Rule #1 vs. Real Estate

Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week!
by Phil Town

(Page 5 of 7)

Okay, so let's say you don't buy into the myths of investing, but you do buy into the myth about real estate being a better investment than businesses. You know I'm going to shoot you down on this argument. If you think that because real estate lets you leverage your investment, the rate of return is much higher than a business/stock investment and is, therefore, a better place for beginning investors to put their money, think again.

This is a commonly held idea that's completely mistaken. I've owned a lot of real estate, everything from subdivisions to huge farms, apartments, commercial property, and single-family homes. I've bought into hot real estate markets like Del Mar, California, and Jackson Hole, Wyoming, and slow ones like Fairfield, Iowa. If we're going to do a real estate versus business/stock ownership returns comparison, we could pit the hottest real estate markets against the hottest Rule #1 investors. But it seems better to use the average real estate market and the average Rule #1 investor.

A reasonably good growth rate in a real estate market over a 30-year period is about 4 percent. A reasonably good rate of return for a Rule #1 investor is about 15 percent. True, Jackson Hole and Del Mar real estate appreciated at 10 percent per year for 30 years (in big bursts). And it's equally true that experienced Rule #1 investors nail 25 percent per year return on investments (ROIs) for 30 years. But these are exceptional cases.

[A return on investment (ROI) is simply the return you get from an investment - the dollars you put in and the dollars you get out within a certain time period - which can reflect either a profit or loss. It's usually expressed as an annual percentage return. For example, if you invest $100 into a business and it returns to you $150 after the first year, your ROI is 50 percent. Technically, ROI is calculated by dividing your total amount invested into your profit. (Extra tidbit: This is slightly different from ROIC - return on investment capital - which is a more complicated calculation that's very specific about what constitutes dollars in and dollars out. You'll come to understand ROIC very soon, as it's an excellent indicator of the health of a business.)]

So let's look at the difference between investing $50,000 right now in real estate versus $50,000 right now in a business with Rule #1. This is an especially interesting contrast considering real estate and the stock market might not go up at all for the next 15 years! (If that happens, the real estate example below will seem wildly optimistic!)

Here are the numbers: We buy a $250,000 house for $50,000 down with a 6-percent, 30-year fixed mortgage. Our payments are $1,200 a month, but we rent it for $1,200 and cover our mortgage payments. We are, however, in the hole for insurance, maintenance, advertising, and taxes.

On the other hand, let's assume we never miss a month's rent and can increase the rent by 4 percent a year. By our ninth year, we've been able to increase rents enough to cover everything. From there on to the thirtieth year, it's all cash flow. Then we sell the place. At that point the house is worth $811,000 and is totally paid for. Also, we've pocketed rental income we've reinvested wisely and made the same return on that as on our house overall - about 10 percent per year for an additional $230,000. Total return equals $1,041,000. Our compounded ROI for 30 years is 10.6 percent. Quite respectable, although I didn't deduct for management and maintenance, which I expect we'll do ourselves. This isn't an insignificant headache, and gathering up the investment dollars from such an endeavor isn't easy. We had to do a lot of work (and hoping) to get that 11-percent return. Nonetheless, let's compare that to our 15-percent minimum Rule #1 return.

First, as Rule #1 investors, we incur almost no management responsibility - a significant advantage. We have to spend about 15 minutes a week, and that's it. We're required to know how to do Rule #1 investing, of course, but it's easier to learn than real estate investing once you see the advantages. We buy a wonderful business (actually a part of a business via shares of stock) at an attractive price with our $50,000. We then sell it when it gets unattractive and buy another. We do that for 30 years, averaging 15 percent. (And as with the real estate example above, we're not being taxed on our gains - in this case, we're buying and selling in a tax-protected IRA, which you'll learn about later.) After 30 years, my investment is worth $3.3 million. My 30-year compounded ROI is 15 percent, only 4 percentage points higher than the real estate transaction, but I have $2 million more in my bank account.

It gets better. Now let's compare the two investments when you're 60 and retired. If you invested in real estate, what you do at this point is take the $1.2 million and put it into a nice 5-percent bond that pays you $5,000 per month. After taxes, you keep $4,000 a month. That's a whopping $1,650 in today's money. Better hope Social Security is still working. Or you keep working your real estate, dealing with renters and fixing toilets, and the rent money is your income: about $3,800 a month. Your only other choice is to re-leverage your investment and buy more real estate - which is a whole lot different from being retired, isn't it?

But if you're a Rule #1 investor, it's no big deal to spend 15 minutes a week on your investments, so you'll continue to invest the $3.3 million at 15 percent andthen live on the 15-percent increase each year. Translation: You're receiving about $40,000 a month. That's not a typo. Of course, you do have to pay taxes on that, so you'll end up with about $30,000 a month, which is only $12,000 in today's dollars. Do you think you can squeak by on $12,000 a month when you're retired versus $1,650 in today's dollars?

So there's how I look at it. You can stay ignorant of The Rule, opt exclusively for real estate, and try to live on the result the rest of your life - or you can become a Rule #1 investor.

Copyright © 2006 by Phil Town.

About the Author

He isn't your typical Wall Street guy. An ex-Green Beret and former river guide, Phil Town is a self-made millionaire several times over and America's most widely sought-after speaker on investing. In his new book, RULE #1, he describes the Rule #1 personal financial strategy in detail so that anyone, even first-time investors,can get - and stay - rich.