Jason talks with Michael Kitces, who is a financial planner and runs the blog Nerds Eye View.
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ANNOUNCER: Welcome to Creating Wealth with Jason Hartman! During this program Jason is going to tell you some really exciting things that you probably haven’t thought of before, and a new slant on investing: fresh new approaches to America’s best investment that will enable you to create more wealth and happiness than you ever thought possible. Jason is a genuine, self-made multi-millionaire who not only talks the talk, but walks the walk. He’s been a successful investor for 20 years and currently owns properties in 11 states and 17 cities. This program will help you follow in Jason’s footsteps on the road to financial freedom. You really can do it! And now, here’s your host, Jason Hartman, with the complete solution for real estate investors.
JASON HARTMAN: Welcome to the Creating Wealth Show! This is Jason Hartman, your host, and this is episode number three hundred and thirty-five; thanks so much for joining me today. I’m going to make this intro short. I promised our producer I would, because we have a good lengthy discussion with our guest. Well, not too lengthy. But he keeps bugging me to make shorter intros, so I’m just going to do that anyway. We’ll see if I can pull it off. Anyway, here we go.
First of all, I just returned from Kansas City, and we have I think sold out the development already. That took like a whole week [LAUGHTER] to sell out the development of triplexes there. But I agreed, although we didn’t throw in the money yet—I agreed to actually finance another development there myself, with our developer. So we will have some more stuff coming online in Kansas City. So, more to follow on that. But one of the things that was really the most interesting. I’ve been to Kansas City so many times. I sometimes feel like it’s my second home. But our developer there hired a very astute and bright CFO for his company, and we went out to dinner together. And I have been getting a couple of inquiries from clients, and I think I mentioned this on the last show, who have been interested in investing in funds. And I was talking with one of our providers who is marketing a fund, and they’re saying hey, invest with us, and we’ll do all the management and all the usual stuff. And you know how I feel about pooled money investments—Commandment #3, gosh, I beat that to a pulp, that poor thing.
But I think I found something out that’s pretty interesting. One of the things they told me is that they formed their entity to do this fund in Delaware! And you know, I know a little bit about this stuff, and of course I’m not a lawyer, I’m not a tax advisor. But I was wondering, why the heck did they use Delaware? And so I did a little research on this, and then I also talked to the CFO that I just mentioned that was hired on for our developer, who develops in Kansas City and St. Robert. And guess what I learned? It’s pretty interesting. Well, here it is. From what I understand—well, just let me back up a little bit and say, what I understood in the past is that Delaware, yeah, that’s where all the big corporations incorporate. The publicly traded companies. I’m not sure this is correct, but I’ll bet you Microsoft is incorporated in Delaware, although they’re obviously based in the Seattle area, right?
Well, a lot of these large companies incorporate in Delaware, for many reasons: because it has very favorable laws, and it has a court system that is very pro-business, so, you know, just like I say to you. When you’re a landlord, you want to invest in landlord-friendly places! No one would begrudge you for that. That’s just being a smart businessperson. But Delaware. I’m thinking, why Delaware? Why would they be incorporating, or forming this entity—it may be an LLC, I’m not sure which. I think it’s an LLC, actually. Limited Liability Company. Why would they pick Delaware? Delaware doesn’t make sense for small things; that only makes sense, as I’ve been advised over the years, for big corporations! Big publicly traded companies.
Well, after doing a little research, talking to a few people, I think I’ve figured it out. Here it is. You ready? In Delaware, from what I understand, you can, by contract, get rid of your fiduciary liability. Or, I shouldn’t say fiduciary liability, I guess. I should say fiduciary responsibility. Well, what does that mean? Well, from what I understand as a layperson—a non-lawyer—a fiduciary obligation is the highest level of obligation you can have to someone. And what that means is that you need to represent them with the utmost care and responsibility, and you need to either not have any conflict of interest, or if you do, you need to disclose that conflict of interest.
Well, in Delaware, hmm. A little magic there. From what I understand, you can write in your subscription agreement, or your contract with the investor, that you don’t have any fiduciary responsibility to them! And from what I understand, it is the only state where you can do this. Hah! Thus maybe the reason they have formed their entity for this fund in Delaware. Because you don’t have any responsibility to your investors. So here’s an example of how that might play out in real life. Say you invest in this fund, and this fund is out there to buy apartment buildings, or hotels, or whatever kind of business or real estate deal, or whatever it is, right? And say for example they take all your money, and they put it in this fund, and they start buying properties. All sounds good so far. But what happens when they buy a property near your property, and that’s in another fund, and you’re not an investor in that fund? And then they’re advertising for tenants, or they’re looking to sell the property, and they’re looking for buyers. And one fund conflicts with the next fund, and then you’ve got a potential conflict of interest, right? And if they’re not a fiduciary—they don’t have a fiduciary responsibility to you as the investor—well, they can do whatever the heck they want! As long as it’s legal, no fiduciary obligation.
