Finance Friday: Building a $200K/Year Portfolio on an “Average” Income

Scott:
Welcome to the BiggerPockets Money Podcast, Finance Friday edition where we interview John and Jennifer and talk about how to optimize your portfolio with a high net worth and when you should leave your W-2.
Hello, hello, hello. My name is Scott Trench and with me today is James Dainard from our sister podcast, On the Market. James and I are here to make financial independence less scary, less just for somebody else to introduce you to every money story because we truly believe financial freedom is attainable for everyone, no matter when or where you’re starting.

James:
Whether you want to retire early and travel the world, go and make big time investments in assets like real estate or start your own business. We’ll help you reach your financial goals and get the money out of the way so you can launch yourself towards your dreams.

Scott:
The contents of this podcast are informational in nature and are not legal or tax advice, and neither James nor I nor BiggerPockets is engaged in the provision of legal tax or any other advice. You should seek your own advice from professional advisors, including lawyers and accountants regarding the legal, tax, and financial implications of any financial decisions you contemplate. James, this was an awesome episode. And today, I want to give everybody a fair shake that this is a little bit more advanced. This is a significantly high net worth couple. They didn’t get there by being particularly fancy. They never earned particularly high incomes until maybe the last year or two, but they’ve accumulated millions of dollars and we’re going to talk about the allocation of a portfolio that is well underway and some high-level choices about how we’re going to potentially think about shifting those assets, perhaps, to commercial real estate.
And that involves discussion around, we’re going to throw out terms like 1031 exchanges. We’re going to throw out terms like cap rates, we’re going to talk about net operating income and that jargon. I think anybody and everybody can learn from this, but there may be a couple of terms that we throw out there and those are sprinkled in and available for you to self-educate on throughout the BiggerPockets platform to go look at those up. I hope you like it and we’ll look forward to feedback. Oh, and by the way, listen to the very end because we present, I think, three very different choices to John and Jennifer for them and they’ll have to figure out what the right approach is for them based on a wide array of really good options that they have.
All right, we have a new segment of the show called The Money Moment where we share a money hack tip or trick to help you on your financial journey. Today’s Money Moment is, if your clothing size doesn’t change much from year to year, purchasing clothing at the end of the season when it is on sale is a way to save money and to have a good supply of new clothing available for next year. So, maybe now’s a great time to buy that ski gear and that winter clothing. If you’re thinking about that in the winter here in June.
John and Jennifer have a rental portfolio in the Pacific Northwest. John has a W 2 while Jennifer works for herself as a chiropractor and they have four children all under the age of 10. They’re wondering if their portfolio is optimized to its fullest potential and when John should leave his W-2. John and Jennifer, we’re so excited to have you on the show today. Thank you for joining us.

Jennifer:
Thanks for having us.

John:
Thanks for having us.

Scott:
Awesome. To give a quick highlight about your financial position, you guys are very high net worth individuals. You’ve got an asset balance of over 10, close to $11 million. Most of that’s in real estate, about 8.5, 8.7 million is in real estate and you’re levered pretty reasonably at close to about 50% on that portfolio. A little over 50%. That’s across six different investment assets plus your primary residence. And then, we’ve got, I see there’s a nice 401K and retirement balance, a very healthy cash position, and a business that you guys own that’s successful and profitable. And your household spending I believe is close to, what is it, $8,000 a month here?

John:
Correct.

Scott:
So, we’ve got a very, very healthy financial position and I think that begs the question a listener might be asking, how can we help you today? What are the things that you’d like us to cover?

John:
So, we’ve been looking at how to optimize the portfolio. We’ve done well and we feel like we’ve managed the spending. It goes probably we do better on spending, but we feel like we’re doing well on the spending and investing and we’ve been doing that for coming up on 10 years. And the question is how do you take a strong position and move forward in a smart and sensible way, not destroying the stuff you’ve built but taking reasonable risks as the market changes and trying to be smart. Again, we have a family and young kids and trying not to try screw it up when you do well in a game, don’t mess up.

Scott:
Awesome. Well we look forward to chatting about that. We’re going to dive all into that. But before we go down that rabbit hole and start talking about some ways to begin tweaking or changing parts of your portfolio, let’s hear a quick overview of your money story. How did you guys get to this position where you’ve accumulated 10 million in assets on incomes that are not crazy? They’re not way out outside the norm here.

John:
No, our income’s been pretty normal for the northwest. We’re not ironically high income earners in the Pacific Northwest compared to the tech community. But just starting out of college, getting a first house, which is a duplex, two years out of college, Jen’s been honestly an entrepreneur her whole life, but she really, after graduating college, went back to school and started down the path of becoming a chiropractor.

Jennifer:
We actually met, he didn’t say this, we met on a blind date in 2007.

Scott:
Ooh.

Jennifer:
Yeah. And I kid you, we talked about a funny movie we had seen and investing in high yield online savings account and I had my own business as massage therapist at the time before chiropractic school and so we were chatting about that and he’s like, “Well, you need to pull this money over and get this five point whatever percent.” And he was surprised that by date two, I had done that already. So, I essentially would pull over a third of my income and then I just had it in savings and so I started making money on my future tax payment for that year. And I always said I didn’t care if I married somebody with money or not. I wanted somebody who was good with whatever they had, 5 dollars, 5 million, it doesn’t matter if you can’t do well with it.

Scott:
Awesome. So, first date was a money date. How wonderful.

Jennifer:
It was very worthwhile.

John:
It was very good. Then, let’s see here. I guess, I started working for a manufacturing company here in the northwest. That was what, 2006. I went back to grad school and been working a higher paying job. During that time, we had the great financial crisis that happened, and honestly, I couldn’t buy any real estate during that time. We had lots of cash but we didn’t have the education to know how to deploy it correctly into real estate at that time.
So, we invested in stocks while I was in grad school, ironically 2012, ’13, we had the cash from the growth in stocks to get down payments on properties. We bought a personal house, we bought a duplex. We actually ironically bought a foreclosure, not intentionally, but we couldn’t close on it and they took it to the courthouse. So, we bought that as really our first property together.

