The Smart Take:
One of the beginning steps in every retirement plan is to value your assets and project their values into the future. Valuing assets like stocks and bonds is easy (though making accurate projections becomes more difficult.) Complexity increases even more when you consider illiquid assets like real estate and business ventures.
Hear Kevin discuss how to model illiquid assets in your retirement plan. Learn why focusing on rental income is shortsighted and how scenario analysis with low to high values can be helpful for business owners.
If you ever plan to sell real estate, this episode will be helpful. And the more of your net worth is in illiquid assets, the more you need to understand these key concepts to have a well-constructed retirement plan.
Need help making sure your investments and retirement plan are on track? Click to schedule a free 15-minute call with one of True Wealth’s CFP® Professionals.
Click the below links to subscribe to the podcast with your favorite service. If you don’t see your podcast listed with your favorite service then let us know and we’ll add it!
Intro: Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions and get educated about the financial world. It’s time to retire smarter.
Walter Storholt: Well, hey, there. Welcome back to another edition of Retire Smarter. Walter Storholt here alongside Kevin Kroskey, president and wealth advisor at True Wealth Design, serving you throughout northeast Ohio, and Southwest Florida, and the greater Pittsburgh area. You can find us online at truewealthdesign.com.
We’ve got a great show on the way for you today. We’re going to talk a little bit about real estate and assets and business values and wrapping them into your retirement plan. We’ll get to all those details in a few moments. But Kevin, great to be back with you. How are you, sir?
Kevin Kroskey: Walter, it’s my pleasure. We’re coming here pretty close to Father’s Day. And my two-and-a-half-year-old, soon to be three-year-old, is in a little sort of preschool. And I have something in front of me I thought I’d share. It says, “My Daddy,” by my two-and-a-half-year-old. So it’s like a fill-in-the-blank sort of thing.
But it says, “My dad’s name is Daddy,” very pragmatic. “He is three years old.” My daughter’s going to be three, so you’ll see a theme here. I think she just blurted out things as she was being asked, so I’m definitely a little bit older than three. “He is as big as me. He has no hair and brown eyes.” My eyes are blue, by the way. “His favorite food is lettuce.”
Walter Storholt: Oh, wait, what?
Kevin Kroskey: “His favorite color is red,” blue. He likes to go to the store to get food and pizza.” Okay. Ding, ding.
Walter Storholt: Okay, got one.
Kevin Kroskey: “For fun, he likes to lay down and sleep,” double ding, ding. “And my favorite thing to do with my dad is play Play-Doh.”
Walter Storholt: Nice.
Kevin Kroskey: Yeah. It’s this little laminated thing. We got a good laugh out of it. It was really cute.
Walter Storholt: Well, she got a few right there, it sounds like, so that’s good.
Kevin Kroskey: Yeah, she knows her birthday, and she already thinks she’s three. So it’s cute.
Walter Storholt: I like that. She’s not messing around with the two-and-a-half or two-and-and-three quarters or two and X amount of months. She’s just like, “No, I’ll just stick with the round numbers and round up to three.” That’s the math influence that you’ve probably had on her already.
Kevin Kroskey: Yes. And my seven-year-old isn’t doing the halves either. I remember doing that a lot. I’m six-and-a-half. I’m seven-and-a-half. You’re always rounding up sort of thing, and neither one of them are doing it.
Walter Storholt: See, until you get to 10, then it stops. The half years don’t matter anymore. But anyway.
Kevin Kroskey: And then as you maybe get further up, it’s just decades, you just-
Walter Storholt: Well, that’s true. “I’m in my early 20s,” or late 20s or early 30s. And then, eventually, you’re just, “I’m in my 40s.” It just gets broader and broader. “I’m of retirement age,” eventually when you get to that point. No need to drill in any further than that.
Kevin Kroskey: Or you just give a stern look back like, “Don’t ask me that question.”
Walter Storholt: That’s right. That’s right. Exactly. Well, as I mentioned, we’ve got a great show on the way today. And yeah, Happy Father’s Day this month to all those who are listening to this show after its release and or near its release. And hope everybody has a good month and a good weekend when that rolls around.
Let’s dive into the topic today, Kevin. I’m actually excited about it because I like talking about real estate. I host a couple of real estate podcasts, and radio shows more about just buying and selling real estate, talking to different real estate agents across the country, and things like that, less from an investing standpoint.
So I’m excited to get a little bit of exposure to your point-of-view, your opinion of where you see real estate involved in people’s lives, especially when it comes to retirement and planning.