And this is what, from my understanding, the hedge funds generally do. They form an LLC in Delaware, and it’s the first fund, and then they form a management company also in Delaware that manages the funds. So, they’ve got multiple layers of protection for themselves legally, here. And they might form some other entity that’s an advisor to the fund. You see how convoluted this gets? It basically means at the end of the day, as the investor, you have no recourse or rights in any real way that you can hold these people accountable for their actions. And then they get this first hedge fund subscribed, and then they form another entity for a couple hundred bucks—it costs almost nothing to do this. And then, that entity may have the same investment advisor, which is another entity. And then it has the same investment manager, which is a whole another entity. And then somewhere back there behind all these entities is an actual human being, and good luck holding them accountable for any of their dirty deeds, right?
So, this may be the answer, and again, you invest in a fund, a pooled money investment, and you have those three major problems I talk about in Commandment #3. You might be investing with a crook. You might be investing with an idiot. Assume they’re honest, assume they’re competent, they take a big fat management fee off the top before the money goes to you as an investor. And then they’ll say things like this—well, we offer a preferred return. Well, that’s a preferred return to you as the investor, after all the expenses! So…you know my feelings on this whole thing. Okay, enough said. But, I tell you, everybody keeps asking me, why don’t I open a fund? Yeah. I’m getting a little more interested as I see all the money these guys are making [LAUGHTER]. Maybe I’ll go against my own advice some day and open a fund. Who knows. We shall see.
Don’t call me a hypocrite if I do! I’ve explained all the reasons you shouldn’t invest in them, so. There you go. Alright. Our Austin trip is coming up, just about a month away—exactly a month away from today, actually. Brittany decided she wanted to market a little contest for that, and give away just one set of tickets there. That basically means two tickets, we’re giving away. And you can enter for this. It’s real easy, it takes like 20 seconds at www.jasonhartman.com/contest. If you already bought a ticket and you win the contest, we’ll give your money back.
And you still have to pay for your accommodations and your travel expenses, of course. But you could get a free ticket to the tour, so go to www.jasonhartman.com/contest, and just opt into that, it’ll take you about 20 seconds to do that. And if not, get a ticket! Buy a ticket; for it you get the Creating Wealth Home Study Course for free, included, and it’s $297. And if you become a member, you get it 20% off, so I recommend you do that first, at www.jasonhartman.com.
And the last thing I wanted to talk about, because we recently talked about our newest market, which is Little Rock. And I wanted to just talk to you real quickly about a property in Little Rock, because wow! This was a pretty awesome little deal here. I was rather impressed. Since this is a new market for us, we’ve only got three properties on our website, at www.jasonhartman.com, but here is one of them. A totally nice looking little house built in 1990, and it is $109,000. Subject to qualifying, your total cash invested is around $27,000, and your projected rent is $1200 a month, and your projected cash flow—listen to this, folks—this is really good. $318 per month. Remember, your taxes are very low. That’s your property taxes. Your cash on cash return projection here is 14% annually, and get this—I hope you’re sitting down!—again, these are all just on the pro forma here, but we’ve got good experience with this vendor.
It may be a new market for us, although I did business there several years ago, and in the outlying areas of Little Rock as well. But this is not a new provider here—this is only new properties in this market, okay? So we’ve got good experience with this provider. Very reliable, very good businesspeople, good provider we’ve been working with for a while. The overall return on investment here is projected at 44%. So what is the common thing I say? Well, what if you only do half as well as that—22% annually. That ain’t bad. What is it, about 4400% better than you’ll get in the bank? It’s pretty darn good. So check that out – www.jasonhartman.com/properties. You can look at our brand new properties available in Little Rock. This property has granite counter tops in the kitchen and bathrooms, ceramic tile, nice faucets, hardwood floors, nice deck, what a—and it’s just a great looking property with a nice bay window,
I’m looking at the picture of it now. Looks very, very nice. Not that looks should matter that much, because we are investors, and we invest based on the numbers and the pro forma and the analytical aspects of the deal, not the looks of the property. So anyway, let’s go to our guest. You’ll really like the Nerd’s Eye View that our guest is going to give you of the economy, of government, of policy; we’ll talk about gridlock, a bunch of other things, and we will be back with this guest in just about 60 seconds.
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ANNOUNCER: Jason provides an extremely unique service: deal evaluator. Are you interested in a property outside of our network? Need a second opinion? No problem! Let our experts evaluate the deal. Find out more about it at www.jasonhartman.com!
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JASON HARTMAN: It’s my pleasure to welcome Michael Kitces to the show! He is an expert on some interesting financial planning topics, and he is a partner and director of research for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Maryland, and oversees approximately $1 billion in client assets. And is also publisher of a Nerd’s Eye View blog—I love that, by the way—and I’ll let him tell you a little more about that. Michael, welcome! How are you?
MICHAEL KITCES: Doing well, doing well. Great to be here, Jason.
JASON HARTMAN: Good. So, tell us about the Nerd’s Eye View blog!
MICHAEL KITCES: So, the Nerd’s Eye View—obviously, as you might have gathered, I’m the nerd. So, Nerd’s Eye View is really a place where we try to look at some of the financial planning trends, industry developments, as well as just opportunities that are out there. I tend to write and blog targeted more for a financial advisor audience than necessarily sort of the endpoint client that we all work with. But I actually have very much a readership from both ends of those folks that are maybe a little bit more hands on with their finances, that kind of want to get a glimpse into what’s the advanced stuff that the planners are talking about, as well as an advisor base itself that comes to the site regularly and reads for latest news and developments in financial planning.
