case something happens. The new property is where I plan to live for the next five years.
3) Frees Up A New Cash Flow Stream. I don’t want to get into too many details, but I can rent out my house for roughly double my mortgage interest + property tax amount a month. Renting out my house would therefore increase my cash flow beyond what I lost in CD interest income as I settle down in a new place. The trick is to find a place in a market when there’s hardly any inventory. I went to check out this nice three bedroom, three bathroom + bonus room house which I liked, but the asking price was literally 20% higher than what I had initially guessed.
THE BIGGEST DETERMINANT
So far I’ve simply assumed property prices will continue to go up or stay stable. I believe we’re in the 6th or 7th inning of a 10 inning ball game, but of course I don’t know for sure whether property prices will hold steady. Interest rates could surge higher (unbeliever after 35+ years of downwards interest rates) and there could be another terrorist attack, which could pop the bubble in tech and internet enthusiasm.
If there is a downturn in the property market, I’ll wish that I had paid down debt instead of leveraged up to buy a declining asset. That said, homeowners went through the worst economic decline in our lifetimes and we’ve turned out OK five years later if you held on. I don’t think we’ll seen another catastrophic economic crunch in the next 20 years, but who really knows? I do know that being stuck with a bad investment really hurts my mood.
I absolutely hate holding cash. Although my Personal Capital Dashboard classifies my CDs as cash instead of as investments, CDs are absolutely investments in my book. They are like bonds with a FDIC guarantee component. I had to declare my CD investments at my previous employer because they consider my CDs outside investments. The fact of the matter is that I’ve got more expiring CDs that need to be put to use once this first CD comes due – five more actually.
If I don’t pay down debt or buy another property, I’m strongly considering just handing the money over to a financial adviser. I’ll tell the financial adviser that this money is to be invested conservatively with a target return of 5% per annum and to not mess things up! I’m busy writing, traveling, and consulting. I’m happy to manage my money as I’ve done for the past 15 years. But I’ve come to realize that after a certain threshold, I’m warming up to the idea of an adviser always looking out for my money as I’m doing other things. The key is finding the right financial adviser.
SO WHAT WOULD YOU DO?
If you were to come into a decent chunk of liquidity, would you pay down debt that doesn’t need to be paid off given the rental income more than covers the interest payments? Or would you leverage the money to buy a new home in a different part of your favorite city and rent out your existing home to unlock income? I don’t need more cash flow anymore because of my online business and consulting gig. It would be nice to own another piece of property if there aren’t any headaches involved in renting out my home.
The goal of this post is to hopefully come to a conclusion on what to do after laying out the various choices. I’ve spoken to several of you who are going through this exact same exercise now of paying down debt or buying more property for passive income purposes. I originally had a stretch goal of generating $200,000 a year in passive income by around 2017, but that was when I was preparing for leaner times after leaving my job. Now that two years have passed I’m not sure it’s worth being so mechanical about generating more income. I’ve overestimated how much I need to feel happy and secure.
What would you do if you were in my situation? Do you happen to be in a similar predicament? Investing more in the stock market at record highs is not an option. I just don’t know if I can find a nice property at a good price either. Perhaps it’s time to look for lagging property markets around the country instead. But that just sounds like a lot more headache. Any risk-free investments out there that provides a 4-5% return?
Further reading: How To Correctly Value And Analyze A Rental Property
Recommendations For Homebuyers Or Homeowners:
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Photo: Palace Of Fine Arts, SF, 2015.