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No. of Recommendations: 63
This post is a discussion between REITnut (aka Ralph Block) and Yodaorange.

Y: REITnut, once again it is time for us to settle up with Uncle Sam. For some reason he insists that we dot every “I” and cross every “T” and send him a ream of paper every year.

R: Yoda, I do my fair share also. I am trying to get by on half a ream of paper this year.

Y: This year had a pleasant surprise. I was working on the tax return for a young fellow that just started his career. Since this is his first job, he is on the lower end of the salary spectrum. In working on his return, I discovered a program that Uncle has to help fund retirement programs for the low income segment. The program called Retirement Savings Contribution Credit originated in 2002 and was made permanent in 2006. You use IRS Form 8880 to calculate the credit. There are several conditions that apply but the most significant are:

a) Maximum income= $57,500 for married filing jointly, $28,750 for filing single
b) Must owe some amount of income tax.

Uncle will give you a tax credit up to $1,000 or the amount of taxes owed, whichever is lower. For the case I worked on, Uncle was willing to give a TAX CREDIT of $1,000 to this man if he contributed $2,000 to a ROTH IRA. The taxpayer’s choices were to pay $1,000 to Uncle or use the same $1,000 to fund an IRA/ROTH/401k/etc. The percentage of credit Uncle will give you decreases as your income rises, with 50% being the maximum. You can see full details of the program at: [1]

Getting an immediate 100% return on a $1,000 investment seemed like a good idea to me.

R: One should never turn down a free lunch; they are extraordinarily rare, especially these days!

Y: This young man’s father volunteered to put in $1,000 to match the $1,000 that Uncle was putting in. This makes a nice $2,000 start to a ROTH IRA account for a ~ 20 year old. Since it is a ROTH IRA, the proceeds will NOT be taxed when the money is withdrawn in retirement. At least that is how the tax law is currently. So the money grows tax free and will be withdrawn tax free.

R: Tough to beat that!

Y: The plan will be to add additional money to the ROTH account each year if it is tax efficient. If the young man gets a high paying job, he might not qualify for additional ROTH contributions. He also would NOT qualify for Uncle’s tax credit. Of course if he makes that much money, we would classify that as a “good thing.” In that worst case situation, this might be the only year that the ROTH is funded. So you would have a onetime $2,000 contribution. Subsequent retirement funds might be 401K’s/403B’s/Regular IRA’s that are tax deferred.

R: We certainly hope the young man lands a high salaried job, but those are not exactly plentiful these days. If he continues in lower paying jobs, he will be able to add additional funds to the ROTH every year. Since the account is tax free forever (assuming Congress doesn’t rescind this retroactively as sometimes happens in Latin America), it opens up a lot of possibilities for investing. I think we can safely assume the US retirement age will increase, say to age 70, by the time this young man retires. That gives us a 50 year investment horizon.

Y: 50 years is a long time. You would expect many growth spurts and recessions over that period. Lord knows what inflation will be over that period. My crystal ball only guarantees to accurately forecast for the next 5 minutes, so it is not much help for 50 years. Not knowing what inflation will be, one major goal would be to pick out investments that are likely to beat inflation, hopefully by several percent per year, rather than being victimized by it

R: I think I know a sector that has a good chance of at least matching inflation and, with some good management, providing a positive return above inflation. That sector is real estate.

Y: That is a great idea! Yoda has always been partial to the single family cave sector. Generations of the Yoda family have lived in caves and they seem to hold their value well. Do you know of any publicly traded companies that own properties in the cave sector?

R: I have been doing this for a few years and I don’t recall ever seeing a company that specializes in single family caves. There are a few other areas of real estate that might work though

Y: I’m all ears!