JASON HARTMAN: Sure. Well, one of the things you mentioned to me, Michael, before we started recording is that you try to be apolitical. But of course, the political world is pretty busy nowadays, and has been for several years, which may make that impossible. There’s a lot of stuff on the table; you know, one of my big criticisms of the Obama administration is that they leave so much uncertainty. People don’t know—executives don’t know, when they’re trying to make business plans—where things are going! And that uncertainty creates I think a lot of economic hazard. If people don’t feel confident in what the rules are, then they don’t know what to do, right?
MICHAEL KITCES: Absolutely. We see it as a huge ongoing challenge with clients. Obviously depending on your political bent, you know, it’s either a failure of the administration to lead or a failure of the Republicans that come to the table to negotiate with the president. But whichever direction you’re on, I mean, we see it pretty universally. Certainly with our clients, and within the financial planning space, it’s incredibly difficult to plan, to do long-term planning, when you don’t know what the environment’s going to be. And in some cases, the time horizon sort of gets shocking about how compressed things are. When we literally pass the final version of what became the American Taxpayer Relief Act within several hours of midnight on December 31st, I mean, we were going through planning issues with clients straight through the end of the year, trying to decide, well, what decisions do you want to make with your portfolio, or about your incomes, or your deductions, or other planning strategies that we could do, that were drastically swayed depending on which way the rules came out.
And we didn’t even know what the rules were going to be until all businesses were closed. So it’s certainly a challenging environment, although I think, as we view it, we’re not actually into a little bit more of a period with some permanence and stability, given the legislation that got passed on what ultimately was ultimately January 2nd when it got signed into law. The law, as it was passed, was permanent law. Now, permanent in the words of Congress only means permanent until they write a new law to make it something else. But, particularly in the tax context, when we look at what’s actually gotten done over the past decade that we’ve been talking about tax reform, there are basically only two major pieces of legislation that actually got done. The first time we passed fiscal cliff legislation, and the second time we passed fiscal cliff legislation. Unless we have some multi-trillion dollar consequence of not doing something, nothing seems to really get done in Washington. And so, now that our default is the laws are what they are unless we write something new to change them, it’s not clear to us whether there’s actually going to be a lot of change, and we actually think this may be more of a stability for the next few years. We’ll tinker at the edges, because we never stop tinkering with the tax system, to some extent. But we actually think this may be the environment we’re in for several years to come now, and that it’s actually a little bit easier to plan, with the set of rules that we’ve got.
JASON HARTMAN: Is that because we’re deadlocked?
MICHAEL KITCES: Yeah. I mean, in essence, that’s a discussion of deadlock, but notwithstanding both sides saying they’ve got certain views about what they think should be done, and how to resolve this, when we actually drill down and look at what finally gets passed when the time comes, it’s pretty much, unless there’s a multi-trillion dollar consequence, it doesn’t actually get done. And the permanence of the legislation that we did at the beginning of the year took all of those fiscal cliffs away. You know, the last mini-version was the sequester, and it wasn’t big enough to bring them to the table, and we actually did go off of that little cliff. So, it’s—you know, it’s just a discussion of gridlock, and obviously, the old saying, especially since I’m local here to the DC area, is: it’s great when Congress is gridlocked, because they can’t hurt anything. And you know…
JASON HARTMAN: There’s a lot of people that agree with that. That gridlock is the best we can hope for. Because many people think—and there is some real rationale to it—that almost everything the government does is in essence bad. So if they can’t do much, or anything, then at least it won’t get any worse.
MICHAEL KITCES: Yeah. I mean, certainly when we look at the history, particularly on the tax code, and we actually have a remarkably consistent generational cycle, where we do these sweeping tax reforms about once every 25-30 years. Make the tax code a whole lot simpler, strip out a whole bunch of the junk, and then basically spend the next 25-30 years mucking it up again, so that we can be due for the next tax reform legislation. So we did a version of this—we made the tax code in 1913; we did a version of this in the 30s; we did a version in 1959; 27 years later we did a version of it in 1986, which certainly impacted a lot of people, and now we’re exactly 27 years hence in 2013 here.
And to me, you can feel it in the air. Like, we’re all very much feeling like it’s time to do another simplification reform of the tax code, and get it back to something that’s a little bit more manageable, if only so we can spend another 25-30 years mucking it up again. But, it’s just not really clear that it’s all that likely to happen over the next 2-3 years. You know? We’re viewing this as something that’s—if it’s gonna happen, it’s probably gonna happen after the next presidential election. And that’s not particularly a comment about President Obama, but just the balance between where Congress is and where the White House is, and that it’s not likely to shift enough to materially change the dynamics in 2014 in the midterm elections, and that we’re probably looking until 2016 before one party or another, depending on—who knows what happens over the next 3 years—takes enough of a lead that they can actually push through some version of tax reform or another.
JASON HARTMAN: Talk to us a bit about how this affects people in their lives of personal financial planning, if you would. What does it mean when it trickles down, if you will?
MICHAEL KITCES: So, the kind of environment that we’re in right now is what we call—and certainly what you label from the tax policy terms—a fairy progressive tax environment, which means higher tax rates for higher income individuals, lower taxes on lower income individuals. So your classic strategy in those environments is in essence one of income smoothing. So, we want to do what we can to spread the income out, because if we bunch too much of it up into the same year, we end out in the higher tax brackets, we end out in the higher tax brackets, we pay a larger dollar amounts of total wealth.