I know you also want to talk a little bit about business values and wrapping all of these things into the conversation of retirement and planning. So I’m looking forward to where you take today’s episode.
Kevin Kroskey: Yeah, me too. I’ve had a few meetings recently with clients that were business owners. Some had a lot of real estate, some had what I would call like an operating business, something that they work in day in and day out sort of thing, and not necessarily as passive as real estate.
But we were working on some planning for them, and it’s just a different level of complexity. And the assumptions that you make in any retirement plan matter a great deal. They’re definitely more difficult to make with some of these what I would call illiquid assets.
So if we just back up and not necessarily just focus on real estate or businesses, but any of the stocks or bonds, cash that you have, very easy to value, maybe a little bit more difficult to think about how those values may change in the future. You have to think about some sort of return expectations, which we’re actually going to talk about in our next episode, what can we expect from stocks and bonds and real estate.
But when you cross over from the liquid to the non-liquid, even valuing the asset becomes more difficult. What is my business worth? Well, it’s worth what somebody is willing to pay for it.
Real estate may be a little bit easier, at least for say, single-family homes. Everybody’s probably poking around on Zillow or Realtor.com these days. It seems to be almost a daily hobby for many people, particularly with the hot real estate market that we’re in.
Walter Storholt: We just moved a little over two years ago, and I’ve been blown away by some of the different open door offer valuations and different things that people are saying, “Oh, your home’s worth this now.” I’m like, “Are you kidding me?”
Kevin Kroskey: Right. Yeah. It’s been a good time for asset price inflation all around, real estate included. If you have equity in the home, it’s not like an ATM machine. You just can’t punch through the wall and reach in and pull out money from between the walls. You have an equity value that’s in there, whatever the market value of the property is minus any debt that you have on the property, and that’s your net equity, but it’s certainly not liquid.
It’s probably a little bit more liquid than a business, even though you do have pretty high transaction costs. Let me define that briefly. Liquidity is basically how easily an asset is converted into cash. So obviously, if it’s in cash, boom, very easy.
If you have a stock or a mutual fund, you can sell it any day that the market is open and have cash in your account within maybe a day or a few days at most, the same thing with bonds. So you can get a little bit more complicated than that, but nonetheless, it’s a good proxy for liquidity.
You go into real estate, in this market, maybe you can sell your house in a week or so, close in a couple of weeks, but maybe traditionally it takes a little bit longer, maybe a couple of months depending where you’re at, and maybe a business could candidly take a couple of years, commercial property, a little bit longer.
So everybody has real estate, anybody that’s going to sell real estate, you need to make some assumptions in your financial plan about it, what kind of value are you going to get for it? Ultimately, what are you going to buy next? Those sorts of things.
So this really applies to everybody, but the more these nonfinancial assets that you have, if you are a business owner, if you do have investment real estate, the more it matters to go ahead and model these appropriately within your plan, and the more you’re probably going to get out of our conversation today.
Walter Storholt: It’s interesting that you hear more and more about this from people in your meetings and your conversations with them. Is that specifically because we’ve seen such a high increase in the home values, and people are just now more and more curious about, hey, should we go ahead and try and lock in some of these gains and sell our home and change our living situation and that sort of thing?
Kevin Kroskey: I would say a couple of things. I mean, we have had several clients buy second homes recently, so we had to model that within their financial plan. They had some money going out today, but they’re probably not going to hold on to two homes forever, so one of the homes is going to be sold or downsized at some point. So you need to project those values forward, and then the money is going to come back into your retirement plan and available for spending. So that’s a common one. Or even if somebody is just downsizing, that could be one.
But we’ve also just had, just over the last couple of weeks, I had several meetings with business owner clients or clients that maybe weren’t business owners, but they had some investment real estate as a passive income sort of thing that they’ve done over the years. So that’s really where it’s coming from. But again, it applies to anybody with real estate to a certain degree. But the more you have of these illiquid assets, the more it’s going to apply for you.
So we’ll start with real estate, and then we’ll go into businesses. I think real estate may be a little bit more intuitive, a little simpler. But we have a lot of clients that own property, rental property or two or three, maybe they got into it when they were younger or back in the 2000s, everybody was going to become a real estate tycoon before the bubble burst in 2007.
So we still have, I see a lot of clients that have properties like this, but when you think about it, if you own a property or two, it’s not the same thing as owning a real estate mutual fund that’s highly diversified through geographies, through asset types, whether it’s multifamily, whether it’s office, retail, industrial, so it’s very, very different. So any time that you’re modeling things in the financial plan, you just really need to think about the risk and, again, kind of how you’re modeling it overall.
