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I understand diversification; the idea is that one should spread capital over a variety of investments to mitigate risk. This question is about diversification across Roth IRA/401(k), state pension accounts, and real estate.

TL;DR Does it make sense to significantly back off of contributions to a well funded 401(k) and redirect those funds to buy a second home in order to convert our current home into our first rental property? I see this as merely reallocating retirement funds from one investment into another. Am I doing mental gymnastics to rationalize my desire to buy a second home or does it actually make sense?

Long Version Here is our deal:
-2006-2010 I maxed out a Roth IRA which I can no longer contribute to without "back-dooring" contributions
-2010-Present I have been maxing, or nearly maxing, a Roth 401(k)
-My SigOther has been contributing a token amount into a government pension account (above/beyond what is automatically deducted)
--Assume we live in a financially stable state that will pay obligations
--We live in one of the largest (area & population) and fastest growing metropolitan areas in the US
-Our home purchased in 2011-ish is over 50% paid off on a 15 year note
-We carry no other debt of any kind

I do not like the idea of socking away all of our money into the market. It's not that I don't trust banks, but I just feel like throwing all of our money into intangible investments is unwise. I'm not about to go out and buy guns and gold but I do like the idea of owning rental properties.

My question:
Does it make sense to significantly (-80%) or completely back off of the 401(k) contributions and redirect what would flow into the 401(k) to a second home so we can use our existing home as a rental property? We'll live in the second home for at least the next 20-25 years.

1.) The rental would cash flow a few hundred dollars/mo, best case, until paid off
2.) The second mortgage we'd carry on the "forever home" will eat up the redirected-from-401(k) funds but would not require PMI

I generally do not view homes that owners live in as "investments" so I am having trouble wrapping my head around the idea that redirecting 401(k) funds into a second home is a good idea. That said, it will enable our current home to cash flow so maybe I'm overthinking it.

  • I don't think there is a simple general answer other than "run the numbers for your specific case." – keshlam Jan 23 '17 at 4:16
  • Agree. I guess I'm just sanity testing the logic. – acpilot Jan 23 '17 at 4:17
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    Continue contributing at least enough to your 401k to claim any matching funds. That's free money. – keshlam Jan 23 '17 at 13:09
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Here are the issues, as I see them -

It's not that I don't trust banks, but I just feel like throwing all of our money into intangible investments is unwise.

Banks have virtually nothing to do with this. And intangible assets has a different meaning than you assume. You don't have to like the market, but try to understand it, and dislike it for a good reason. (Which I won't offer here).

Do your 401(k) accounts offer company match? When people start with "we'd like to reduce our deposits" that's the first thing we need to know.

Last - you plan to gain "a few hundred dollars a month." I bet it's closer to zero or a loss. I'll return to edit, we have recent posts here that reviewed the expenses to consider, and I'd bet that if you review the numbers, you've ignored some of them. "A few hundred" - say it's $300. Or $4000/yr. It would take far less work and risk to simply save $100K in your retirement accounts to produce this sum each year.

The investment may very well be excellent. I'm just offering the flip side, things you might have missed.

Edit - please read the discussion at How much more than my mortgage should I charge for rent? The answers offer a good look at the list of expenses you need to consider. In my opinion, this is one of the most important things. I've seen too many new RE investors "forget" about so many expenses, a projected monthly income reverts to annual losses.

  • No company match but they do kick in 6% to a separate account regardless of how much the employee elects to save. All taxes, HOA, insurance, etc are included in my costing analysis. We already installed a new water heater and air conditioner as well. – acpilot Jan 23 '17 at 15:29
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Diversification (background)

As a general rule, diversification means carrying sufficient amounts in cash equivalents, stocks, bonds, and real estate.

An emergency fund should have six months income (conservative) or expenses (less conservative) in some kind of cash equivalent (like a savings account). As you approach retirement, that number should increase. At retirement, it should be something like five years of expenses. At that time, it is no longer an emergency fund, it's your everyday expenses. You can use a pension or social security to offset your effective monthly expenses for the purpose of that fund. You should five years net expenses after income in cash equivalents after retirement.

The normal diversification ratio for stocks, bonds, and real estate is something like 60% stocks, 20% bonds, and 20% real estate. You can count the equity in your house as part of the real estate share. For most people, the house will be sufficient diversification into real estate.

That said, you should not buy a second home as an investment. Buy the second home if you can afford it and if it makes you happy. Then consider if you want to keep your first home as an investment or just sell it now.

Look at your overall ownership to determine if you are overweighted into real estate. Your primary house is not an investment, but it is an ownership. If 90% of your net worth is real estate, then you are probably underinvested in securities like stocks and bonds. 50% should probably be an upper bound, and 20% real estate would be more diversified.

If your 401k has an employer match, you should almost certainly put enough in it to get the full match.

I prefer a ratio of 70-75% stocks to 25-30% bonds at all ages. This matches the overall market diversification. Rebalance to stay in that range regularly, possibly by investing in the underweight security. Adding real estate to that, my preference would be for real estate to be roughly a quarter of the value of securities. So around 60% stocks, 20% bonds, and 20% real estate. A 50% share for real estate is more aggressive but can work.