Jennifer:
We found out two days before it was going to hit courthouse steps that we were no longer going to be in contract with it.

John:
We had to roll down to the courthouse and pick it up. And then, from there we were actually pretty aggressive over the next few years with adding properties. Ironically, real estate is very forgiving. So, even with all the mistakes and just really not smart things we did, the market was accelerating upwards. You manage a property well, even if you didn’t do the smartest due diligence on the front end or necessarily really understand the expenses as well, we were able to manage that, a lot of sweat equity, and build that into a real estate portfolio that’s where it is today over the last, those intervening 10 years, essentially.

Scott:
What would you say your max combined income was over the last 20 years that you just talked about, the story? And what was the minimum or average during that time period?

Jennifer:
Now, granted, it has fluctuated quite a bit. When I came out of chiropractic school, we had gotten married halfway through. So, when I came out, then came babies and we used to joke with our tax guy every year it was either a baby or a building or both. And in some of the lean years, we basically, I was very part-time and mainly on John’s income. So, I would say combined was probably…

John:
Well, maybe 100.

Jennifer:
About a hundred.

John:
About a hundred when we’re for combined income. My first job out of college was at 30 grand, like it was 2002, so very, very low. And then 2005, ’06, we jumped up close to 50. And then, when Jen and I got married, it got to the 80 to 100 range and then it’s really accelerated in the last few years.

Jennifer:
I’d say max.

John:
Max is probably going to be this year and that’s going to be close to between the two of us, 340, maybe 350.

Scott:
And that does not count your real estate incomes. That’s just active income.

John:
That does not count the real estate. That’s just the two of us working.

Jennifer:
At this time, we keep our real estate stuff very separate. That just goes back into the business. We live off of our income. And so, one of the questions is like, how do we make that transition? Do we just keep that rolling? All the renovations and purchases come from the real estate portfolio.

Scott:
So, again, just congratulations on this and this is an incredible, incredible wealth building journey that you guys have been on and an incredible financial position that you guys have built. Again, without being a doctor or a CEO or any of these professional baseball players, whatever it is. So, congratulations on that. And one more point that I want to call out here and just highlight, how would you classify yourselves in terms of spending? How frugal have you been and how important has that been?

Jennifer:
I would say on the big things, we’re pretty darn frugal as far as we don’t buy the big shiny new things. The furniture in our house, we buy a couple of new pieces. The rest of it, it’s offer up, and it’s marketplace because we’re realistic and we have kids and we don’t take the huge vacations. We go to visit his family in Ireland. We just got back a little bit ago.

John:
The spending on the personal life has been pretty darn tight where we probably go overboard and when you look at our finances is our spending on the properties. Because in those over the last 10 years, we’ve probably averaged at least investing probably about 100,000 every year into the properties, whether it’s, usually they’re all improvements but CapEx, those types of things on the front end when we buy a property. So, that’s what kind of skews it. It’s funny, our spending looks really high and then you go, oh, that’s actually the portfolio spending all that.

Scott:
Awesome. And so again, the story here is one of frugality, middle, upper, middle class incomes, a study accumulation and some really smart real estate bets that you guys have made predominantly self-managing, I believe this portfolio over the past two decades and building up a really cool position here. So, one of the things that I noticed here just to round out the financial profile is that the business on about $4 million in equity, it generated last year close to $32,000 in profit or in cashflow. And this year it generated a 123. Your projection is for $170,000. So, can you explain that jump and I think that’s going to be a critical piece of the puzzle to understand in going through how we can optimize your portfolio.

John:
So, for those, we added two properties that were pretty heavily distressed, ironically, both from the same seller and they needed a lot of rehab. And for that reason, well one was vacant for, call it seven months out of 2022, and the other one, the fourplex, it was vacant. It’ll be vacant all the way up until this coming month where the rents start coming in for that. And between the two of them, the rentals for those units are quite valuable. So, it equates to, what is it? It’s like 50, almost like 5,000, call it for the duplex and for the fourplex you’re looking at…

Jennifer:
Between 8 and 9,000.

John:
Yeah. Between eight and nine for the fourplex. So, it adds significantly to the cashflow every single month.

James:
Question on that, those properties that you just purchased, those value add, because a lot of times when we’re looking at your analysis, we’re going to be looking at cash on cash return. What kind of liquidity do you have? How do you increase that? How do you structure those deals when you guys are doing those upfront? Do you structure those as a construction loan where you guys are rolling in the financing on the purchase? Or is it where you guys are just putting down a down payment and then funding all those rehab out of pocket? Because I know you said a lot of your income goes back into your portfolio, but how do you structure the initial deal for capital?

John:
So, for those, we’re essentially straight conventional financing, just purchase the property and then use the cashflow from the existing rentals to fund any improvements that are needed. So, that way, you’re not paying the higher interest rate and you’ve got, because the rates were so attractive the last few years, it just seemed like we wanted to capture those low interest rates and not lose the ability to lock them in for the next 30 years.

James:
Were you able to still get cheap financing on those two before they jumped or was that purchased after?

Jennifer:
Correct.

James:
Okay, so you were able to lock that debt at four and a half to five rather than the eight it’s at right now.

John:
So, you crossed the portfolio because in 2020, we refinanced basically everything and locked in anywhere from 3.1 to, I think, 3.65 is our highest.

James:
Are those locked at 30 year or those on balloons or?

John:
Thirty year.

Jennifer:
Thirty.

James:
Okay.

Scott:
Yeah, so this is the problem and why this is going to be such a fun exercise is because the portfolio is so optimized. You’ve got what, four, four plexes, one duplex and a 10 plex plus your house, all at below 3.75, 3.6525 is the highest rate you have. All that are cash flowing or projected to cash flow at a considerable rate. Yet, if we believe your projection model, you’ve got $4.5 million, something in that ballpark, $4 million. In real estate, that’s generating $160,000 and you’re probably like, “Well that doesn’t quite feel free to me.” Is that the crux of the issue if I were to put it in a nutshell?

