A 5% CD is twenty times more than what you could get in 2021. But it's still not enough. Not nearly enough if you're trying to amass wealth – or even tread water with real inflation. Here's why a 5% CD isn't getting you anywhere:
- After paying tax on the interest, your actual rate of return is closer to 3% than 5%, assuming normal tax brackets.
- The rate of the inflation has been hovering around 3% for a while now, which makes your after-tax, after-inflation rate of return around 0%. So you have basically been achieving nothings with your investment strategy.
- Even worse, that 3% rate of inflation has been the unit of measure for normal living expenses, but the rate of inflation on houses has been running roughly twice that, which is also true for cars and other investment-grade assets. So you're actually going backwards.
So what is the minimum annual rate of return you need to actually make money with your investments? I would say it's around 20%. And here's why:
- After taxes, a 20% rate of return yields around 13%.
- Assuming 3% core inflation, the after-inflation rate of return is around 10%.
- At a 10% rate of return, your invested capital doubles roughly every 7 years.
So to compare the difference in a 5% CD and a 20% alternative investment, let's look at what happens to $100,000 in invested principal over a 15 year horizon:
- With the 5% CD, that $100,000 has grown in 15 years to $100,000 in purchasing power. No growth at all.
- With the 20% alternative investment, that $100,000 has grown to $400,000 in purchasing power.
This concept is not revolutionary. Warren Buffet's average rate of return is 19.8%, which is what propelled him to one of the richest people in U.S. history.
But if 20% is the magic number to actually create significant wealth, the bigger question is how to attain that level of return. Here are some initial assumptions:
- You cannot hit 20% with any form of traditional CD, T-Bill or Bond. You are lucky to hit 25% of that goal. So you can cross that off the list entirely.
- You cannot hit that with the U.S. stock market, which has a lifetime average of around 10%. And that's not even a fair assessment, as it's all about your timing. The stock market had two periods (1960s to 1980s and 2000s to 2010s) in which the stock market posted a 0% rate of return. Given that stocks are currently priced higher than at any time in U.S. history – including the period before the 1929 "Great Depression" – there is little hope of even hitting 10% until the market corrects and then rebalances.
So traditional investments (anything offered by any consumer investment house like Charles Schwab) are hopeless in the quest for 20% return levels. So that leaves basically two options:
- You can quit your day job, risk everything, buy or start a business like a Subway sandwich shop, and pray it works out. But the odds are that you are more likely to lose money than make any. And, when it fails, you've lost your day job income, too.
- You can keep your day job and simply invest in commercial real estate with a 3-point spread between the interest rate on your loan and the cap rate of the deal. This is the only safe and scientific approach, and the one favored by most successful investors.
Why does a 3-point spread between the interest rate and the cap rate work? It's just math:
- Most commercial real estate is structured at a 70% to 80% loan-to-value rate, which means that you are using leverage. And, like a lever, this allows you to lift higher yields than you can in the absence of debt.
- The cap rate is the net income from a real estate deal divided by the purchase price. It basically reflects what you paying for each dollar of income. A 10% cap rate equates to paying $10 for $1 of annual income.
- When you have a 3-point spread between the cap rate and interest rate, here's an example of how it works:
- Assume that you buy a property at a 10% cap rate which has a $100,000 annual net income, and you pay $1 million for it.
- Assume you finance this purchase with a $800,000 loan at 7% interest, with a corresponding $200,000 down payment.
- The interest on the loan is $800,000 x 7% = $56,000.
- Subtract $56,000 from your original net income of $100,000 and you have a surplus of $44,000 per year.
- A $44,000 return on your $200,000 down payment equates to a 22% per year rate of return.
So if commercial real estate is the only safe method to hitting a 20% cash-on-cash rate of return, the only remaining issue is what sector of commercial real estate can offer a 3-point spread between the interest rate and the cap rate. And that's an easy question to answer:
- You cannot hit a 3-point spread in any form of real estate other than housing. Everyone knows that office, retail, lodging and self-storage are shot due to bad performance on rents and occupancy. Office vacancy in Chicago, for example, currently stands at 27%. The only sector of real estate that has strong, consistent demand is housing.
- In the housing sector, there is weakness in apartments due to massive overbuilding since Covid, which has resulted in lower occupancy and rents. And, at an average rent of $2,000 per month, has very little room to grow rents in the future.
- The sweet spot in commercial real estate today is simply one asset class: affordable housing. And the leader in that segment is the lowly mobile home park.
In summary, mobile home parks are your best shot at hitting a 20% rate of return. Here's why:
- The demand for affordable housing in the U.S. is huge and growing.
- There are roughly 44,000 mobile home parks in the U.S. and they come in all sizes and geographies to meet most any investor's needs.
- You can buy mobile home parks with cap rates above interest rate levels.
- There is plentiful, attractive financing available for mobile home parks including seller carry, bank financing, CMBS "conduit" debt and Fannie Mae/Freddie Mac. Note that Fannie Mae/Freddie Mac is only available to housing sectors and represents roughly 50% of all mobile home park lending today.
- You can grow the net income of mobile home parks over time in several ways including 1) increasing lot rent 2) increasing occupancy and 3) streamlining costs.
- In this manner, mobile home parks are your best shot at hitting 20%.
But there's one other item worthy of discussion, and it's the one advantage that mobile home parks have over all other forms of commercial real estate: "supply vs. demand". You have not been able to build a new mobile home park in the U.S. in any meaningful way since the 1970s. That's when virtually every city and town in America banned mobile home park zoning as they thought it attracted less desirable residents and was too big a drag on city services. When this occurred it created the barrier to entry that keeps the "supply vs. demand" ratio always favorable for mobile home park owners – what Warren Buffett calls the "moat".