But when you think of real estate, I’d say the common mistake that people often make is they look at some gross rents that they have. Maybe they think about some expenses that they typically have. And then they say, “Okay, here’s my net cash flow. That’s what I have. I can bank on that. I’ll just put that in my financial plan.”
Well, that doesn’t work so well. For one, when you think about any financial plan that anyone’s constructing for you, whether it’s through software or through using Excel or something like that if you’re putting an income stream within the financial plan, basically, you’re putting it in, and it’s considering it as just like it’s a pension that’s not going to vary per month or even like a Social Security payment that is going to continue for your lifetime.
Real estate is not that certain. Your income from the real estate is certainly not that certain, particularly if it is just a property or two or three or four, rather than hundreds of properties or something like that. So you got to think through your income. Everybody’s going to have some repairs that they’re going to have to do over the years, have some unforeseen things. I call it the joy of homeownership. You’re always dealing with something. Some years may be good. Other years, maybe not so good.
So if you’re just going to look at your income, you’re probably going to be overstating your confidence to quite a high degree when you’re actually going through your financial plan and stress testing it. So that’s really, really important to remember.
What I would say, some other issues, actually, that I see all the time is maybe bookkeeping or the tax records aren’t all that great. A lot of times you see people, maybe their records, well, I mean, we do the tax returns, so a lot of times we get information on the rental properties, and we have a lot more questions, “What about this? What about that?” Like, “Oh, yeah, I’m sorry. I forgot to put in my real estate taxes,” or my insurance or whatever it may be.
So a lot of times, if you have bad data coming in, you’re going to have bad outcomes. A lot of times, with the real estate we find, we just don’t have a lot of good data. And people are taking care of these properties a lot of times on the side. It’s not like their primary business. They’re not an expert in it, that sort of thing. So having good information.
Walter Storholt: Or a lot of people don’t treat it like a business when really, that’s what it is.
Kevin Kroskey: Oh, yeah, for sure, for sure. I could really go on and on about this real estate. And for most people, it hasn’t turned out. If you’re just buying like a single-family rental, in my experience, it hasn’t turned out to be that good of an investment for most people when you look at it versus other investment alternatives that they could have done. I like real estate, but I’m just talking about like simple, single-family, try to do it on the side sort of thing.
Again, we do the tax returns. I’ve seen this and looked at the cash flows and modeled this in many, many financial plans. For most people, it just hasn’t maybe met their expectations. Or if they do, maybe it hasn’t done as good as what they really have thought that it’s done as well. That’s often the case. People are putting more money and more time into it than they foresaw going into it, and it’s just been underperforming compared to some other alternatives that they could have done.
But the point being, the income, if you’re just taking your income and put it into some spreadsheet, financial plan, you’re treating it like a pension, you’re treating it like Social Security, it definitely is not that. So it’s really overstating the confidence that you have in that income stream.
What I would suggest is often a better way to go ahead and handle this is just to look at the equity value of the property. If you have a $100,000 property that’s paid for, just put $100,000, treat it like a regular asset that you would have, like an investment account. And then, we could just treat it like, “Hey… ” Let’s just say, yeah, it’s only one property. It’s not diversified, but let’s treat it like a real estate fund at least, and we’ll project it forward at a more reasonable sort of rate of return and not just in income.
And then, we can also stress test it that way. So, where the income is really not subject to most stress tests and financial plans or in just a linear projection in an Excel sheet if you do put in an asset value, there are different ways that you can go ahead and more accurately stress test that. Monte Carlo simulation is a fancy mathematical term for one of those ways that you could do it.
But that’s really one of the keys that’s there, just looking at the equity value in the home and then projecting for like an asset and subject to stress tests that you would do for other liquid assets within your financial plan.
It can get a lot more complicated than this. Are you going to hold this property for your lifetime? Are you going to sell it? What the tax implications are upon sale. Those are all things that need to be worked through, but we won’t get into that today. But the key thing about investment real estate is, for most people, you’re not very well diversified. You own a property or two or three or four, particularly if it’s single-family, I mean, you only have a couple of doors there versus a big multifamily apartment that maybe has 100 doors.
But if you go out and you buy a real estate mutual fund or something like that, you may have thousands of doors and property types and geographies that you’re diversifying against. So that’s one.
And then, two is you can’t use the income for projection purposes. It greatly overstates the confidence within your financial plan, particularly if those holdings are pretty sizeable relative to your total wealth. So a better way to do it is just think it through and look at the net equity, maybe even net equity after taxes if you’re going to sell it, and then project it forward like an asset subject to the other stress tests that you would do for the other liquid investments that you would have.