John:
And when you look at next year, the income will jump again from 100, and call it 170, 180 this year to closer to maybe, depending on if we keep our occupancy full, we could hit two 250 to 260 next year just in the cashflow coming off the rentals. And then, you still get all the principal, which is right now across the portfolio right around eight grand a month as well. And so, it’s like that’s the hard part is how, like you were saying it’s like you do this, you optimize it.

Jennifer:
Now what?

John:
Now what?

James:
I think you guys have done an amazing job on your portfolio. You’re very well-balanced as investors, you have cash reserves, you got good cash flow coming in that can weather any kind of maintenance issues. What you’ve done is you’ve perfected your portfolio the way it is right now, right? You’re running at full tilt. But one question I have because what you guys like to do is, a lot of investors like to use leverage, right? Leverage is how you grow faster. And obviously, you guys were able to attain the cheapest financing we’ve seen ever in the history of the US, which is a great thing to have.
But is there a reason why you guys never set up, because setting up with that extra leverage gives you more cash, more cash you have, you can grow more units and especially when you guys are averaging roughly a 7% return on your true cash flow because that 260,000 you’re talking about that’s a net. That’s not gross. Okay. So, on a 4 million equity you’re making about a 6.5%, which I’m sure on your cash you’re making 12 to 13% roughly?

John:
Yeah. That’s usually what we’re trying.

James:
Okay. It like 12 to 13%. Is it just because you started purchasing that way in the very beginning, just putting 20% down funding all the rehab out? Because, I mean, to have your portfolio at 50% sometimes is underutilizing leverage where that leverage, you can 2x that sometimes by pulling out more money? Have you guys looked into tapping into that 4 million through other different revenue or is it more like your personal goals are to keep your debt costs down?

Jennifer:
Those are the areas that we don’t know enough to know enough and so we don’t want to miss stuff on that. I mean, when the rates went down, we had done a couple purchases and I was poking him like, “Hey, if we’re going to pull money, we should…

John:
Do it now.

Jennifer:
We should do a cash-out refi now. And I’m glad we did because then things quickly, that wasn’t an option. But as far as how to capitalize on that leverage. That’s why we’re here.

James:
Yeah. And to be totally frank with you, I mean the whole thing was, you always hear the horror stories of leverage kills and we try to be smart and stay away from that, because again, it’s that whole thing of don’t go bust. But we’ve realized, now you’re sacrificing opportunity and ability to grow by potentially being overly conservative with the leverage position.

Scott:
John, what are your goals? And Jennifer, what are your goals?

John:
I want to continue to grow our portfolio and I realize now, especially as we’re starting to have really high income coming in from the rentals where I’m spending my time is no longer, it made a lot of sense early on have a great W-2, really strong earnings. It’s how you take care of your family. And now, it’s like “Okay, I’m spending way more hours on a W-2 that is making far less money for my family.”

Jennifer:
Way, way, way, way more hours. While I’m hugely supportive, it gets to be like, “Okay, what are we getting out of this?” versus how much stress. What would you rather be doing with your time? I work two and a half days a week in my clinic and it’s a huge blessing to be able to do that and make what I do and can I amp it up? Yes. Do I want to? Not really. That’s not why we’re doing all of this. And luckily, both of our goals are pretty similar on that. If anyone wants to stay at the W-2 job more, I’m trying to pull him away and saying it’s never going to feel comfortable. It’s never going to feel like the perfect time. And even if you do an interim job, it may not be the final, but there’s going to come a point where being there doesn’t make sense.
So, we’re thankfully aligned on that. We know some couples where one wants to invest and one doesn’t and they don’t agree on how much work should be spent where. And we work really hard to make sure that even with our kids, we’re first and foremost as far as our health and relationship before the kids, before the business, otherwise, what’s that all for? Right?

Scott:
John, do you like your job?

John:
I do. There’s a lot of aspects that are bugging me at the moment. But in general, I do. I’ve been there nearly almost 20 years, but you realize you’re getting to the point where I know I have a lot less road ahead of me with that career than I did when I started.

Scott:
So, here’s the good news. You can do whatever the heck you want to do and you’ve won the game. You have, again, 6 million net worth, you’re going to generate $300,000 easily per year in cashflow from these investments on a go forward basis. It sounds like your job is irrelevant to the financial position here. Not irrelevant, but it’s less, it’s almost like a non-factor. It’s not the 80/20 of your position. The 80/20 is managing and growing this business, which is way more impactful to the overall finances for this. So, you have complete freedom. You can keep working on that job as long as you’d like. You can cut back your hours whenever you want.
If you ask me what a strong position to leave your job is, $500,000 in cash and $6 million in net worth with $100,000 in passive tax advantage cash flow is one where I would say you’re probably good and you spend $8,000 a month on your household. So, things are good there. It’s a matter of what makes sense on a go forward basis. When do you want to do that and what do you want? And then from there, we can figure out is your portfolio given you all that you want from it. Surely, it’s eclipsing your spending goals, but we can modify it to either have more aggressive growth targets by adding leverage for example, and going bigger.
Or we can have it yield more cash flow in the near term by reallocating some of that portfolio to higher cash flowing investments, if that’s something that’s interesting. Although that will come at the expense of having to get very creative on the tax front and maybe pay some income taxes in a tax inefficient way. That would be the high-level diagnosis that I’m bringing to the table here. And then, I know that there’s other also ways to optimize your existing business in some areas to look at. Which of that sounds most interesting to you? Where would you like us to dive in first across that?

John:
I guess, option A is probably.

Scott:
When you said option A, do you think that the idea of figuring out how to optimize the portfolio for long-term value creation in excess of where it’s at is the most interesting?