So, the goal is to smooth out the incomes that we can stay in lower brackets year after year and not be plowed all the way into the upper ones. To me, one of the biggest changes that happened particularly around investing, whether that’s portfolio or real estate, is the change that we got this year to create for capital gains tax brackets. So we now have three base brackets—you’re in 0% capital gains at the lowest income levels, 15% capital gains if you’re in the middle income levels, and 20% capital gains if you’re in the top ordinary income brackets. On top of that we have a new 3.8% Medicare surtax that applies to all portfolio income including interest dividends, any long-term capital gain that shows up on your tax return, any net rental income, any passive income.
And so, we really end out with basically 4 capital gains brackets—the 0% rate, a 15% rate, a 15 plus the 3 which is 18.8, and a top rate of 23.8, because anybody who’s in the 20% bracket has to be subject to the Medicare surtax as well. So that puts us into the strange environment where if you do a really good job pushing your capital gains out over and over and over again indefinitely as far as you possible can, when you ever finally actually liquidate your investments, you end out blasting yourself up into very high tax brackets. You actually end out with less wealth by pushing all the gains down the road. So it’s taken us to some very kind of strange and unique planning environments.
In the portfolio context, we see people do things like not the old traditional strategy of harvesting capital losses where you sell an investment, you can claim the loss and get the deduction, you have to go through the wash sale rules where you own something else for 30 days, but it’s a very popular strategy. Now we see people at the other end of the extreme. Their goal is not to harvest the losses; it’s actually to harvest the gains! You deliberately sell the thing, we recognize the capital gain, we buy it back immediately because we still want to be invested in it, but by reporting the gain this year, we can take a little bit of gain this year, and then a little bit next year, and then a little bit the following year, and keep us with so much gain three years out from now that we end out plowing ourselves into the top tax brackets.
JASON HARTMAN: So your world is in the world of stocks and bonds, I assume. Wall Street-type investments. So you’re saying that people are wanting to take gains now, or at least this year, right?
MICHAEL KITCES: Yep. And we’ve seen it for the past few years, and we see it over the next few years. It plays out in similar ways in real estate transactions as well. So we’ve seen people doing things like deliberately not doing 1031 exchanges. We even watched a client that actually deliberately busted a 1031 exchange. He had a forward exchange that was underway through the end of last year, and he blew it up this year because he actually wanted to make sure the gain got recognized last year after all, because he was looking at his rates were going to be higher this year given some other stuff that was going on on this balance sheet.
JASON HARTMAN: But that’s interesting that you say that, because with the 1031 tax-deferred exchange—and what Michael’s referring to, of course, most of our listeners know, but for the benefit of those who don’t—with income property, you can trade it all your life, and just defer the gains indefinitely, and there’s no limit to the number of 1031 tax-deferred exchanges you can do, but I guess this guy wanted to be out of the market, which right now seems crazy to me, that you’d want to be out of the market. But there may be personal, individual reasons that we don’t know about, for the purpose of this conversation.
MICHAEL KITCES: True enough. If you’re going to end out holding things ultimately until you pass away, get your stuff up in basis, by all means we push the gains out indefinitely and just keep going and going. But, this actually was a scenario where he was trying to rejigger a little bit. He was kind of feeling like he was a) a little bit too concentrated in real estate, and b) really didn’t like where he was in particular. The property was unequivocally getting sold; it was just a matter of whether it was going to get reinvested into more real estate or reinvested elsewhere, and he ultimately decided he wanted to take some of it off the table. But it’s an interesting environment. We’ve also seen scenarios, although these frankly were done previously, but become a little bit more appealing now. Other folks that are exiting real estate, we see them doing things like trying to make sure that they specifically do installment sales that stretch the gains out, because they want to again, smooth them out, keep from getting too much lumped into a single year where it knocks them over into the top tax brackets.
JASON HARTMAN: It’s just a weird environment, Michael, to think that anyone would want to pay tax sooner rather than later, you know? We always—whenever we enter into this decision-making, we all think of the time value of money, of course, and we think of inflation, and it’s better to pay later than pay today. But I guess investors, many of them think that the capital gains tax will be so much higher in the future that it actually makes it worthwhile paying sooner?
MICHAEL KITCES: Well, yeah, just with the tearing that we’ve got—if I’ve got some property with, we’ll call it a relatively modest hundred thousand dollar gain—if I’m facing $15,000—if I’m facing a 15% rate, I’m going to owe $15,000 of taxes on it this year. If I’m facing a 23.8 down the road because I lumped too much income up, I’m facing 23.8 down the road—when we start doing our time value of money calculations, that’s essentially almost a 70% increase in your relative tax rate. You gotta keep your $15,000 invested, and pick up almost 70% to actually make back the taxes that you’re going to owe by chewing through this. So that’s this enormous burden.
I mean, if I can really defer my gains out, and compound it out and get 10, 15, 20 years’ worth of growth, then maybe I can be at the 70% threshold. But it’s just this extraordinary threshold that we have to beat with some of these time value of money calculations, because of the way the rates ramp up. And we just didn’t have to deal with it for decades! We haven’t had to deal with that until this year. Up until last year, we basically only ever had two capital gains rates. A lower bracket for the people in the people in the bottom one or two tax brackets, and one flat rate for everybody else, whether your gains were ten grand, a hundred grand, a million, or ten million.
