mrcupcake's Journal

[mrcupcake]

I have been meaning to start a journal, and there is no better time than now.

I am a 33-year-old male living in San Francisco. I have worked as a web developer and technical manager in the advertising industry for about the past 10 years. I recently quit my full-time job, and now I spend my days exercising, playing video games, reading and thinking. Although I think that I will eventually go back to work someday, I do have a cushion that should provide me with an indefinite block of time to figure out what I want to do next (more on finances later).

I have posted only a couple times on the forum, although I have been an avid reader/lurker for the past several years. I have read the ERE book, most blog posts several times over, and I keep up with the forum (thanks, you guys, for all the interesting and useful content).

I am interested in technology/programming, economics, philosophy and in-person events in the Bay Area.

[mrcupcake]

I have always enjoyed charts, and I track my progress in an elaborate Google Doc. Periodically I notice an error in my calculations, or find an opportunity to save on a recurring expense, and it's fun to see the numbers update and the countdown until "crossover" decrease.

My assets total about 22x my yearly budget, making my withdrawal rate about 4.6%. This is definitely not what I would consider a "safe" withdrawal rate, but I expect to pick up freelance work and maybe even full-time stints in the coming years.

My asset allocation look like this:



The blue part is half 401K and half personal stock investments.

The orange part is the equity on my 3 rental houses in Memphis, Tennessee + REITs.

The small slices are bonds, Lending Club notes and cash.

Being newly unemployed, I am adjusting from being able to easily cover all my expenses from my paycheck to having to strategize how to cover expenses from my passive income. The first thing that I want to do is sell some of my stocks while prices are up to increase my cash position.

[altoid]

Great to see you started a journal, one question on your bond holding, what is the duration on these bonds? Is it domestic corporate bonds ? Or Muni ? I have some exposure in bonds laddered between 3-5 years, and wonder if I should get out before interest rate rises.

[mrcupcake]

@altoid, thanks for your reply.

You didn't know you were doing it, but you may have opened a can of worms. Now I feel the need to justify my holdings in a series of posts. I think this will be healthy for me, though, as it will force me communicate some things that I needed to think through anyways in order to generate liquidity to pay my SF rent.

Most of my bonds are long-term U.S. government bonds through BLV.

I also have some VCLT, and technically I need to mention JNK (although JNK correlates with stocks more than bonds).

Yes, my understanding is that rising interest rates decrease the value of bond holdings (because investors will want to move out of existing bonds and into new bonds at a higher rate). This is also part of why my bond allocation is relatively low. At the same time, I tend to be cautious/pessimistic about the economic recovery and could see a scenario whereby interest rates remain low longer than expected, or they rise only to dip back down again.

One point that I would add is that I think that my risk tolerance my be higher than yours (examples include my out-of-state rentals, high stock allocation and Lending Club position).

Overall, though, my strategy resembles a permanent portfolio. I do not believe that I can outsmart or predict the market. I think this will lead to my next post regarding my asset allocation and how I got here...

[mrcupcake]

Learn by doing.

I very much followed a "learn by doing" mentality during my growth phase. I worked very hard in a lucrative industry and was lucky to land in a company that provided opportunities for me to move up the ladder very quickly. This generated an income that, along with my natural curiosity and willingness to make mistakes, allowed me to practice investing with a safety net. I made a lot of mistakes, which I would rather think of as points of learning:

1. Timing the market: I am positive that I have underperformed the market by trying to time the market overall as well as individual stock price. I sometimes bought high and sold low when I got scared, I have tried to "catch a falling knife," and I have also missed out on additional profits by selling too soon when I thought I was being pragmatic by "cashing in my gains."
2. Commissions: I have paid hundreds (thousands?) of dollars in commissions by moving around between stocks that were probably more correlated than I thought at the time.
3. Taxes: I learned that MLPs, foreign investments and precious metals have extra paperwork at tax time. I can feel my anxiety level rise as I silently utter the word "tax" to myself.
4. Dividends: Dividends are not magic. They help me psychologically, as they smooth out the volatility and give me a starting point to project passive income in the future. But I have finally realized that dividends are simply a bet that I can generate higher returns with that money than the company may make by reinvesting it, that the tax code will treat the dividend payout preferentially versus capital gains, and/or that spending the dividend is preferential to paying the commission to sell a stock position to generate income.

I travelled a long journey only to reach the conclusion that index investing is the way to go. My bible for stock investing is now the Jim Collins Stock Series. Today I find myself with a lot of individual stocks that I plan to liquidate over time to pay my SF rent.