John:
I think so and don’t get me wrong, I realize the bias towards the stuff you own, you overvalue the things you hold. I wonder if I’m falling victim to that.

James:
We all do, John. We all do.
Yeah. And that’s why we’re having the conversation is you get stuck in what works for you because this has worked really well and I do the same thing. And all of a sudden, I got to be like, “Okay, I need to do it a little bit different here if I want to grow.” Many, many people have that same thing. These houses have done well for me over the last six years. They want to keep them because it’s a proven track record, but then we can talk about how to make it even better. Because at the end of the day, financial freedom is just about the best financial position you can put yourself in and those are important things to think about with your goals.

Jennifer:
Well then, in the wild card too is with the interest rates going up and we would’ve thought, well we would finish this fourplex and keep growing and accruing more buildings, but that’s gotten a bit harder with the interest rates and trying to get those to cash flow and from the beginning you know can buy and hold and hope that you can refinance in the future.

John:
And that’s sort of that weird space where we’re in right now where it’s like, I know that if Jen and I just sit here and do nothing, in four years. We’ll have another million dollars to essentially invest, right? Again, it’s really like you’re saying it’s really hard to let go of that…

Jennifer:
Security.

John:
Security, right?

Scott:
Well, I think, again, it all depends on where you want to go and I don’t think you guys have quite figured that out yet. What’s next here? So, I’m going to start spitting out some, here’s things that I’d be thinking about in your position based on my sentiments. They’re going to be completely different than that. Personally, if I was sitting in your portfolio, I don’t know if I’d change a thing. I think James will disagree and I want to hear his take on this. I’d optimize maybe a little bit on the expense side, but there’s this phenomenon going on in United States where interest rates have risen a lot.
People have locked in their 30-year mortgages and they’re locked in to their housing. Americans are not going to move, right? Why would you? You’re going to trade your 3.5% mortgage for a 6 or 7% mortgage. So, you guys have made a decision in the past that has led to a really good outcome and I agree with the diagnosis. I think you’re going to have to sit on this portfolio and watch the millions trickle in over the next four or five years. I don’t know who knows about appreciation and those types of things. But you’re either going to do that or you’re going to refinance these properties and take on way more crazy debt and take higher risks with the next project.
I think that from a high-level diagnosis, I think you ‘are kind of stuck. Yes, you can get creative, you can sell these properties, you can 1031 exchange. But by the way, a 1031 exchange means that you have to get a new property with the same amount of debt on it unless you want to pay taxes on the reduction in what’s called boot and then you’re going to have capital gains tax to pay. If you sell the property and just harvest the tax, the equity that’s in them, you’re going to pay an agent to sell the property for you and you’re going to pay a commission there and all the closing costs, then you’re going to pay the capital gains on there and the pile of money that you’re left with after that and your debt is going to be very nice.
You still have some spending money, but it’s not going to be quite as much, it won’t feel like very much to you at the end of the day when you run that calculation. I don’t know if you have done that math or talked to a CPA about those topics.

Jennifer:
No. Not really an option we’ve ever considered.

John:
It took so much to build the portfolio over the last few years.

Scott:
So, you’re stuck with a pile of wealth and plenty of cashflow to cover your needs. I think the plan A for me is sit on the portfolio and do nothing and manage it effectively. And then, when you have the next pile of cash flow that’s coming in, what do you do with that? Well, you either continue adding onto this portfolio in thoughtful and creative ways. I love the idea of assumable or subject to mortgages or those types of things. So, you can keep buying properties like this with last year’s debt if you find those opportunities. Or I like the idea of going into lending. I know that’s where James puts a lot of his extra cash is in hard money loans and those types of things.
And you guys are very well positioned to do that kind of stuff and that would help you get a 10 plus percent potential yield on that additional million that you’re going to generate over the next three or four years. And if worst case scenarios, you now foreclose on a property that you know how to operate and manage pretty well. So, that would be my bias coming in. I know James is going to have a very strong differing opinion on that.

James:
I’m naturally a trader. So, one thing I do believe people get stuck on right now is the low rates and yes, cost of money. And there’s a good example right now. I just sold a duplex in Queen Anne, Washington, great area. I had no cash in the deal. I was cash flowing 1,500 bucks a month and I had a 4.5% rate or 4.25% rate. But I just traded it for a property that actually, I go from $1,500 a month to break even and my rate now is going to be 7.5%. And I would do that trade 10 times over right now and let me tell you why.
It’s because at certain point, these assets, they get into steady growth. When you guys purchased these properties, you got them at the right time, right? In 2012, when the market was flat, your guys’ income were up, you could obtain cheap financing and you bought them, right? And buying them right gives you gunpowder to explode your portfolio out. And because the equity is really what can grow you rapidly. Right now, you guys have an amazing portfolio, you’re making a great cash on cash return on it, but your overall return on equity is around 6%, which is 6% is still good growth, but it also is below inflation at that point.
And so, for me, I’m always looking at what kind of equity and what can I trade I to? And even if I’m getting a higher rate down the road, it’s 6.5%. If I’m getting a higher surplus, it doesn’t matter if my cash on cash return is going from seven to eight with a higher rate, then I’m still advancing my position at that point. Things that I would look at, there’s two ways. You can either look at your portfolio like it’s a gold mine, which it is, right? It’s steady, it’s safe. You’re not going to be the Seahawks on the one-yard line throwing the interception in the end zone. You’re not going to be doing that, right? Run the ball. If you just run the ball in with your portfolio, everything is going to be fine.
But with this quest of financial freedom, like you were saying, you want to get down to two days a week. John might want to stop working to give you that extra padding in your expenses because right now yours’ expenses rates run great, you’re at 30 to 35%. That’s amazing. But once John leaves that job, that’s going to go right back up to 50% and that’s going to be trailing with the average and then you have to figure out how to increase that.
What I would do is, you have properties scattered everywhere. Well, they’re all in one central city, but there’s still different properties that come with different expenses, and right now, your portfolio is running an average of about 50% expenses. And that’s with you guys self-managing too, correct?