R: You sure are! Real Estate Investment Trusts aka REITs own physical buildings that are leased out to tenants. Tenant incomes tend to rise with inflation, and they can afford to pay higher rents over time. Also, inflation makes new competing property development (and land) more expensive, thus increasing replacement costs. It does not happen instantly or smoothly (much depends upon at least some growth in the US economy), but over time, rents will roughly track inflation plus a bit more. If the high inflation pundits prove correct, REIT revenues will be able to keep up. REITs must pay out 90% of their earnings each year in the form of dividends, so investors will be direct beneficiaries of the increased rents.

Y: It is sounding pretty good so far. Since there are NO income taxes owed on the dividends received in a Roth, the value can better build up over time. Also, most brokerages will reinvest the dividends into additional shares for free. They do this even with companies that do NOT have “Drip” programs. Since you have dashed hopes for cave companies, do you have any REITs in mind that you think will do well for say 10 or 20 or 50 years? I would like to put these Roth investments on autopilot, and I guess the Blue Chip REITs would meet this criteria?

R: Yes, there are a few dominant REITs that I think have a durable brand, excellent management and good and stable prospects for at least the next 10 or even 25 years. We might want to re-examine them at the 25 year mark, but they should be good for quite some time. I would split the $2,000 into four investments of $500 each. Here are the four REITs I would buy:

1) Simon Property (SPG) - leading owner of major shopping malls in the US. Very strong management team, excellent property portfolio and conservative balance sheet (very low cost of capital makes them very competitive).

2) Ventas (VTR) is the leading owner of seniors communities, medical office buildings and other healthcare properties. Also, strong balance sheet, proven management, reasonably recession-resistant.

3) Avalon Bay (AVB) is a leading owner of upscale apartment communities in the US. It focuses on supply-constrained markets, is one of the few great apartment developers, and has an extremely strong balance sheet.

4) Extra Space Storage (EXR) is the second leading owner of self storage centers in the US. It’s not as large as Public Storage, but is equally as well-run, and being smaller enables attractive acquisitions to “move the needle” of value creation.

You never know for sure, but I am betting that these four REITs will perform well over a wide range of economic outcomes for the foreseeable future. Even if Armageddon shows up and hyperinflation sets in, these companies are likely to survive. People forget that common stocks performed pretty well in the Weimar hyperinflation. Short of Armageddon, if the economy goes through a more normal range of booms and busts, I expect these companies to do well.

Y: I don’t know, REITnut. Maybe we should just put 60% into the S&P 500 and 40% into a bond fund. Two of the large components of the S&P are Apple and Google. They have great Iphones and software. We could use the Iphone 55 with Google search 50 years from now! Or not. On second thought, maybe owning bricks and mortar has a higher probability of success, and with less risk, than a software company over the next 50 years.

And that bond allocation is looking a little dicey. With 10 year US treasuries currently paying ~ 2%, I think it is safe to forecast rising interest rates over the next 25 to 50 years. That would mean bonds will be swimming upstream for a long time, and bond investors may be swimming with the fishes.

It sure seems reasonable to invest the $2,000 in these four REITs, particularly for those with a reasonably long time horizon.

R: You know Yoda, even if Uncle did not help fund this ROTH IRA, it would still be great for a young person. A parent or grandparent could fund one for a high school or college student with a part time job. You can put in $5,000 or the W2 income, whichever is lower. And you get the same tax free compounding and withdrawal.

Y: OK, you have me sold. But we have to review this a few times in the future; The Force may be with us, but going on pure autopilot goes against my grain. Stuff eventually happens.

R: No problem, we can review them periodically and change course if need be. This is what I do with my grand-kids’ accounts. But, truth to tell, I don’t look at their REIT holdings very often.

Y: Great! I keep my calendar in hieroglyphics on the side of the cave. I will put us down for meetings at the 5, 10, 15, 25 and 50 year marks!

Thanks REITnut.

R: Thanks Yoda. But keep in mind that at the 50-year mark I will be 120 years old, and may then not know the difference between a REIT and a bushel of wheat.

[1] Details of Retirement Savings Contribution Credit
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