Winters in Minnesota are terrible—I get it. All it took were two consecutive 40-below-zero mornings in the 1990s, and I decided to move away for college. It was off to sunny California for me, and I didn’t return for another 12 years. San Diego was nice, and I miss it, but Minnesota is a great place to raise kids.
As people see their net worths climb from a strong stock market and red hot housing market, we hear more friends ask about whether they can afford vacation homes. Increasingly, it’s looking like that is a reasonable option for many folks, and I want to take you through some of the things that we talk about in these situations.
One client recently thought about buying a $500,000 winter condo in Southern California. She has friends there, enjoys the area, and recognizes that she can probably afford to do it. Frankly, Minnesota winters are not a compelling retirement locale for her next couple of decades.
It isn’t easy to acquire a property at a reasonable price right now—bidding wars are crazy. During these wild times, I helped a client buy a house in Los Angeles with 42 other bidders. Shockingly, nobody had even been in the home (due to COVID)! Fortunately, the client won the bidding war, but it can be potentially very expensive to buy a home right now amid the frenzy.
Like all hot markets, things will soon normalize, and these intense and stressful bidding bonanzas will be less common. The real estate market might be cooling off already considering lumber futures have crashed from their May peak.[i]
Many clients we talk to have the flexibility to postpone a purchase until calmer waters arrive or they might have the patience to pounce on a unique deal. Assuming you are at a point where you can buy a place, where do you come up with the money?
Crunching the Numbers
If you need $500,000 cash, we must tap assets such as:
- retirement accounts, which would normally be taxable at ordinary income upon distribution
- appreciated securities that have capital gains tax liability if we sell now
- cash that we may have on the sidelines or even withdrawing from fixed income securities
Federal taxes on long-term capital gains are usually 15%.[ii] State taxes can be another 8-10%. Total capital gains tax can even go higher than that, to upwards of about a third of the gain, depending on your tax bracket, so you must be very careful when liquidating appreciated securities in taxable accounts.
If we need distributions from retirement accounts, they are generally taxed anywhere from 20% to 45%.
Pulling cash from a non-retirement account is relatively simple and easy. It’s important to bear in mind that we’ve been raising cash as the stock market has climbed to ensure our safety buckets, including bonds and alternatives, are funded. We want to be prepared and opportunistic during the next market pullback.
There are constraints regarding what can be sold in some investment accounts because we are careful with taxes regarding unrealized gains. Also, consider that most people don’t have a huge piggybank of low-risk, safe investments to jettison into real estate. Finally, we must carefully maintain a safety ratio of anywhere between five and 20 years' worth of dry powder in case the stock market pulls back sharply, then does not recover quickly.
It might require a $700,000 gross distribution to net $500,000 of cash after-tax.
On top of that, there is the opportunity cost of letting $500,000 to $700,000 idle in cash when it could potentially be growing in the equity market. I like to assume a conservative 5% rate of return for that $500,000 to $700,000 if we leave it in the markets. The last year has been many multiples of that return assumption, but the stock market doesn’t always double in 16 short months!
So let's be realistic—5% on $500,000 to $700,000 yields $25,000 to $35,000 in a year.
That's the first component of our framework on the opportunity cost, call it roughly a cost of $2,000 to $3,000 per month ($25,000 to $35,000 per year) just on the capital you would no longer have invested by purchasing the home.
Next, we have to figure out HOA fees, maintenance, property taxes, vehicle costs, and everything else that goes along with owning a second half-million-dollar home. These expenses quickly add up. We'll call it another $2,000 per month in ongoing monthly costs.
$24,000 per year in recurring costs plus $25,000 to $35,000 per year in opportunity costs; now we are already upwards of $50,000-$60,000 annually. Are you getting nervous yet?
Of course, there might be home price appreciation at the rate of inflation. Let’s assume 2%, which is about $10,000 per year, netting you a long-term cost of $40,000 to $50,000 annually.
Stepping away from the numbers for a moment, many people in really warm places like to cool off elsewhere in the summertime. I get that, too! I have family that winter in the California desert, and 120+ degree summers are not desirable for many Midwesterners!
The point—your getaway house could be vacant during those scorching months. So $3,000 to $5,000 might be your monthly cost of a second home if it is indeed vacant for a big chunk of the year.
Another Buying Option
Putting on my cash flow strategist hat, it might be wise and opportunistic to take on a 30-year mortgage, then only pay the minimum monthly payment since borrowing costs are near record low levels. The average 30-year fixed-rate loan is back under 3%.[iii] Full disclosure, I am in no rush to pay down my low-rate mortgages.
You can qualify for the best mortgage rate possible with retirement assets as collateral. In this scenario, we only need to take out perhaps $100,000 to cover the standard 20% down payment. By taking out just $100,000, the opportunity cost drops to just $5,000 per year. With the $2,000 monthly maintenance costs and a $1,700 mortgage payment, the total cost is about $50,000 annually.
Now let’s talk about making money! Consider that the $400,000-$600,000 left to grow in the stock market should return roughly 5% a year over time. So now we have $20,000-$30,000 a year in investment returns plus $10,000 of home price appreciation.
So the mortgage idea could cost somewhere between $5,000 to $25,000 a year. Not too shabby versus $35,000-$50,000, right? All it takes is some careful planning and strategy.
Focusing on Your Situation and Desires
We can strategize and optimize all day long, but your goals and wishes are paramount. There's no perfect answer and your risk tolerance must always be considered heavily.
It’s helpful to consider future scenarios. With the mortgage idea, you might face regret should the stock market and your investments decline in value. On average, however, if you give a diversified portfolio of stocks enough time, it will clear a 3% yearly hurdle rate.
Finally, the “Give Yourself Permission Framework” is knowing that it would cost you potentially X or Y to buy (and maintain) a home with cash or buy a home with a mortgage. If that all fits within your financial plan, we can tell you if you can afford it.
Consider the alternatives—what else could you do in lieu of a vacation home? What if you just “gave yourself permission” to spend that vacation home budget that you would be creating?
What about just going on vacation every year for the rest of your life? You could travel wherever you want and not have to worry about whether the lawn person showed up. That sounds like a fun alternative!
These are just some of the things that we think about when trying to help our clients through complex decisions. If you'd like to talk about your situation, we'd love to help. We also recognize there is an emotional part of owning a home and putting in new roots. In all events, we're here to help you do the math of life and help you maximize your net worth and happiness!
Thanks for taking a look!
Tom
[i] https://www.bloomberg.com/news/articles/2021-07-12/lumber-wipes-out-2021-gain-with-demand-ebbing-after-record-boom
[ii] https://www.irs.gov/taxtopics/tc409
[iii] http://www.freddiemac.com/pmms/
[i] https://www.bloomberg.com/news/articles/2021-07-12/lumber-wipes-out-2021-gain-with-demand-ebbing-after-record-boom
[ii] https://www.irs.gov/taxtopics/tc409
[iii] http://www.freddiemac.com/pmms/