John:
That’s correct.

James:
And so, if you add in property management, you’re going to be running like 60% expenses on your portfolio, which is a little bit higher. And that’s what happens when we start accumulating units and they’re spread out everywhere because we did the same thing. I’m a Pacific Northwest investor, I started with single families, we rolled the small multi into large multi. If you took these buildings and you went and sold them right now and the combined value is 8.7, if you took that and you bought a unit, if you bought that in Everett, you’re going to get that for about 150 grand a door.
You’re going to be able to obtain like 70, 80 units in Everett with that pricing at that point with today’s market. In addition to when you’re buying a big portfolio like that, even if you’re trading into a 6.5% rate, our average expenses or your expenses on bigger properties actually go down because you’re more efficient. And so, you can naturally add in 10 to 15% in cash flow just by reducing your expenses on that one trade.

Jennifer:
Wow.

John:
Wow.

James:
And that will offset all your debt costs at that point. And so, just by making that one move of selling off the properties and putting them into one, your cash flow would go from annually, if you’re projecting to get to 360 by the end of the year, you’re going to be picking up an additional 54,000. You’re going to be at 415 just by making that trade.

Scott:
What would be the cap rate on this 70-unit apartment complex and what would be the interest rate on the debt for that apartment complex?

James:
So, with commercial debt right now, and this is a perfect time because we just closed on a 58-unit in Everett, so I can rattle the cap rates. Stabilized, we are at 7.9 cap stabilized when we’re all said and done. So, that’s already going to increase your cash on return on equity right there. We were able to get financing locked at five years or it’s a 10-year note, fixed for five and that’s at a 6.1 rate right now. So, yes, you’d be giving up your 3% rates. But then, your overall return and your spread’s going to go up at that point and your costs are going to go down. So, naturally, you’re going to pick up that extra 15 to 20% even with paying that higher rate at that time.
And your life, if you guys like financial freedom, you have one site to manage. It is a lot simpler, a lot easier. And if it’s about that work life balance too. Okay, well to run around and manage all these properties with all different areas, that’s different demographics, tenants, it’s just harder. And whereas, if you have a bigger building too or if your properties are spread out everywhere, typically your property management costs is going to be eight to 10% because it’s more work for a property manager. If it’s in one, you’re getting 5 to 6%. So, all of your costs had go down just like you guys have ran your living expenses.
You’ve built it based on keeping your expenses low by doing the one trade that will match what you do personally as well. Your expenses will match what your life’s expenses are. And the 15% will almost, that will pay for a third of John’s salary just to stop working. Just by making this one trade would pay for 35 to 40% of John’s salary when he leaves the door without putting any more money in the deal.

Scott:
James, this is awesome. I have a quick question as well on this. What is the purchase cap on a TTM basis? So, you said stabilizes, it’ll be 8%, that’s your cash flow for those listening. So, essentially your net operating income will be 8%. So, if you have a million-dollar property, you make 80 grand a year in rough cash flow before allocations for CapEx and those types of things and principle payments. But what are you purchasing it for? Because you said that’s the after stabilization cap rate?

James:
Yeah. So, we were buying it at a 5.8 cap on existing right there. So, logically, that doesn’t make sense when you’re buying with a 6.1 rate. Typically, your cap rate needs to be above your interest rate. That’s a general rule of thumb to keep. But it was a very cosmetic turn too, which they definitely have done by looking at their portfolio because they’ve bought some pretty old buildings. Those are harder renovation plants. And actually, what we have found is going from the small harder renovation like what you described on your last purchase was a great buy. You got it well under market but it needs a lot of work.
You know that’s a six to 12-month deal to get that thing fully stabilized and optimized. The great thing about buying bigger buildings is you’re buying them a lot newer, like the building we bought was built in the ’70s. So, all we have to do is swap out flooring cabinets, doors, trim, but the overall bones and structures and the mechanicals are good because so it makes it very efficient at that time. When you’re buying bigger, you don’t have to take on the same amount of work either. So, it is just basically you’re getting more efficient at that point. But you have to get comfortable with trading that rate out.
And going back to my example of why I did that deal because people are like, “Have you lost your mind? You had a lower rate in your cash flow in 1,500. Now you’re not cash flowing anything.” I did that trade because the building I sold was maxed out. If you guys sell these and these are at the top dollar it, you’re going into steady equity growth at that point. You’re going to be getting your 3 to 4% a year. Whereas, if you can buy something where, a bigger building, where your cap rate’s 5.9 and you can increase it to 7, you’re increasing the value of that building which is going to create that equity pop.
And so, I made this trade to a duplex in Bellevue because yes, my cashflow position’s worse, but that will get better when rates fall. But my equity position once I’m stabilized is increasing by $350,000. And so, over a 12-month period, where my $1,500 a month in cashflow is not going to get me there for the wealth. And then, I can trade that 350 then later for more cashflow because I’ve done a great job building equity. And then, it’s about maximizing your equity to get you to that final space where you’re like, “I don’t even need to manage my properties anymore.” They all pay for each other be because the equity just keeps buying it down, buying it down and getting you more doors.

Scott:
I think that’s awesome. What James just said is that’s a business, right? You’re going to go in and you’re going to buy a property and you’re going to turn 50, 60 units. You’re going to take on a different type of debt to purchase that portfolio. To exercise this, you’d need to sell essentially all six of those buildings and 1031, exchange the equity into this new property and close that debt. This will be a project and yeah, you’ll absolutely get better returns on that if you can drive rents up in a pretty meaningful way in the period following acquisition and property. Probably, it’ll take you a year. I don’t know. Is that right, James, you think to move the property to its post stabilized rental rates?

James:
Yeah. It takes about a year depending on the size of building because what you’re doing is you’re doing a structured, that when you’re buying these a little bit more cosmetic, you’re moving out five people at a time. You’re turning the units. So, you’re still going to keep your debt service going. But yeah, it’s about a year process when you’re moving people. I think in that one, the 58, we’ll be done with that in about seven months all the way through. But we also had a third of them moved out when we bought, so we could just tackle those immediately.