And that’s different now. Now we’re suddenly in this environment where you’ve got one capital gains rate for the bottom brackets, then another one for the middle one, then another for the upper middle one, and then another one for people on the top bracket, and it really starts to incentivize some of these timing decisions about exactly when are you going to recognize a gain. Obviously if you’re going to hold it forever until death, that kind of comes off the table. But for anybody else who’s looking for these transactions to get realized at some point, it really takes us to a very sort of strange different new world, where suddenly the best economic decision you might be able to make is actually to voluntarily recognize your tax bill and pay your taxes. Because even with time value of money, it’s actually still cheaper than pushing them out till the future.
JASON HARTMAN: Yeah. Well, let’s talk a bit about Obamacare, and how that’s impacting investors. Which by the way, before—actually, sorry. Before we leave that other subject, maybe just address for a quick moment, if you have any thought on how this issue we just discussed, of people taking gains now, and selling, is affecting the markets? Because there’s definitely economic impact into the markets now. We’ve seen markets generally increasing as of late. But you print $5 trillion up out of thin air, and of course that’s gonna happen. But, what are your thoughts about that? Would they be even higher if investors weren’t doing sell-offs because of tax considerations? Or, how much of the market really is that? I mean, no one really knows what each investor’s thinking, so it’s impossible to quantify….
MICHAEL KITCES: It’s hard to estimate, but actually, it looks like the impact is really not that much, and the reason is twofold. One, frankly, from the somewhat negative, cynical end, a huge amount of market movements these days is institutionally driven and not retail investor-driven. So, the retail investors struggle to have enough market share to materially move the market on any particular day. The second thing, though, is a lot of this gains harvesting strategy, kind of like loss harvesting—it’s a little harder with the loss harvesting—but we don’t necessarily want to get out of the investment. We sell it and buy it back, so in the context of things like stocks and ETFs that trade through the day, you might sell the investment and buy it back 30 seconds later. You don’t actually want to leave the investment, necessarily.
You just want to recognize the gain this year and get it at a favorable rate, and step your cost basis up, so you have smaller gains, or more favorable losses, in the future. So, as long as most people are doing these gains harvesting strategies by truly harvesting them—meaning, selling and buying it back—you actually don’t get any net selling pressure on the markets. You just create these series of offsetting transactions for you that truly, purely are for tax purposes, and accelerate your tax bill, but in this sort of upward ramping tax rate environment, that can actually be a good deal. I mean, we see the same kind of behavior for people that save diligently in IRAs and then discover if you do too good of a job at that you finally hit age 70½ and you have these absolutely enormous requirement of distributions that start coming out, and you realize it would have been a better deal to partially do Roth conversions or partially contribute to a Roth IRA or do something to smooth your tax bill out so you don’t have it too back loaded into the top brackets.
And it’s the same kind of thing flowing through now on the capital gains side. It’s certainly not a general rule—a lot of folks, if your rates are higher now or lower in the future, you keep harvesting your losses, and you can keep pushing your gains out. But for a lot of people, it—the reverse actually works now; it was just never on the table before this year, except for very low-income folks who were using 0% rates.
JASON HARTMAN: So, the Nerd’s Eye View of Obamacare. I mean, we’ve got January 1st, 2014. We’re really starting to see this thing kick in. and boy, I mean—for the past few years, our PEO for my company—well, one of my companies—our Professional Employer Organization, they have just been inundated with issues dealing with health insurance. I mean, it’s just a ginormous, to use a made up word, problem. It sort of fits, you know.
MICHAEL KITCES: So, two things kind of on the Obamacare side. One, the transition process from where we’ve been to where we’re going to is going to be messy. Frankly, I’m very concerned, and starting to really push some of these conversations out to the advisory community as well. I think we’re sort of administratively and collectively as a country, very, very far behind in actually understanding all the new rules that are coming, and how much our world is about to change. The estimates are as many as 20-25 million people are going to get added to the health insurance roles later this year. That means, someone needs to be administering the applications for 25 million people, starting October 1st.
And there aren’t even staff hired and trained to do much of any of this stuff yet, and it’s a couple months out. So, you know, on the one hand, the warning is administratively this is going to be a bumpy rollout. I don’t think there’s any way around that at this point. But from the longer term perspective, the implementation of the Affordable Care Act is a really, really big deal in how we handle health insurance. And the driving fundamental change is for the first time ever, this is going to separate your decisions about health insurance from your decisions about employment. For the first time, you will not need to worry about where you work to be guaranteed access to health insurance at basically small business group rates, except the small business group rate is everybody in the country in one giant pool.
JASON HARTMAN: Right. And let me state for the record that that is maybe one small part of it that I actually like. Because I don’t know why health insurance was really ever tied to employment. That was just—I mean, I heard it came out of the Depression, somehow, and employers were trying to get the best workers, or something.
MICHAEL KITCES: It kind of came out of the Depression. It came out of some actually wage-limit rules that we had in place in the 50s where employers were trying to figure out, how do we give employees better benefits? Because they were actually limited in many industries on how much they could pay them. We kind of sanctioned it further in the 60s when we made the health insurance deductible for employers and excluded for employees. And bear in mind, that was an environment where the top tax rates where 70-90%, so people were really eager for tax-preferenced employee benefits, and less on wages.
