A large financial windfall can either be a joyous occasion or a stressful occasion. It all depends on how well you plan. Because it’s generally easier to spend than to save, I always recommend folks sit on their cash for at least a month before making any moves.
Holding a lot of cash is not a bad thing even in a raging bull market. A cash stash is only stressful if you suffer from an overwhelming amount of greed. Greed can kill your returns because you don’t properly think about the risks. All you think about is how much you could be making from a particular investment class without realizing how much you could lose as well.
In this post, I’ll focus specifically on what to do with the proceeds after a property sale. This post is applicable to any type of large windfall e.g. inheritance, year-end bonus, gift, etc.
The first thing you should do if you find a bag of gold inside an airport locker is to run some financial diagnostics to set up your investment framework.
Questions To Ask Before Reinvesting Your Proceeds
1) How much will the sold house be worth in 5, 10, 20 years? The goal is to come up with a baseline financial target to shoot for. Either use the asset’s historical annual rate of return over a 50 year time period or a risk free rate plus a reasonable premium.
2) What does your net worth allocation look like post sale? Once you find out, you can make a better assessment on where to allocate capital. After an extended period of time, your net worth allocation may skew more towards one asset due to outperformance.
3) How do you feel about the current economic environment? You are either bullish, neutral, or bearish. Make a best estimate of where we are in the cycle by studying previous cycles and extrapolating current data into the future.
4) What are your upcoming financial needs over the next 1, 3, 5, 10+ years? There must be a purpose to investing otherwise there’s no point. The biggest expenses include another home purchase, college tuition, healthcare costs, and retirement.
5) What is your estimated tax liability? There’s no avoiding the tax man. Calculate all the costs involved in selling your house (commissions, taxes, etc), the amount you spent improving your house, and any tax benefits such as the $250K/$500K tax-free profits to figure out your taxable profits. Put that money aside.
Once you’ve answered these questions during your one month+ cooling off period, you’ll have a much clearer sense of how to reinvest your proceeds.
How I’m Reinvesting The House Sale Proceeds
I’ve gone from having $2,740,000 of exposure in one asset in SF with $815,000 in leverage (mortgage) to having ~$1,800,000 in cash after selling.
Here were my initial thoughts after despositing the check.
1) Reduce risk by $815,000 by paying $1,800,000 cash for a different San Francisco single family home. But I’ve already got exposure in San Francisco through my primary residence, a rental condo, and a vacation property in Lake Tahoe. So I’m thinking this isn’t the best idea unless I can find another sweet panoramic ocean view home that has a clear appreciation path to $2,500,000 (39%+) over the next 5 – 10 years.
2) Reduce risk by $815,000 by investing all $1,800,000 in a portfolio of different real estate assets e.g. REITs and real estate crowdfunding projects to keep real estate exposure from falling by only 29%. This is the most sensible move since I’m bullish on real estate long term and I get to diversify from a single home to multiple properties around the country.
3) Find a dream home in Honolulu with a 10,000+ sqft flat lot near the beach. Unfortunately, these homes cost ~$3,000,000 – ~$5,000,000 and we’re not ready to leave San Francisco until its time for my little one to go to kindergarten in 2022. I’ve been searching for a couple years and haven’t found the ideal property at an affordable price.
I usually like to reinvest proceeds in the same asset class while I work on building up greater amounts in other asset classes to get to my desired net worth asset allocation. But after much deliberation, I wanted to focus on de-risking.
When you survive a financial crisis with a relatively large amount of assets that got pounded, you really appreciate second chances to take money off the table. Remember, I took a big risk in 2014 by taking out another $1,000,000 mortgage to buy another property while keeping my previous home as a rental with a $1,000,000 mortgage for three years. Further, I’m unemployed!
Here’s how I’ve reinvested the money so far:
Municipal Bonds: $500,000 into various individual California municipal bonds with a 3% – 4% tax free coupon, which is equivalent to a 4.4% – 5.9% gross yield based on a 32% effective tax rate (federal plus state). I’ve always enjoyed keeping a good amount of low-risk/risk-free investments because it ironically allows me to take maximum risk in my life: moving cities, switching firms, starting a business, retiring early, etc. Target annual return (gross): 5%
Real Estate Crowdfunding: $250,000 into multiple real estate crowdfunding projects, which brings my total to $500,000 + a $10,000 Conshy, Pennsylvania commercial project. The fund made new investments in Virginia, Dallas, Seattle, and Utah. This investment is my way of reinvesting a portion of the proceeds in 100% passive real estate that hopefully has more upside than San Francisco real estate, which has started to slow. Target annual return: 8% vs. their 15% target return.
Stocks: $100,000 into an S&P 500 index ETF IVV and $50,000 into various large cap tech growth stocks. I used the small sell-off in August and early September to allocate capital. I’m not excited about the stock market, so this is more an asset allocation decision. I will be allocating $100,000 into the stock market with every 2% correction, with an assumption the stock market won’t correct by more than 10%. Target annual return: 7%.
529 Plan: $35,000 to my son’s 529 plan. I can super fund the plan with $70,000 in one year, but I’m not sure I’ll do so because these long-dated target funds are very aggressive. With an 18 year target date, the fund has a 90%+ weighting in stocks, so this 529 plan is really just a stock fund at this moment. Besides, I have 18 years to reach the limit of $359,000, which should go up in the future. I’m more worried about allocating capital at the top of the market and not being able to legally allocate more if there is a correction.