Scott:
So, I think that’s a potential option for you. That’s a business activity, right? So, that would take your existing portfolio, which probably feels to you fairly diversified even though it’s all in one place and concentrating it into a single asset. I think there’s a spectrum of optionality along there. You could for example, purchase a property, well you’d have to keep probably about again $4.5 million dollars in debt on the portfolio, which will dramatically change your debt service. So, you’d want to run those through. I would run the numbers on the two things and say, “Hey, if the opportunity size is dramatically,” for me, it would have to be dramatically better to go with James’s option there than to just go with the status quo because what you’ve got is working there and it may well be.
But several things, I think, I completely love James’s strategy. If you can find a deal, if can add the value and you’re willing to assume the project there, you will be able to drive a much better return than holding the existing portfolio. But the existing portfolio is freedom in today’s sense as well without any modifications to it. So, it’s all about what that end goal is and the comfort with that. I think that’s, you know.

Jennifer:
I think that’s probably our biggest hurdle is the comfort with the security of it and that’s with our portfolio. Our current life is W-2. I think it’s real stuck. I’m going to throw you under the best here. Real stuck on the security of like, “Well, this is my salary and we have medical and we have kids.” But getting past that comfort level and pushing it, I think we’re both interested in, it’s just kind of jumping over that hurdle. And so, the comfort and the security is a good thing, but it’s also one of the things that’s detrimental to us in our future growth. And we do want future growth. I mean, the good news is that we can stay with what we’re doing now and still be okay or we can push to what James is saying and accelerate, which, you know me, that’s my vote.

John:
So, she’s generally the, I’m usually the conservative one, I’m the handbrake and she’s the one who’s like, “Let her in.”

Jennifer:
We balance each other out.

Scott:
Another route I might take in your situation is I might say, what is that number that I’m super comfortable with? If I had a pretty safe $200,000 in passive cashflow every year, would you then, John, be willing to take the remaining 4 million bucks of your portfolio and go big on a James bet here? Would that change things for you?

John:
I think in some regards, yeah, it probably would. And the other thing I realized too is I wonder if I’m getting caught in a little bit of market timing thinking as well with the portfolio because we still look at deals all the time for properties and admittedly nothing has been ever as big as a 50 unit or anything deal that size. So, we haven’t really considered those to James’s point. But there’s so much assumption that our belief, I guess, that there will be these opportunities later, whether it’s later this year or into ’24. Are we jumping too early? If I decide to get super aggressive, am I being overly aggressive and not reading the signs?

James:
But there’s one thing about that and I get trapped in the same thing because I’m a 2008 investor so I have bad whiplash and I lock up sometimes. But if the opportunities are better in one year and pricing is less, your portfolio’s worth less too and it’s an equal trade.

John:
That’s a good point.

James:
It’s about what can you do today and can you increase that return? And that’s what you guys can do to make that big growth jump. But it is also not for everybody. I’m also a high-risk person that I’m chasing this equity growth. I actually don’t care about cashflow at all right now. I’m just trying to get the biggest equity position. And then, when I’m ready to settle down, I’m going to sell it all, roll it into one thing and then I’m going to take all this equity, buy a bigger building and I’m going to have one building that’s going to pay for everything. But you guys do have a great portfolio and there’s room to improve too, right? Because you’ve maximized it but your expenses are high in just implementing other strategies. Right now, do you guys do utility bill backs?

Jennifer:
We don’t. In the duplexes, they do their own garbage, but water sewer garbage is included in the fourplexes and the 10.

James:
Okay. If you guys want to start growing a little bit too on your existing, because maybe you get to the point where you’re like, “I don’t want to make the trade right now. We don’t want to fumble on the one-yard line.” But you really start breaking down your portfolio on how to perfect it. And if by putting in utility bill backs, which are now standard up in Everett in Snohomish King and Pierce County, that’s going to automatically put about 3 to 5% back in your return right there. And then, you can take that savings. And then, what we were talking about was adding more units to your building and just really going, “Okay, once we save up a certain amount of cash on this extra cash flow, then take that and invest in our profits into adding that building or adding that unit.”
And as long as you can generate the same cash on cash return that you expect, so what we were talking about before that we hopped on was you were going to add a unit for 250,000. You have to make sure that you can generate $2,500 a month in rent if your minimum return is 10%. And so, you just want your build out cost to track with what your rent is and then that will make the decision. If it doesn’t, then you want to make your portfolio more efficient and get your portfolio to pay that overage at that point.

Jennifer:
Okay. Now, what’s your strategy with the billback? Do you do per person or do you do per unit or is it a mixture?

James:
We do per unit and then units that we do have multiple tenants in one house, we make them sort that out, it’s in their lease, that they’re all obligated to pay the one bill, but they got to sort out their own separate billing.

Scott:
And I just charge a utility fee.

Jennifer:
Okay. Got it.

John:
Oh, that’s smart.

Scott:
So, that’s another, I don’t know if that’s an option in your state, but here, I estimate the utilities on an average basis. So, then, just charge that on top of the rent. And so, the payment includes rent and plus utility fee.

Jennifer:
Excellent. Okay.

James:
Just make sure you’re not cash flowing your utilities that is not allowed.

Scott:
That’s right.

Jennifer:
Got it. Good to know

John:
Yeah, it is. Make sure the fee is slightly below actually.

Scott:
Yeah. So, James is probably more like long-term appropriate. Mine, yes, I still cover a small amount of the utilities, but yeah, it’s very simple.

Jennifer:
Well, I think there’s also a little more responsibility and utility usage if you’re on the hook for it.

John:
Exactly.

Jennifer:
Versus like, “Hey, we don’t pay water. Everybody come over and do laundry.” So, we now have that in our lease if that’s not allowed.

