Need advice: Rentals or max out 401k's?

Question

I'm 38, my wife is 36. We just had a baby 5 months ago and purchased our first home 2 years ago. Due to many factors, including a career change and zero financial literacy or savings we got a late start and are now thinking about 1. Life when our daughter goes to college and, 2. Retirement expenses.

We lucked out on our house in that we got an incredible deal on a refurbished foreclosure in a top neighborhood, so instant equity. We got the house for 510k, have a mortgage of 480k, but the house would easily sell for 600k, according to comps and expert opinions (I know a developer and two real estate agents). Even luckier, my grandfather (The developer) is going to replace all of our windows and put new siding on the house as a gift (The windows and siding are quite ugly, so assume the appraisal will only go up from there).

The house is a mother-daughter type setup and when baby was on the way we knew we needed to act fast to start saving for babysitter and retirement, so grandpa turned the lower level into a proper 1 bedroom apartment which we now rent. We net 1600 / month for that, mortgage is 3600 included and PITI is 2200 (taxes are very high in NY). We would like to take over the entire house in about 5 years, once we need more space (although we are willing to push this back to make the numbers work).

So here's the heart of the question (Thank you for making it this far). With this rental income, our income, and two side gigs I have (tutoring and playing music) we are easily able to save 3k / month and we don't know where we should invest it.

Two months ago we built up our emergency fund, then dipped into it for a dental emergency (thank god we had it), and now it's back to where it needs to be. So now we are ready to invest.

Our goals: As I said, I'm 38, been teaching for 5 years, and want to retire in 25 years. In about 18 years, when my daughter goes to college, I would like my wife, who makes 70k / year, to be able to work at a school so we have the same days / summers off and we can spend more time together and even travel. That would require her taking about a 40k pay cut. We would definitely put a renter back in place to help with that. Also, by then my income will be higher so that will be very doable.

We have two competing ideas, although they are not mutually exclusive. 1. We max out our 401ks (She already maxed what her company matches) while we have this renter and go the typical and "easy" and "safe" route of saving money. But doing the math that makes it so my wife will be able to take a pay cut in 20 years however there would likely be no traveling. And once we are both not working things will be even tighter. This way would leave about 1M in our 401ks by retirement.

2. While we have the renter below us, leverage 4 - 5 single family homes in the 100k range (Put 25k down for each house), use the rental income to pay off the mortgages, and in 20 years have 4 - 5 fully paid off rental properties. As I mentioned, we are saving about 3k / month so this can happen quite fast. Perhaps even more homes than that.

To me the latter seems to work best for our goals. We would have great cash flow from the paid off properties so my wife could take the lower paying job and the houses would be our source of income in retirement.

Thank you for reading this. I am sure there will be a lot of great comments and suggestions about how exactly to move forward with either process but before getting into that can you just let me know whether you think "401k" or "houses" is the winner for this scenario? I also realize asking this question in the BP forum will likely yield more "houses" responses but the members here always have such great insight.

Ryan Fox · Answer

Hi Allen,This is likely the route we will be taking. We're going to do a renovation on our home, which we bought as a foreclosure, and look to access equity that route. I have been researching the heck out of the BRRRR method and it seems like the best way to go. It's a win-win for us (renovated house, capital to invest). My grandfather is a real estate developer and does mostly very large projects with private lenders, however, he has agreed to do the Rehab for whatever our first project is, to teach me the process. Very lucky as I've heard that finding a good contractor usually makes or breaks the deal. In this economy, we are just waiting patiently for things to settle down. The last thing we want to do is rush our first project. Hopefully, it will be the first of many!A bit late but, thank you for the reply. Good luck out there!Ryan Fox

Brit F. · Answer

Yes, 20-25% down/equity is typical for investment property, and some lenders may want to see 6 mo's cash reserves per property (not sure if that's close to your $5k number or not). The amount of total leverage across your portfolio will be governed by your risk tolerance and your Debt to Income (DTI) ratio. Only you can decide what's appropriate for your situation. You could certainly make a plan to buy houses at 75% LTV until your DTI is too high for conforming loans, then pause and let your DTI come back down, or find non-conforming lenders with more relaxed DTI rules at the expense of paying higher interest rates.It's a matter of looking objectively at your budget and deciding how many worse case scenarios you can absorb.

Allen Tracy · Answer

With all of the equity in your primary home you can look into a HELOC to fund your real estate investments. This is the route I plan on going. If you use the BRRRR method you could potentially borrow from the HELOC then pay it back fairly quickly. That would allow you to max out your 401k while also getting into the real estate game. Just something to look into.

Ryan Fox · Answer

@Brit F. we are actually looking to build a portfolio of over 10 units and planned on using leverage for all, then paying down the mortgages with renters money one by one. The plan was 20% down on about a 100k peppery with 5k in cash reserves before down payment and saving 10% for vacancies, expenses, and repairs. We understand with one home that could be a risk but with a diversified portfolio do you still see that as over leveraged?what’s your take on borrowing?side note: our first couple we were thinking of putting a larger down payment (30%) for a larger cushion.

Brit F. · Answer

Take the following with a grain of salt since I don't know your market: 2.4% annual cashflow seems oddly low for a property where you have 75% equity.On the chance that you meant 25% equity with 75% LTV, then 2.4% annual cashflow seems more realistic, but I would hope that there is very little, if any long-term risk, i.e. it's in a great neighborhood with almost no expected vacancy. Plus, there would need to be significant equity upside that adds to your overall return. Don't over-estimate equity appreciation, however; some people call it 'hopium'.Since we're comparing to 401k, a good metric for you might be that your after-tax cashflow plus estimated equity growth outpaces your current 401k return or a stock market index like S&P500. If the S&P500 avg is 8%, try to find properties that will do better than that. Hopefully, your market offers this in abundance. If you have trouble finding them, check your math, look at more properties, and/or talk to other local investors (with the understanding that many investors inflate their return %).

Ryan Fox · Answer

@Brit F.Thank you for your reply. My wife and I have crunched a lot of numbers since this post and we are going to be doing exactly as you suggested. We will contribute up to her match and that money, in 20 years, will actually be pivotal for some plans we have.At our rate of savings we should be able to have ten 100k units in about 15 years (probably less time).I appreciate the other suggestions and I am sure down the road we will look at other places to put our money, since I can't predict whether we will want to take on more real estate investments than that. However, we are excited to get started quickly. A friend of mine recently said, "Treat your money like they are your employees. Never have them just idling by; just get them started working on something."For us, pulling the trigger on the first rental will be a huge psychological move.Doing the research we estimate for a 100k unit, leveraged at 25%, we should be able to take home about $200 / month. How do you feel about that estimate?

Brit F. · Answer

@Ryan Fox, love all the thought you're putting into this. Can you do both? Meaning, contribute to 401k but only up to the employer's match and participate in REI, making sure to evaluate other REI strategies beyond SFR, such as multi-family, crowdfunding Resi & Comm, private lending/investment clubs, notes, etc. I mention these other options because diversification is still important in REI, and ideally, you find strategies that you have a lot of passion around that also meet your financial goals. But, if you've already explored those and really want to move forward on SFR's, then go for it.