JASON HARTMAN: Right. One thing that should be noted though, and I know this is a little bit of a tangential issue, but feel free to comment on it. One thing that should be noted about those old high tax rates, is that back then you had a lot more loopholes and deductions. Well, I don’t know. Nowadays you have more code, and more pages, and more words, and more complexity and confusion of course, but back then, people were doing all sorts of things that made no economic sense. And I think of all the windmills, and the limited partnership deals where people in the 70% tax bracket could get their taxes knocked way, way down. So the effect of rates—
MICHAEL KITCES: Knocked all the way down to zero! That was the origin of the alternative minimum tax, was kind of this backlash of people that were facing 70+% tax rates in 1966, making hundreds of thousands of dollars and paying literally a tax rate of zero. So, yeah. I mean, it was a very contorted system, and frankly, part of this was—part of the health insurance environment was kind of an outgrowth of that. So, as businesses and individuals were trying to get savvy about what are ways that money can move around that doesn’t get slogged through this ultra-high tax rate environment. This was kind of the era of lavish employee benefits, very rich employee health insurance, retiree health insurance, country clubs, company cars, and all the rules that we have restricting benefits are basically relics of when we shifted tons of money through employee benefits because the tax rates were so high that nobody wanted to get it as a salary.
So, it’s—certainly we’ve shifted the tax environment as well. But we got stuck with this thing along the way that really makes very little sense, regardless of what you think about the rest of the health insurance changes. Which is that we had this strange system where getting access to health insurance was contingent on working for an employer. And that created—you know, it put small businesses at a huge disadvantage. Certainly we’ve seen the small business environment, I’m sure you have as well, and you have employees that come to you and say, well, I can work for you because my spouse gets health insurance to cover us at least, so even if you don’t put it through your company, I can work for you. And obviously from the other end, I’m sure there are employees and talent that we didn’t have access to in time periods where we couldn’t afford to give them health insurance because they couldn’t take our job if we didn’t provide health insurance.
JASON HARTMAN: Yeah, so the one side of it is that small businesses that formerly found it tougher to compete with big company insurance benefits will now find that playing filed more level. But on the other side of the equation, as if employee disloyalty and company disloyalty to employees—we can argue which came first, the chicken or the egg, all you want—but as if it wasn’t bad enough nowadays! This may cause a lot more job hopping, because there isn’t really a retention, a golden handcuffs, if you will, to get people to stay, thinking that oh gosh, if I go out there on the job search again, I’m gonna have to deal with insurance issues, and it’s so complicated, and who knows where I’ll end up, and what I’ll get; I need to stay here and keep my job because of my insurance. So.
MICHAEL KITCES: Yeah. I mean, from both ends, you know, I think it’s been very sort of understated in looking at how this dynamic is going to shift. We view this as a significant increase for people in job mobility. So, their ability to change jobs and make job decisions not sort of hindered or restricted by what’s going on with their health insurance environment. So for some businesses, that’s a nice attractor; for other businesses that’s going to be a retention problem, because the health insurance was maybe a little handcuff, whether they realized it or not. We see it as a big opportunity around lots of financial planning issues for individuals, though. It means, if you’re trying to retire early, maybe because you’ve got enough passive income from your various investments, you no longer have to wait until Medicare at 65, or try to cut some creative solution on how you get access to health insurance.
You simply retire when you want to retire, you go to health insurance exchange, and you buy your health insurance. Now, there’s still going to be costs, and a lot of people aren’t used to that cost, because they’re used to having the costs at least defrayed by the employer. So we’re still going to have to have some of an affordability discussion. But at least the access discussion is off the table, and we can sort of deal with the affordability discussion, work towards that over time. Likewise, as we’re already starting the conversation with some of our clients, to simply sit down and say, if health insurance was not an issue, would you still be working where you are today doing the job that you are doing today? And we continue to be astounded by the number of people who answer, well, actually, no. I wouldn’t. I’d be doing something else. Maybe that means they go out and start a business. Maybe that means that they’ve got an entrepreneurial desire, or itch, to go do something, maybe that just means they find a different job, or a better job, or a job that makes them happy, or a job that makes them more money but no health insurance but that’s fine, because they can get the health insurance elsewhere.
JASON HARTMAN: Or a job in a different location.
MICHAEL KITCES: Right. Or finally making a geographic change that they want, which, you know, is a whole other discussion around which regions and locales may do well or poorly for real estate. When you start dissociating insurance from large employers, and you make employees more mobile, you know, particularly in this sort of increasingly wired, digital, remote worker world, I know a lot of folks making a really interesting case now that this is actually going to start feeding a movement away from some of the denser metropolitan areas and out to places that are lower cost of living.
JASON HARTMAN: Well, I think it’s definitely going to feed the movement that has been happening for many years now, you know, of leaving places that are not just dense, as you mentioned, but places that are expensive and dense and have high burdens—big government burdens like California and the northeastern states, where you’re located. I mean, those places are going to become less desirable, in my opinion, as people can work anywhere, and if health insurance isn’t tied to employment, people are going to look for generally speaking warmer climes with lower cost of living, less government intrusion, lower taxes. So I think that’s going to fare badly for the big government financially-disturbed states, like California.