John:
Trying to get smarter over time.

Scott:
Yeah, that’s like the no archery sign at the beach. Somebody sometime put that into the, they made that sign a requirement here, right?

John:
We really don’t feel that’s necessary but…

Jennifer:
It was.

John:
Apparently it is.

Jennifer:
Yeah.

Scott:
Let me try another one here because I don’t think you guys have a math problem here, right? I think there’s more of an allocation and psychological issue to resolve your situation because you’re way past the point in terms of net worth of what you’d need to actually leave your job. John, [inaudible 00:43:22] uncomfortable with that. So, I want to go through a couple more exercises here and try a few more portfolio allocation things on. I think if I handed you a pile of $2.5 million dollars in cash right now, how would you allocate that, John, to feel so super comfortable with leaving your job?

John:
I think you have a different allocation than I do.

Jennifer:
Go ahead.

Scott:
Luckily, you’ll both be able to go through this exercise because you have more than 2.5 million each to allocate if you wanted.

John:
I would keep a substantial amount in cash reserves. I honestly, I’d probably put at least 300 to 500 in cash reserves, and then truly, I would go figure out investments for the others. Again, I default to buying the duplexes and fourplexes because that’s what I know, but that’s how I would allocate it and try and find opportunities there to buy undervalued assets. And that would be my cash cushion would help ensure that we don’t get tipped over and I pick up one or two properties and start working on them.

Scott:
And how would you allocate it?

Jennifer:
Honestly, pretty similarly. I honestly thought he would keep more on cash reserves.

John:
Being aggressive.

Jennifer:
Yeah. Yeah. Because again, security, security, security. But no, pretty on par with that. We’ve been together too long.

James:
Can I jump in really quick? So, I started stalking all your properties on the internet as we were talking and you guys have some hidden value on these. With the plan that I proposed is this, the way I do it, I know a lot of people do it that way. It’s aggressive. There’s nothing wrong with also being more conservative and keeping your financing locked in. And what I’m looking at, even on one of your properties, like the one four-unit that’s on Walnut, you have a big parking lot there and Washington has just eliminated single family zoning and they’re allowing for mass up zoning and you have a very good potential to add one to two ADUs or DADUs to your parking lots. Your rents would go down a little bit.
And then, the nice thing about doing that is you have to come up with the cash to build those. They’re going to cost you about 300 grand to build each one of those. But then, once you condo those off, you can leave your financing in place on your four unit, your cheap 3.5% rate and you can refinance just those two units at about 6%. And once rates fall, then you can bring it in. But it allows you to add more units in, get more rent income and keep your financing in place. And then, eventually, if you want down the road, you can sell those off later if you wanted to, but I’d probably just keep them as one big package. But it allows you to expand out your portfolio without having to reset your loan basis.

Jennifer:
Interesting.

Scott:
That’s a good plan. That’ll keep you busy, John. That sounds like a better value add than the W-2 for a year or two.

John:
Yeah.

Jennifer:
And that’s just an Everett proper that they’ve been allowing that more.

James:
That’s in all three major cities. So, Seattle, Everett, Tacoma are really pushing these ADU law in DADU expansion. In Seattle, you can condo them off and sell them in Seattle and Tacoma. You have to keep them as rentals, but that works for what you guys are trying to accomplish. And you have a great lot here. We could cut this thing up all day long, so it’s a good thing to hold onto. But the thing that you have to think about is you got to come up with that money to build it without resetting your loans. So, if I was you, I would network with some private investors, borrow the money, and then refi it. It’s going to cost you a little bit more upfront, but it allows you to keep that really good rate because that is a great 3.5% on a third year fix is a good thing to have.

John:
There’s some of the similar properties like the fourplex on Chestnut, it also has a big open area just in front of the building as well.

Jennifer:
And then 4510 in Marysville has a large lob that’s currently a carport.

John:
Yeah, I mean we use it as, yeah, it’s parking and storage. So, we hadn’t actually really thought at all about the change in regulation, the DADU law. We never really considered that. We always thought that was for single family, to be totally frank with you.

Scott:
I think that’s a bingo, right? I mean we just asked you guys what would you do if we handed you $5 million in cash and you said, “I do exactly what I’m doing currently, but I want to grow my portfolio more on this.” There you go. There’s the answer. Now, you have now this opportunity to add value to your existing structures that you know really well and you can pull off these projects either in tandem or one at a time. You have the cash right now to finance one of the projects completely, if you wanted to and you’ll replace that entire reserve in one year without even, you probably would not even notice your reserves dwindling while you tackled one of these projects would be my guess because the cash flows to finance, each phase of the construction would likely be replaced by the rental income from your portfolio.
If you were just looking at your balance over time, you probably wouldn’t even notice it with your current situation. So, I think that’s a fantastic discovery by James. Great job, man. That’s awesome. I had no idea. I would never have gotten there because I don’t know that regulation in Washington.

James:
And you could also take a loan out against your 401k that you’ve done such a good job just temporarily to build it and then put it back in once you refinance back out because you guys have done a great job saving and that’s usually a lot of investors’ biggest problems, but tap into those investments. I would break out of the, hey, this bucket, this bucket, this bucket. How do you maximize the buckets? And maybe you got to mix them for a short amount of time, but it still gets you to your end goal.

Scott:
I think you got some fun options here. Your portfolio is so close to optimized in today’s shape that yes, I think that if you wanted to go big and build a business, James’ approach is going to get you richer faster than the one that I held out there. The current portfolio though, if you do nothing is going to cashflow and cover all your needs. So, game is one, victory is complete. We’re pretty close to it with your current situation. But I think that if you want a blend of both, then I think James’s approach of just adding value by basically taking into the account that your properties have been rezoned recently without you be really being aware of that.

Jennifer:
Yeah. Awesome.

Scott:
That seems like a pretty good place to go hunting for opportunity there and I’m sure you can continue with your preferred choice of paint and floor in those new constructions that you’re going with. James, what do you think the back of the napkin, since you know the area so well, you said cost 300 and ARV of one of those projects would be.