Along with a house or rental properties, another option for increasing the real estate share is a Real Estate Investment Trust (REIT). These are essentially a mutual fund for real estate. This takes you out of the business of actively managing properties.

Rental costs

If you really want to manage rentals, make sure that you list all the expenses. These include:

  1. The mortgage payment.
  2. Property taxes (which may increase in the future).
  3. Time to find new tenants. In some cases, this can be as high as 25% of the rent, so be careful. A 10% vacancy rate is more manageable and may be achievable depending on the type of renter. Tends to be high for college kids and lower for families with kids and/or pets.
  4. Clean up. You usually have to spend extra to clean between tenants. Check local laws carefully before assuming that you can get this out of the damage deposit. High for college kids and families with children or pets.
  5. Maintenance. You are responsible for keeping the rental in good repair. If you rent out an oven and refrigerator, they have to work. When they fail, you have to fix or replace them. You are responsible for keeping the roof from leaking, the furnace running, etc.
  6. Wear and tear. Over time, carpets will wear out and need replaced. Hardwood floors need refinished. Walls need repainted.
  7. Damages. Yes, you can sue the residents if they damage things. However, some of that may be counted as wear and tear. Also, for large damages, you may not be able to collect from your tenants. They may not have enough money.

Also be careful that you are able to handle it if things change. Perhaps today there is a tremendous shortage of rental properties and the vacancy rate is close to zero. What happens in a few years when new construction provides more slack?

Some kinds of maintenance can't be done with tenants. Also, some kinds of maintenance will scare away new tenants. So just as you are paying out a large amount of money, you also aren't getting rent. You need to be able to handle the loss of income and the large expense at the same time.

Finally

Don't forget the sales value of your current house. Perhaps you bought when houses were cheaper. Maybe you'd be better off taking the current equity that you have in that house and putting it into your new house's mortgage. Yes, the old mortgage payment may be lower than the rent you could get, but the rent over the next thirty years might be less than what you could get for the house if you sold it. Are you better off with minimal equity in two houses or good equity with one house?

I would feel better about this purchase if you were saying that you were doing this in addition to your 401k. Doing this instead of your 401k seems sketchy to me. What will you do if there is another housing crash? With a little bad luck, you could end up underwater on two mortgages and unable to make payments. Or perhaps not underwater on the current house, but not getting much back on a sale either.

All that said, maybe it's a good deal. You have more information about it than we do. Just...be careful.

  • Good points all around. It is easy to simply shift myself into a RE heavy position which really won't solve anything. I'm in a REIT or two right now but there's somthing about owning the property and getting that monthly check...I know I sound like a goldbug. – acpilot Jan 23 '17 at 15:49
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With a healthy income its quite possible to contribute too much into 401Ks/IRAs. For example, if your retired today and had 3 million or so, how much more would you need? Would an extra million materially change your life? Would it make you happier if you invested that extra in some rental properties or perhaps a business like a sandwich or ice cream shop where you have more direct control?

This kind of discussion is possible as you indicate that you have taken care of your life financially. It seems at odds with the negative press describing the woefully condition of the standard person's finances. These articles ignore a very simple fact: its because of bad behavior. You, on the contrary, have behaved well and are in the process of reaping rewards. This is where I feel your "mental gymnastics" originates.

Looking to engage in the rental market is no different then buying a franchise. You are opening a business of your own. You'll have to educate yourself and are likely to make a few mistakes that will cause you to write checks to solve. Your goal is to minimize those mistakes. After all, what do you know about the rental home business? I am guessing not much. Educate yourself. Read and spend some money on taking knowledgeable people out for coffee.

In the end you should understand that although a poor decision may cost you money you cannot really make a bad decision. Lets say you do buy a rental property, things go south, you sell for a loss, etc.... In the end the "butchers bill" is 50K or so. Will that materially change your life? Probably not. The worst case is perhaps you have to work a year or two beyond the anticipated retirement age to make up that money. No big deal.

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    I agree that it's a business and should be treated as such. I've made friends with people in the business (service company owners, other landlords, etc) and they've all given me good insight. Despite the downside risk I still think it's a reasonably safe way to accumulate wealth if you're smart about it. Like you say, you can always jettison the property and be done with it if things get out of hand. – acpilot Jan 23 '17 at 15:39
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    I kind of left this out, but there is tremendous upside too that transcend monetary. How do your children or employees benefit from your behavior? How do your customers? – Pete B. Jan 23 '17 at 18:03
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This is going to seem pretty far off the beaten path, but I hope when you finish reading it you'll see the point...

Suppose someone offered you a part time job: Walk their dog once per day for at least 20 minutes, and once per week pick up the dog poo from their lawn. Your compensation is $300/month.

Now suppose instead you are given two choices for a job:

  1. $1500 per month for doing nothing.
  2. $1800 per month for taking the same dog care job described above.

Your preference probably has more to do with your personality and interests than the finances involved.

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