MICHAEL KITCES: So, if I was, I guess, for some of your listeners who are maybe into real estate long plays, I think there’s certainly some interesting long play discussions out there of trying to figure out what kinds of less expensive cities out there—I think probably generally in the middle of the country or the southern regions, that tend to be a little cheaper—which kind of, I’ll call them secondary cities, out there right now may be variable, poised for growth and rising population density as the country starts moving and migrating? We’re already seeing a little bit of that from just the sort of, the state tax arbitrage of population migration from high tax states to low tax states. When you start telling people, oh, you don’t need to live near your employer to work there, and you don’t need to work for any particular employer to have access to your health insurance, it really starts to free people and open them up to make some broader decisions about where do you want to live, where do you want to work, what do you want to do, that really dissociates from geography.
JASON HARTMAN: Well, I agree with you, and I tell you something. The thing I’ve always said to my listeners when they’re considering investing in real estate, is that homeownership really is overplayed, in my opinion. I think that being a renter can many, many times be a much better deal for people. And I’m getting a lot of this from that—I think it was a TIME Magazine article about three years ago—that talked about how homeownership causes increased unemployment. They did this huge study showing that areas where they found high homeownership rates, they actually have lower employment, in many cases. And what came out of that for me is kind of a saying I’m constantly repeating. And it is, the best thing you can have on a résumé is mobility! If you can move to where the jobs are—and that similarly goes if you have entrepreneurial aspirations. If you can live where you want, and start a business wherever you want, where are you gonna go? Generally speaking, the southeastern part of the country is where the action is. You look at states like Texas, Georgia—that’s where people want to live! It’s low-cost, the weather is pretty nice, you don’t have to be—you can be in a city, metropolitan area, and live in a high rise if you want, or you can live in the suburbs! There’s just a lot of attraction.
MICHAEL KITCES: Yeah, and so, we’ve already seen that kind of emerging to some extent with this world of digital telecommuting and digital employment, and I think we’re going to be surprised to see how much it perhaps accelerates over the next couple of years as we start dissociating health insurance decisions and access to health insurance from employment. So to me, that’s a very big deal from the planning end, around what do you want to do with your business and your career, as well as perhaps your investments, and where you choose to live, and whether you choose to buy to live there.
JASON HARTMAN: Yeah, I’m looking forward to those not being tied together. I think that is one of the good things that will actually come out of this. But yeah, okay. So, what else? I mean, what are your thoughts on the general economic outlook? I mean, do you write about that?
MICHAEL KITCES: Yeah, I do write about it some, and certainly that’s part of what our firm does. We manage portfolios for our clients on an ongoing basis, so we have to always be kind of apprised of it, in negotiating this. You know, I think we’re kind of—and I don’t know that there are any great revelations here—I think we’re a little bit mixed and tepid about the economic environment. There’s no question that quantitative easing and the ultra-low interest rates are driving some level of activity, and that really just puts a lot of ambiguous questions in the air of, so, just how stable is everything gonna be when we finally unwind some of that?
And, what’s it going to do to, you know, frankly, asset prices of a lot of different stuff? We know on the one end, that certainly the money flowing through the system seems to be, some would say, stimulating some buying activity. But, from the flip side, it’s also a little bit difficult but certainly concerning to try to get a perspective on what happens when rates start to normalize. So, how many people would really still want to be invested in equities at these prices if you really could get a 5 year, a 5% CD again? Which we didn’t have all that long ago. We had not all that long ago, but now it seems like kind of a strange fantasy, to say well wouldn’t we like to get 5% on a CD.
That can be a hit to equity prices, that’s going to move interest rates and borrowing rates, which presents both challenges for just the financing of real estate at current prices, at least for some areas, as well as just to the kind of general impact when you start moving cap rates up. So, that certainly is kind of our concern to it. The reality is, you never get an economy that just gets to grow indefinitely without recessions and pullbacks; these things happen, and that’s part of the business cycle. So, it’s just been tough, I think, for us to try to decide just how much worse is the nest cycle potentially going to be. As we try to unwind this are we pretty much just going to have a normal recession? Will it be a nice buying opportunity, as many of them are, or is it going to be a little more of a hit to asset prices? And honestly, at this point, we’re still very much in a wait and see, you’ve just gotta keep your ear to the ground and focus on what’s going on and the data as it comes along, and trying to make those assessments. We view it as an environment that I think is a little bit too uncertain to make really extreme calls one direction or the other.
JASON HARTMAN: Well, good points. Well how about just the age old simplistic concept of inflation or deflation, in the future?
MICHAEL KITCES: We’ve been in the camp for a while that we don’t see this dramatic explosion of inflation anywhere in the near term. Certainly in the long term at some point the Fed has to either figure out how to unwind, or eventually some heavier duty inflation is going to start pushing through. But, as long as unemployment stays as high as it is, and there’s still kind of this slack in the economy, what we get is more like what we’ve had over the past several years, which is, asset prices kind of jump upwards, then they hit some sort of invisible wall where they’re sheerly not affordable, and they fall back down again. So we’ve bounced off of $4-$4.50 gasoline several times now over the past almost 10 years. And every time we say this stuff’s going to the sky, and inflation’s going through the roof, and every time it turns out the economy is not weak enough to sustain those prices, and it falls back down, because that’s the natural self-correcting mechanism. You can’t get drastic inflation—
JASON HARTMAN: You meant to say the economy’s not strong enough to sustain those prices.