All that being said, I am also grateful that I was smart (lucky?) enough to keep skin in the game all along. My new plan is to reduce this allocation from 48% to about 35% over the next year or so. And I am still naive enough to believe that I might pick the best individual stocks to sell, and that I will sell them at their peak in perfect alignment with my rent schedule.

I think that is a good summary of my stock history and philosophy. I think my next post will be about my real estate holdings, but now I am going to go outside to play because, well, I didn't quit my job so I could sit in front of a computer all day.

[Hankaroundtheworld]

Nice style of writing, keeps the suspense, want to read more what's next !

[mrcupcake]

@ Hankaroundtheworld, sometimes ERE keeps me on the edge of my seat too. I am also limited by my energy to write in one sitting...yet urged on by the need to catch up on sharing my background so I can get into simple monthly updates.

Real estate experiment

So by 2012 the stock market was well into recovering from the recession. Between my 401K and personal investments, I felt like I was over-exposed to stocks, and diversifying seemed like a smart thing to do. I had heard about "real estate" and already owned REITs, but I thought it would be good to own a house (partially because the prepper in me thought of it as a refuge in case SHTF).

Most of the SF Bay area is not affordable, and it seemed like "diversifying" should also include diversifying geographically away from my own home. The logical thinker in me also thought that there must be better and worse places in the country to invest in real estate. I started reading everything I could find and narrowed the search down to several cities including Atlanta, Memphis, Phoenix and Las Vegas.

I finally settled on Memphis for a few reasons, including:

1. Rent ratio: Rents are high relative to home value.
2. Tax and insurance: There is no state income tax in Tennessee, and insurance rates are low.
3. Economy: The economy seemed stable and I saw it listed on some silly internet "top 10" lists.

This will probably sound a bit impulsive, but I ended up purchasing three rental houses between May and October of 2012. I felt like this was a time to act, and I mentioned in my last post that I had a safety net in my full-time job income.

Fast-forward to now, and my real estate allocation looks like this including the REITs (NLY, AGNC, OHI and O):



Although I am only in my second year, I feel there are some clear benefits to investing in rental property:

1. Tax benefits: Interest, property management and maintenance are tax-deductible.
2. Hedge against inflation: The interest rates on my mortgages are between 4.5 and 4.75%. My payments will continue to be in "2012 dollars" while my rents should increase with inflation. If a loaf of bread starts costing $1,000, well, rent should go up at the same time.
3. Principal pay-down: Each month my principal goes down by a bit more than the last month, and most months it is paid entirely by my tenants.
4. Appreciation: This is kind of like capital gains on dividend-paying stocks. It is a nice bonus that is multiplied by leverage (I know this could slice both ways). And a big chunk of it will get eaten up in commissions when I sell.

I am, however, at conflict about the risk I may be taking on by owning these, especially out of state. Vacancy and management fees/maintenance add up to a lot. Down the road there will be more expensive maintenance like replacing a roof (or worse). There is a "trapped" feeling of owning a house compared to a stock that I can sell on a whim in a matter of seconds. But it's also reassuring to think that I will eventually own them free-and-clear.

I do regularly debate with myself over whether I should sell my personal stock investments to pay off the mortgage on 2 out of 3 houses. Do I think the stock market will return more or less than 4.5% over the next 28 years? That's a tricky question and may be a subject for another post...

Next time

Having probably put any last readers to sleep by this point with my financial posts, I think next time I will make a giant list of the things I do/want to do for fun now that I have quit my job.

[altoid]

@Mrcupcake, I am still awake And I agree with Hankarountheworld, that your writing style makes it very easy to read.

One thing I like to point out, is your mortgages on the rental properties and your bond positions, are they correlated ? Since you mentioned your bond investment is long term government bonds (20-30 years?), is the term comparable to the mortgage time frame ? Is this designed as a hedge ?

[mrcupcake]

The intricacies are mostly over my head, but my high-level understanding is that bonds are a hedge against deflation while real estate is a hedge against inflation. I think of my real estate holdings as a substitute for gold in the vanilla permanent portfolio (but this might be my first mistake).

Your question is, are my mortgages correlated with my bonds? The answer seems especially complicated because the houses incorporate both a mortgage aspect as well as an equity aspect. In some ways, those two parts may not be correlated. Plus, over time the allocation is changing as I pay down my principal. This kind of makes my brain hurt! Help me out here please.