Let me pause for a moment. Walter, are you with me? Did I lose you here, buddy?
Walter Storholt: I’m with you. I mean, I’m picking up the idea that you need to run real estate like it’s a business entity as part of your financial plan. And that’s probably why you’ve also looped in the business values into this same conversation if we’re going to view those through a similar lens as one another.
Kevin Kroskey: Yeah. And again, it’s really anything that’s illiquid, illiquid being that it’s how easy can you convert it to cash? The more illiquid something is, you may not know what the price of it is. It’s going to have transaction costs like just when you sell real estate. You’re going to have title costs. You’re probably going to have some brokerage fees, things like that. You may have some negotiation where, hey, you’re asking 100,000, but your best offer is maybe 95, so there’s a 5% spread there.
So anything that’s illiquid, typically there’s a bigger spread between the ask price and then the buy price. That’s another way to think about it. And the same is true, and even more so for businesses. So when you think of like a single-family home, there’s a lot of people that may be interested in buying a home in your community. There’s a lot of different sales.
But if you have a business, well, depending on the type of business, maybe there’s more of a market for it. If you have a McDonald’s franchise or something like that, franchises are maybe a little bit more sellable, particularly if they’re well-known. If you have some sort of unique skill, what kind of business value is there? Maybe there are many fewer buyers; maybe there are fewer people that would really want to give you what you feel is market value for that.
So, I mean, you can get into other things too. I mean, you could get into art or collectibles. I mean, all of those are other examples of illiquid assets. But I’d say real estate and businesses are the ones that we most commonly see in our practice.
So for business owners, one of the things I would say is you really need to just look at a base case, how well is your retirement plan funded without relying on the sale of your business? So have you built up assets in your 401k, maybe in a joint or trust account? Any Roth IRAs, things like that? Have you paid off your house? Did you eliminate the mortgage?
So if you get zero from the sale of your business, how well does your retirement plan look like? That’s often a really good base case to start with before you start looking at any sort of scenario analysis for the business. And what I mean from the scenario analysis is maybe just looking at a few different low, mid, high values for the business being sold at some point in the future. So that’s also helpful.
So for many clients, we may have a base case and an alternate scenario for the financial plan. When you get into business owners like this, you may have multiple scenarios. But if you have that base case where there are core needs for retirement or well-funded without reliance upon the business, well, that’s a good starting point. That, to me as an advisor, brings a lot of confidence that, hey, they’re going to be okay. It’s just more of a question of how okay are they going to be? And then you can get into the scenario analysis and maybe start looking at some low, mid, high values.
Pragmatically, one of the things that I’ve found over the years is when you’re working with the business owner, walking them through that, and then maybe giving them a number that they do need, if they do need some money from the business, we’ll help them go through the sale process. It’s a very complicated, stressful thing to do, sell your baby, your life’s work, so to say.
And if you at least know that you’re going to be okay on the other side to a high degree of confidence for your own personal retirement plan, and you know the number that you maybe need to net out from the business, just lay out the options that you have to go ahead and sell the business, whether you’re going to sell it internally to somebody, maybe a group of key employees or something, or you need to seek some outside sale or something like that,
Walter Storholt: Just lots of moving pieces, it sounds like, to evaluating any of these decisions, and you got to make sure you’re making it in context with your entire retirement plan. You can’t make any of these choices in a vacuum.
Kevin Kroskey: If you think about the retirement planning process overall, it’s something that at True Wealth we call our Retire Smarter Solution. But step one in our six-step process is what we call the Retirement Visualizer. It’s really aggregating your financial assets. It’s looking at those assets that are liquid. Those are pretty easy to look at.
Again, you have to project some values forward. What rate are they going to grow at over time? And we’ll actually talk a little bit more about that in the next episode. But you’re going to then also have to look at these nonfinancial assets. I mean, we have some clients where maybe they have a million dollars in liquid assets, but maybe they have 3 or 4 million dollars in non-liquid assets. That’s a really different retirement plan to work with compared to somebody that maybe has all their assets in the liquid bucket, except for a primary residence that they have.
So that first step when you’re aggregating everything together and projecting it forward is important. But the more complex, the more illiquid the asset, the more difficult it is to think through and model it. And, again, everybody has some real estate, so this is impactful for everybody to some degree. But the more that you have in that non-liquid bucket, the more important this is.
And business owners are often some of the most complex clients that we have to work with, that we have the pleasure of working with, but you really have to think through some of the risks and cash flows, as well as some of the modeling that you do to make sure that you’re thinking through everything well and getting a future projection that is reasonable.