Debt Pay Down: $50,000 was used to pay down a 4.25%, 30-year fixed mortgage on my Lake Tahoe vacation property that can’t be refinanced into a 5/1 ARM for a lower rate. The goal is to pay this debt off completely by 2022 before leaving California.
Total Invested: $935,000 over three months
Total Cash Remaining: $865,000 from proceeds
Return Hurdle: 4% (I estimate the house I sold will increase by 4% a year on average for the next 20 years). $1,800,000 of my equity will turn into $3,944,000 in 20 years at a 4% compounded return, if I cancel out the cost of carrying the $815,000 mortgage (2.35% + 1.2% property taxes + maintenance expenses = a wash).
Estimated Return Of Reinvested Proceeds: 6% (blended rate of return for investments excluding cash). $935,000 will turn into $3,000,000 in 20 years at a 6% compounded return.
Activity Difference: Going from semi-passive income to 100% passive income. Hallelujah!
Rating The Reinvestment Risk
It’s always good to make sure that what you are reinvesting in matches your risk tolerance and financial goals. Here’s my reinvestment risk assessment:
On a scale of 1-10, 10 being super risky and 1 being risk-free, I rate keeping $2,740,000 of exposure in SF real estate with a $815,000 a mortgage an 8. My rental property was valued at ~30X gross annual rent (crazy expensive IMO) after prices rose by 60% since 2012 and I’m already long three other properties in the Bay Area. If this was my primary residence and I had no other properties, I would assign a risk score of 5 for holding on, despite the surge in prices because I have to live somewhere.
I believe there’s a 50% chance the property I sold could decline by 10% ($2,500,000) over the next several years due to an increased supply of luxury condos, a small chance mortgage rates go higher, and a slowdown in hiring. Heck, I may have sold my property for $2,500,000 this year if the buyer threatened to walk away. But I also believe there’s a 70% chance my old SF property will simply appreciate at a rate of 1% – 4% a year forever, just like inflation.
I give my reinvestments a 3 out of 10 in terms of risk. 51% of my reinvestment is in almost risk free investment grade municipal bonds that will pay back their principal plus a coupon over the years. 25% of my reinvestment is in real estate crowdfunding in cheaper markets with higher yields. 20% of my reinvestment is in higher risk equity investments, while the remaining 4% of my reinvestment was used to pay down debt.
Why Still Hold So Much Cash?
Despite not wanting to own any more physical property, I just can’t seem to break my addiction. For 16 years, I’ve been combing the listings and going on open house walks every Sunday. There’s still so much upside for cheaper property on the western side of SF.
I believe there’s a 20% chance I can snag a property for 5% – 10% below fair value because that’s exactly what I did when I bought my current residence in 2014 from a 72 year old part-time realtor who didn’t live in SF. He was the seller’s childhood neighbor in the 60s so they asked him to do them a favor. There are inefficiencies in the real estate market due to out of town sellers, out of town realtors, bad listing timing, bad marketing, inexperienced sellers/realtors and so forth.
Visualizing Reinvesting The Remaining Proceeds
With whatever cash you have left, clearly visualize how you plan to reinvest the proceeds in what time frame. You don’t have to exactly follow your plan, but you should write something out in order to have a good idea when opportunities arise. In my case, I’ve got $815,000 left.
$100,000 $150,000 set aside for April 2018 (thanks to reader feedback). I’ve actually been looking to buy a Honolulu dream home to do a 1031 exchange once 2014, but couldn’t find the right house. It’s hard to leave my network in SF and get on a plane before my son turns three.
2) Physical property in SF: All $815,000 if a bargain can be had at a 10% discount to market. Need to have lots of cash to be competitive, unlike my buyer who had to take out a $2,000,000 loan and a $300,000 bridge loan to get the deal done.
2) Municipal bonds: $100,000 if the 10-year yield gets back up to 2.3% and $300,000 if the 10-year yield gets back to 2.5%. Minimum $10,000 a month no matter what happens to interest rates.
3) Stocks: $100,000 for every 2% correction in the market, and up to $500,000 if there is a 10% correction. Minimum $10,000 a month no matter what happens in the market.
4) Debt pay down: $10,000 a month without fail, and $100,000 in 12 months if the 10-year yield doesn’t get to 2.5% and stocks do not correct by 10%.
5) Real estate alternatives: An additional $100,000 – $500,000 in real estate crowdfunding if existing investments do well.
Given all the fund’s investments are equity and not debt, it can take years to see any type of returns, which is exactly what I want because of my current high tax rate, especially since I just sold a house. I plan to have dinner with a member of the investment committee before committing more capital.
Below is a snapshot of my account so far. I’m surprised there’s income already being paid out.
It’s Worth Being Patient With Cash
Locking up $310,000 in a 4.1%, 7-year CD from 2007 – 2014 was a suboptimal financial move since the S&P 500 outperformed. But using $246,000 of the $400,000 in proceeds to buy a fixer upper for $1,230,000 in 2014 that has now appreciated to ~$1,650,000 (33%) or ~$2,000,000 (40%) if you include the $180,000 I spent remodeling, was a good financial decision so far. The $426,000 in equity for the downpayment and remodeling has grown to ~$1,160,000 (+176%).
There will always be great opportunities in the future if you have the cash and the courage to take advantage. Not everybody could have bought my house in 2014 because not everybody had a $250,000 downpayment or the desire to look west. When you have cash, you have options.
Besides providing optionality, cash also provides security. You don’t have to worry as much about losing your job, paying for an unexpected medical bill, or seeing your business go down the drain. With less worry, comes more happiness. And happiness is what having money is all about!
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Updated for 2019 and beyond.