Thinking out loud about economics

• The value of my bonds goes down as interest rates go up because the new bonds become more attractive than my old bonds.
• At the same time, it would seem that the intrinsic value of my mortgages goes up as interest rates go up because I am locked in at lower rates?
• And (this starts to get really confusing) part of me thinks that the market rate for my houses would initially go down due to people having less access to cheap money...but I think over the longer term house prices would correlate with inflation, and the value would eventually go up. This whole thing creates some controversy within the economics community.

Maybe it's simpler to look at what I was thinking when I bought the rental houses.

• Home prices were at a historic low due to the housing bubble bursting/foreclosures. Some houses were cheaper than the cost to build the same structure.
• Interest rates were at a historic low due to stimulus. My understanding was that they could only go up from here.
• I knew that real estate was a way to diversify out of stocks. Gold is hard for me because of tax complications and the fact that I have a hard time understanding its intrinsic value (jewelry vs. shelter).
• Related to this, I liked knowing that I could pay off a house and live in it if SHTF.

I feel like an economics n00b, that I might not have answered your question, and that I might have even misspoken in my response. As an INTJ, though, I only seek the truth, so, ERE community, help me fill in the gaps.

My main objective with my allocation is to diversify in a lot of directions and trust that this is the best insurance against the next black swan.

[IlliniDave]

There are some bond-like qualities to rental real estate--but think about the time you mention you bought the houses--real estate in a trough, bonds soaring (price of older, higher coupon bonds at least). So the correlation can be low or negative, which means there is some diversification value to holding both.

The question about mortgages being correlated to bonds is interesting. I've heard mortgages informally called negative bonds, but I don't think that implies negative correlation. A mortgage is a liability that carries risk inversely proportional to real estate prices (price drops it gets harder to sell to get out from under mortgage). I suppose if interest rates shoot up a low interest mortgage increase in value (relative to a refinance or new mortgage), but I don't know how to quantify it.

Another thing about bonds is if you hold them until maturity, you'll basically get the yield to maturity when you bought them (accounts for like 90%or more of the return). I buy intermediate term bond funds, and since I intend to hold them longer than the 5-7 year durations, I don't worry much about the prices (I keep a moderate cash emergency fund to preclude having to sell off assets for typical unexpected things that come up).

Sorry about thinking out loud in your journal ... just some things I found intruiging to think about. I'll delete it if you'd like.

[altoid]

@Mrcupcake, we are on the same page, and I am inspired by your out of state rental real estates. Looking forward to your next post on the fun things you plan to do.

[mrcupcake]

@IlliniDave, don't apologize for posting! I would love for everybody to post in my journal.

Your thoughts make sense, and I had not even thought about a simple "sanity check" that says that there have recent times when the two assets were uncorrelated.

Thinking about quantifying the change in mortgage rates, if interest goes up to let's say 10%, then I could (theoretically) give somebody a loan for 10%, use it to pay off my loan for 4.5%, and pocket the difference. I'd just have to figure out the logistics to do this.

I also understood the yield to be as you described. Having pretty much a guaranteed 4.5% from my bond funds seems far preferable to keeping that money in savings.

[mrcupcake]

Things I like to do with my free time:

1. Read or sit on the grass around the Conservatory of Flowers.
2. Picnic in one of the many green areas in Golden Gate Park or one of the hidden parks.
3. Discover public spaces hidden downtown.
4. Play video games from my childhood, especially platform games like the Mario, Bonk and Donkey Kong series.
5. Watch a Giants game for free in right field (or on TV at a bar, or listen on the radio in the park).
6. Play outside sports like basketball or frisbee. Ride bike, run and hike for exercise, fresh air and scenery.
7. Combine the above locomotions to run errands like grocery shopping or returning books. Add friends.
8. Read books, watch movies and listen to audiobooks from the library.
9. Organize and automate things like budgets/spreadsheets, clothing/books/files and mental models.
10. Write in my journal. Make lists of books and movies that I want to see.

Right now I am in the "honeymoon" phase of my ERE/part-time ERE. I am living each day like I am on a vacation or in kindergarten. This morning I have already done 4, 6, 7, 8, 9 and 10, and I plan to do 1 once I press "submit" and finish my lunch.

In light of this realization, I will try to make my next list focus on new skills, hobbies and creative goals. Because it can't always be fun and games!

[FI Fighter]

I like your idea of geographical diversification with real estate, and I do the same myself. How are the cash on cash returns your seeing in Memphis? Have the investments worked out like you expected, or do you have any regrets?

[mrcupcake]

@FI Fighter, thanks for chiming in. It's good to know there are others with out of state rentals.