James:
So, if that was so you can’t sell them off right now, but the value on that building, so you’re going to build it for 300, it’s going to be worth about 399 to 420. Being next to multifamily, you’re probably going to be worth 399. So, you are going to pick up an equity position there and then that unit should rent for about 2,100, I would think, for a brand new two bedroom, two and a half bath. That should be about a 2,000 to $2,200 rental. And that you guys can probably verify that a little bit better than I can because you have more units there.
So, the issue you’ll have is it’s not going to quite hit your cash on cash return expectations because you’re going to spend roughly 300 grand you can probably build that for 250 there too if you do more rental grade.The 300 is more for resale. So, you update it. You’ll be about 250 in and get about 2,200 out of it. But it does allow you to start building that. If you don’t want to trade out the buildings, you can start building infrastructure behind that.

John:
And that’s very similar to what we were looking at when we looked at the property, the 10 unit up in Marysville. We’re estimating the initial rent on it would be right around 2,200, maybe a little bit higher for the town home on a build cost of right around 250 for that. And whether this is good or bad, it’s served us well. Our strategy has been very patient with regards to not having to get the maximum capital today to essentially just lower risk and make sure that we’re slow and steady rather than sprinting and realizing we’ve gone the wrong way.

Jennifer:
But I think we both are wanting to, I tell them all the time, we have to get comfortable with being uncomfortable, comfort in the discomfort. And so, pushing it past what we’re comfortable with as far as the security aspect. I’m usually the one that’s like, “We should go 12 steps that way.” And he’s like, “I’ll compromise with eight.” And so, we land somewhere in the middle. But we are in the scheme of things relatively in the beginning and we do want to do this long haul. So, it seems riskier to him to do it now that the kids are small. And I say, “Well now it’s kind of the time to push, I think to push and grow at a faster rate.”

Scott:
Well, John and Jennifer, thank you so much for coming on the show today. We hope this was helpful and we’re so grateful for you coming on and sharing a unique and awesome challenge for us. And yeah, we wish you the best of luck. Please let us know what you end up deciding to do.

Jennifer:
Absolutely. It was hugely, hugely insightful. Thank you both.

John:
Thank you. Yeah, I’ll have to attend your meetup and go ask you some questions in person.

James:
Yeah. Come hang out.

Scott:
Yeah, absolutely. All right guys, thank you so much.

John:
Thank you very much.

Jennifer:
Thank you.

John:
Take care.

Scott:
All right James, that was John and Jennifer. What’d you think today?

James:
Oh, those are my kind of people. It’s cool to see investors grow their portfolio and not get too far out there because that’s a huge mistake a lot of people do. And I could relate with them a lot about getting locked up, getting comfortable because we all do that and it’s about how do you push to that next thing or figure out whether you even want to do it in the first place.

Scott:
Yeah, absolutely. I thought that was really an interesting dynamic because I bias towards, and the reason I bias by the way, towards the approach that I took is because I’m the CEO of this company at BiggerPockets. So, most of my time in energy is spent on building this company. And I sometimes get locked into that and forget like, “Oh, if I wasn’t CEO here, absolutely I’d be trying to take a more aggressive approach,” like what you just put together or what you suggested with a 58 or 70-unit apartment complex and trying to grow to the next level there. So, I loved, loved the balance of opinions there and I really think you hit a home run when you stalked the properties and uncovered that they have room for DADUs to be added to them. So, that was an awesome find.

James:
Yeah, might as well. I mean, if you don’t want to sell, figure out how to maximize it. So, the one thing I’ve always learned is you can always improve a deal.

Scott:
Do you have any parting thoughts or other things that you’d have for investors given what we discussed on today’s show?

James:
No, I just think it’s important that investors don’t fall into that rate trap. At the end of the day, it comes down to what are you making, what’s your return? And the debt is just a byproduct of that. And so, don’t get locked up because it can prevent growth. And for us, we’re all trying to get to financial freedom. The more growth you have, the quicker you’re going to get there.

Scott:
Awesome. So, yeah, you generally recommend, for me, not doing what I’m currently doing. And I think that’s something to think about. I’d have to go and review that with my business partner on my own portfolio and say, “Yeah, what should we be doing here?” Because right now I told John and Jennifer after the show, that’s what we decided last year is we looked at it. We’re like, “We don’t think prices are going to move much in Denver for the next year or two, maybe three. We are cash flowing just fine.”
We’ve got this low interest rate debt on here. If we sold the properties, we’d have to pay transaction costs and then we’d have to pay capital gains. We’ve refinanced a few. So, the amount of cash we’d actually extract if we didn’t 1031 exchange wouldn’t be that high. And we thought, “Hey, we’ll just hold on and enjoy the cash flow and slowly deleverage these things.” But maybe we should be thinking bigger on that portfolio and moving it to the next level.

James:
Let’s break down your portfolio next.

Scott:
All right.

James:
Let’s do it.

Scott:
Awesome. Well, thanks so much, James. And maybe, we should do that. We’ll talk with Calin and see if that’s a good episode.

James:
I’m 100% in. Let’s get you on The Market Podcast. And me and David, we can go through your portfolio together.

Scott:
Awesome. Well, let us know if you think that will be a good idea, guys, and maybe we can make that episode happen. So, James, great catching up with you again today. Thanks for all the great wisdom and the great thought starters and we hope to have you back on a few more of these Finance Fridays in the weeks to come.

James:
Anytime.

Scott:
All right. He is James Dainard and I am Scott Trench from the BiggerPockets Money Podcast and we are saying, “Be sweet, parakeet.” Thank you, Mindy, for that one as well.

Mindy:
BiggerPockets Money was created by Mindy Jensen and Scott Trench, produced by Calin Bennett, editing by Exodus Media, Copywriting by Nate Weintraub. Lastly, a big thank you to the BiggerPockets team for making this show possible.