If you can just put something in, and, “Hey, I got this rental property, and I have this great income last year. I’m just going to project that forward forever,” well, you’re going to be disappointed. I can’t tell you what year you’re going to be disappointed, but at some point, it’s going to happen.
Walter Storholt: Do you find it easier or more difficult to model or predict where these illiquid assets are going to end up and play into the plan versus some of the more traditional stocks, bonds, and savings, and those kinds of things that you’re working with on a daily basis with many clients? What do you find more difficult to wrap into the plan?
Kevin Kroskey: It’s a good question. I mean, it’s definitely more complex to model these illiquid assets, as I mentioned. But if you were at least before maybe a year ago, before this whole real estate boom and COVID, real estate was pretty easy to model. I mean, particularly if you’re in a place like Ohio. You didn’t have much growth. As long as the home was in, had some comparables in the neighborhood, I mean, it was fairly easy to take a guesstimate what they’re going to get out of it, subtract out some costs that you have, and there you go.
You get in the businesses, more difficult. You get into investment real estate, maybe a little bit more difficult. Again, it applies to everybody. We all make assumptions in our financial plan. We’ll talk about some of the, not so much the methodologies; we’ll talk a little bit about the methodologies for thinking about forecasting stock and bond returns and real estate returns in the next episode.
But when it comes to a business, I mean, if I just think of my business specifically. There’s a lot of other financial advisors that are out there. A lot of financial advisors sell their business every year. So there are some comparables. There’s a market for it to a certain degree. The business is largely dependent upon myself. And so, it’s a little bit more concentrated compared to something that is like investment real estate or something like that. So everything’s different. You do have to think it through.
I was talking with a business owner who has an insurance company recently, a really smart guy really successful. He made the comment that’s true for most business owners, but I took issue with what he said. And he said, “I take the most risk in my business.” And I said, “Well, Steve, let’s think about that for a minute.” I mean, Steve’s in the insurance business. Everybody, a lot of property and casualty insurance for your house and your cars. Been around a long time, hundreds, maybe thousands of years to a certain degree. Everybody needs it to a certain degree.
His revenues, I’m like, “Do your revenues change that much?” And, “No, last year we were flat even with COVID, and we were okay.” And I said, “Well, how long has the business been around?” And in his case, the business has actually been around for almost 100 years. So I’m like, “Steve, I get it, but I think you’re fine, buddy.” I would take issue.
Now, if you’re starting a technology company from scratch and have no revenue, different ball game there, so it’s that unique snowflake that we all are as individuals. Every business is different. Every property is different. But you definitely get more disparity when you get into business assets, for sure.
Walter Storholt: And as Kevin mentioned, we’re going to continue this conversation, but switch gears a little bit to talk about those 10-year return expectations in some of the more traditional investments that we’ve talked about here on Retire Smarter in the past. So make sure you come back for that next episode. Number 75, a little bit of a milestone episode for you there, Kevin. You’re getting closer and closer to 100. So episode 75, we’ll dive in a little bit more into that conversation.
But in the meantime, if you have any questions about illiquid assets, how those get involved into your retirement plan and financial plan, and where those fit in, and you want to walk through some of the things, but in more specifics with Kevin and the team at True Wealth Design, there’s a couple of ways you can get in touch.
One, you can set up a time to meet with a qualified, certified financial planner by calling (855) TWD-PLAN. That’s (855) TWD-PLAN. Or go to truewealthdesign.com and click on the “Are We Right for You” button to schedule a 15-minute call with an experienced advisor on the team. Again, that’s truewealthdesign.com, and we’ll put the contact info in the description or the show notes section of today’s show.
Kevin, thanks for covering this for us today, talking about some of these illiquid assets. Work on your growth a little bit. That three feet tall, you got to work on that a little bit as your daughter thinks you’re kind of short there, it sounds like.
Kevin Kroskey: Three years old. Three years old.
Walter Storholt: Three years old. Well, no, but she’s probably like what? Three feet tall, right?
Kevin Kroskey: She is. A little bit more than that.
Walter Storholt: She did say you were as tall as she was.
Kevin Kroskey: That’s true.
Walter Storholt: Everything is just three. That’s what it all circled back to.
Kevin Kroskey: That’s right, yeah.
Walter Storholt: That’s fantastic. Well, enjoy the time. And we’ll talk to you a little bit later this month. And thanks to everybody for joining us here on Retire Smarter. Talk with you soon.
Kevin Kroskey: Thank you, Walter.
Disclaimer: Information provided is for informational purposes only and does not constitute investment, tax, or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.