Regarding cash on cash returns, it depends on how I calculate it, and I am not even sure of the right way to calculate it considering all the factors at play in real life. It's a fun exercise, though, so here goes:

• Actual returns so far: Actual cash on cash returns over the first 2 years have been 3-9%. This number naturally starts out negative due to closing costs and takes some time to be in the black. I have been pretty lucky so far, except that I had two vacancies at the same time last year. This number should rise and plateau at some point (see next).
• Projected cash on cash: With my maintenance estimates, I would expect cash on cash not counting appreciation to be around 6-10% over the longer term.
• IRR with appreciation: Internal rate of return (IRR) with appreciation is tracking at 15-45%. This has to be taken with a grain of salt, since it is based on Zillow/Trulia, does not include commission and would only be realized at sale.

So only time will tell. I hope to cash out eventually with some crazy rates of return like 20%. But I will be happy just to stay diversified and hopefully beat the stock market.

Do I have any regrets, or would I do anything differently? Yes! I would buy nicer houses. They are all quality, cookie cutter suburban houses in stable, family-friendly neighborhoods with pride of ownership, which is what I want as a landlord. But two of them are right at the median cost for the area, while one is at the higher end of median. I wish I had saved the extra $10K each to get all three houses at the higher end of median.

It seems that this small difference in down payment makes a big difference with tenant stability and appreciation. With leverage, if appreciation merely keeps up with inflation, that can lead to those 20% returns after 5 years.*

*If there isn't another housing bubble and my tenants don't cook meth or punch holes in the walls

[FI Fighter]

Yeah, I'm not sure if there really is a "correct" way to run cash flow numbers since everyone calculates them differently. Some don't include closing costs, others do. I tend to put in 20% reserves when running my numbers. So far, I've been looking for deals that return 10%+ even with the reserves factored in.

I agree with buying nicer houses... You'll get better tenants and more appreciation return with those. I do allocate a percentage of my portfolio towards purely cash flow investments, but those are a bit more risky. The exit strategy isn't as clearly defined.

In the Bay Area, I'm currently sitting on 180%+ return on capital in less than 2 years... There really is something to the whole buy low, sell high point... Looking to cash out soon...

All the best!

[mrcupcake]

@FI Fighter, it sounds like you are having some success with real estate in the Bay Area. What type of real estate do you own/what is your strategy?

Estimated maintenance is something that I am still working on determining a good estimate for. So much of it has to do with the specific property and how lucky you are during a given year--especially when dealing with only a few properties. Your allocation of 20% for reserves seems conservative and smart. I track all my expenses, and I am curious to see what maintenance will average out to over a long period of time.

Take care!

[JohnnyH]

Out of state rentals?!... I'd be really curious to hear about your returns, experiences and costs with the property manager. I once owned rentals in 3 states and it caused many sleepless nights. I'm down to 1 rental, hoping to sell it while the market is high... In the future I only want to own rentals that are so close I can basically see from my residence.

[mrcupcake]

@JohnnyH, I can try to respond to your questions with the caveat that I purchased my rentals in 2012, so my sample size is short. When I got into real estate, I envisioned diversifying across many states too. Over time, I decided to slow down and focus on paying off my mortgages and diversifying into other investments instead.

Regarding my returns, I summarized them above as best I could given that I have not cashed out yet. Currently I would call my results "average" to "very good," depending on if you include appreciation/equity. To your point, it is even harder to quantify the emotional toll of out-of-state home ownership (I can imagine scenarios that would be very scary).

I pay my property manager 10%, which has allowed me to be fairly hands-off so far. I would estimate that I have spent an average of 1-2 hours per week on my rentals. I follow up when I have questions about the monthly expense report, and I spend some time keeping my spreadsheets updated and documentation organized.

It was stressful having two tenants leave during a 2-month span last year, since that was the first time I had to pay my mortgage without receiving a positive net payment. Since I was working at the time, the expenses did not concern me as much as the nagging thought of knowing that I had vacancies. Now that I am not working, this would be much more stressful.

I can definitely appreciate your point about being nearby your rentals. Living in San Francisco, that is not feasible for me. I figure that in the worst-case scenario, I would have a vacant house in Tennessee that I would have to live in until I could fix the problem.

I will keep my journal updated over time. Hopefully I never have to update it from Tennessee unless it's a vacation!

[AugustPlace]

Hi mrcupcake. Would you share the story about what motivated you to quit your job at age 33? Did you feel that you didn't need to work anymore for financial reasons or were there other factors?