Decision: The Doctor's Bill I Left My Wallet In San Francisco?

Johanna’s Take:

I’ll Keep My Heart in San Francisco.

San Francisco is a beautiful and romantic city, but it comes at a price.

According to USA Today, it is the 3rd-most expensive city in the US, costing 24.7% more than the national average.

But that doesn’t matter to our intrepid couple, both physicians, earning almost $1M per year.

Rather, the discussion is whether to keep house #1 as a $2.8M rental when they sink $4.5M into house #2.

We’ll call this couple the Real Estate Moguls, or Dr. and Dr. REM.

Side note:

After receiving this email and responding back to confirm the expected date of publication, I learned that the REMs are CPA clients, both physicians.

They understand I will be brutally honest – and expect me to.

They also explained that they would liquidate the brokerage account for the additional liquidity needed to put $3M down on the house.

Finally, they expect expenses to increase after the house purchase – more below.

The positives:

· High income

· College is covered

· Low debt

· Not retiring until age 61

· Doing a great job on building wealth

The negatives:

· Living in a HCOL area and potential lifestyle creep

· High amount of net worth tied up in illiquid, concentrated assets (real estate)

Assumptions (I use conservative estimates wherever there is an uncertainty.)

· 6% average long-term returns on savings (Assuming no emotional mistakes in upcoming bear markets and corrections)

o By my calculations, you will have between $10M and $11M at retirement

o I did not include the 529s in your net worth calculation

· Average inflation

· You both retire in 20 yrs

· No more children

· $250k saved will cover your outlay for college

· You have plenty of appropriate life and LTDI in place.

· No divorce

· You invest in an appropriately-diversified portfolio and do not make any behavioral mistakes

· No future significant financial assistance for other family members

· Reasonably good health

So, the real question is bifurcated:

Can they afford one expensive HCOL house, and can they afford two expensive HCOL houses.

First, let’s address savings and how I calculated what they should have at retirement.

A 25% savings rate on $900k is $225k invested per year.

But a $1.5M mortgage at 4.2% over 30 years costs ~$13k/mo including insurance and property taxes, or $156k/yr.

Estimating that they are paying about half of this in mortgage payments already, I’ve reduced their savings rate to 16.5% for the remainder of their careers to increase their budgeted expenditures by $78k/yr.

This lowers projected savings at retirement to just over $11M – still plenty to retire on.

What about the downpayment?

I have a serious concern.

They are planning to use their brokerage account, valued at $1.2M, to make up the rest of the $3M downpayment.

Let’s go through the drill:

· Investments are, by definition, long term. Otherwise, one is speculating, not investing.

· The “short term” is any period under 5 years.

· If the account will be used in 1 – 2 years, it needs to be liquidated immediately.

· If the REMs are willing to forego buying the house or will simply take out a larger loan if the market happens to be in a slump when they find their dream home, it may be fine to leave the brokerage account invested.

But I must emphasize that I would never recommend that a planning client leave $$ invested with the specific intent to liquidate for a short-term goal.

· The above also does not consider any tax impact for liquidation. However, they potentially have a $200k overlap that may be available for taxes ($2.8M – $800k – $1.2M = $200k).

· Should the REMs go ahead and liquidate, they should purchase high-quality corporate bonds timed to mature at the date of purchase.

· If they take out a larger loan, their living expenses will be impacted.

Of course, this will be temporary until they are able to get out of the market.

· I adjusted the portfolio accordingly to remove the $1.2M brokerage account from the long-term portfolio results.

What about keeping the first house as a rental?

Another concern.

Clients ask this question frequently, to which I respond with a question, “If you did not own this house, given your specific goals and resources, would you:

1) Decide to be a single-family property landlord?

If the answer is “yes”, then

2) Decide to purchase this property out of all of the other properties on the market?”

If the answer to one or both questions is “no”, then it is irrational to keep the home because, by your actions, you are answering “yes” to both questions.

I also would not be comfortable with the REMs having so much of their net worth concentrated in 2 illiquid expensive homes both in the same city of the US.

Finally, I’m definitely not in favor of paying taxes on an extra $500k of long term capital gains unnecessarily.

How much more would the house have to appreciate to overcome that?

More than I’m willing to bet on.

By the way, to save you 60 seconds of Googling, a 4.2% mortgage on $3.5M for 30 years is > $21k/mo. including tax and insurance.

They would pay $2,661,616.39 in interest alone over the life of the mortgage.

If that doesn’t turn your stomach, you might want to spend more time on XRAYVSN, White Coat Investor, and a few other physician finance sites because you’re definitely not gonna be a Physician On FIRE.

Basically, if the REMs think they want to become landlords to anybody/anything other than to a business they own, I recommend they start with something far less expensive to see if this is really one of their life goals or if they have better things to do with their time and money!

Xrayvsn’s Take:

Location, location, location.

That’s pretty much the mantra of real estate.

Of course such desirable locations come at a premium and San Francisco is certainly no exception.

Sam, from Financial Samurai, raised eyebrows in the past when he said to be middle class you need at least a household income of $300k when living in coastal areas like San Francisco.

Although this dual physician household pulls in significantly more than that, they counterbalance this with the desire to purchase a $4.5M home.

The $2.6M of calculated interest that this mortgage would demand over its life also puts a pretty significant hurdle to achieving high net worth.

With $175k in liquid savings, they have a 7 month buffer in their emergency fund which is a positive.

Although this is not set in stone, there are various rules of thumb on how much mortgage you can afford that exist (White Coat Investor has recommended 2.5-3x your gross salary).

[It is interesting that the only lender of the bunch gave the highest range which might be telling of where their interest lies.]

With a 900k household income this would make the top recommended price range for a house at $2.7M.

Not looking good for the two home scenario.

I am 100% on board with Johanna’s assessment of too much concentrated real estate risk with 2 assets that would account for the majority of your net worth in the same city.

Adding the two mortgages together would constitute a considerable percentage of your take home pay and could place you in a precarious financial situation.

Granted rental income could offset some of the extra expense but rent is never a given.

Also renters never care for the property the same way you would and thus there will be inopportune times when a big maintenance expense could crop its head up.

With the sale of the current home and using the proceeds to increase the downpayment, the numbers become far more favorable.

Care, however, must be made to not go overboard or you will truly become house poor.

The major saving grace is the anticipated 20 more years of continued medical practice.

There are caveats to this as well:

You may grow dissatisfied with medicine and now feel trapped having to work longer just to service the debt (of course you can always downsize at that point and reduce this potential trap).

Assumption that current salary will be maintained during this timeframe.

Speaking from firsthand knowledge of medical reimbursement cuts in my specialty of radiology, I can tell you that the impact is not insignificant and my take home pay has taken a major hit over the years.

If this was my financial situation I would sell the current home and use the proceeds to reduce the mortgage obligation on the desired, more expensive, home.

The Decision:

Johanna: One house thumbs up, two houses, thumbs down

Xrayvsn: Definite thumbs down for keeping two San Francisco homes. Thumbs up on upgrading to more expensive home.