MICHAEL KITCES: Yeah, the economy’s too weak, not strong enough to sustain those prices. You can’t get inflation—if there’s no mechanism where inflation pushes into higher wages so you get that circular flow like we had in the 70s, it’s really hard to just push inflation through the system. Stuff gets expensive, people can’t afford it, they buy less, demand falls, and the prices fall back down.
JASON HARTMAN: Well, let me take issue with you on that for a second. You may be saying that from the amount of money, the last $5 trillion we created out of thin air. But what happens with the next $5 trillion? And I don’t know if you really have to have healthy employment to have inflation. And here’s why. You look at some of the historical examples, of course Zimbabwe comes to mind—certainly that’s no growing economy. The motivation of government would seem to be, inflate your way out of the debt, inflate your way out of the problems, inflate your way to buying votes and pandering. That’s a pretty good business plan for government, as much as I philosophically hate it. But if I were in their shoes and wanted to maintain my power base and my voter base, I’d probably become a scumbag panderer as well. And so, it’s a good deal! And you take advantage of the Phillips curve, and you just create more money, and ultimately that money creates more investments. Some of it’s malinvestment. Some of it creates employment. Again, the whole thing’s a house of cards, ultimately. But who knows when? It could be 40 years down the road. It could be 100 years.
MICHAEL KITCES: Well, I think we have to make a distinction. There’s a difference between inflation events and hyperinflation events. So, Zimbabwe, Weimar Republic, stuff like that—hyperinflation events generally require more than just government spending. So when there have been a few of these studies done recently, you look back at about the 50 or something hyperinflations that we can document well over the past couple of centuries, and basically, the number of them where the hyperinflation was solely stimulated by—we’ll just call it politicians going off the deep end—was zero. Every single one of them have some other kind of supply shock event that disrupts an already granted very delicate economy, because the politicians maybe have been doing some bad stuff. That ultimately plows it forward into sort of the next stage of completely losing control of the inflation and having the hyperinflation go forward.
JASON HARTMAN: See, you gave the example of how that cycle perpetuates into maybe a status quo or even a deflationary cycle, or a moderate inflation cycle. And your example was, if I understand it correctly, is the government prints money, but people don’t have jobs, or they have low paying jobs, and they’re not getting any real wage increases, you know, in real dollars, which all makes sense. And so they spend for a little while, and then they stop spending when they realize, you know, the wealth effect really isn’t there. And when they stop spending, suppliers have to lower prices to keep business moving. And that’s all true. But I say what happens is that that whole concept is not a stagnant concept. I think what ultimately happens, is that the standard of living declines. People will still spend money on necessities—food, shelter—they’ll just have a lesser shelter. They’ll have lower quality food.
MICHAEL KITCES: You tend to see both in the extremes. So you can see nominal price declines, and usually in events that are so severe, you see real declines in the standard of living as well. So you go back to an era like the Great Depression—you basically saw both. So we had nominal price deflation, and it wasn’t even just that prices got cheaper—we saw real declines in standard of living for huge swaths of the country as well. But the issue from the other end, and certainly what we see for at least quantitative easing so far—just pushing more money onto bank balance sheets doesn’t necessarily unhinge that. So from the flip side, there are actually people who have been very critical that quantitative easing is not stimulative enough, because it’s the wrong way of putting money into the system.
You can load up banks’ balance sheets with $100 trillion if you want; if all they see is people who will default if they lend it to them, they don’t lend a dime, the money doesn’t move anywhere, and you still don’t get any inflation. At best, you just get some really bumpy price inflation, or asset bubbles, as the banks try to figure out where to park the money while they’re waiting to not lend it to anybody because the economy’s too weak to find viable borrowers. So, in those kinds of environments, again, we don’t necessarily need to see inflation spew forth at all, and frankly, our modern era case in point is Japan, which is on something like QE 9, or 11, depending on how you want to measure them. They’ve put drastically higher dollars into the economy as a percentage of their economy than we have by a long shot, and they can’t even figure out how to move the needle on inflation to the positive side, much less—they wish they could create inflation! They are trying, and they haven’t been able to do it for decades.
JASON HARTMAN: Who is that?
MICHAEL KITCES: Japan!
JASON HARTMAN: Yeah, Japan can’t because it doesn’t have the reserve currency, and it has a huge demographic problem! Japan’s deal isn’t the same—
MICHAEL KITCES: They can always print—I mean, they can always keep printing, right? Which frankly is also why they’re not hitting a wall on it, because as long as you can print your own currency to pay your own currency off, you don’t even have to worry about outside borrowers.
JASON HARTMAN: Well, but the difference is, they don’t have the reserve currency. You know? I mean, that’s a big, big difference. When you can print the reserve currency, versus printing a non-reserve currency—then you’re just—I mean, all they could really do—
MICHAEL KITCES: Either way, you can still print. You can avoid default indefinitely, and frankly, as long as we have a trade balance, if people—as long as we’re importing what we are, unless people want to stop selling things to us, they have to keep taking our treasuries. That’s just the reality. I mean, the math has to balance on a trade balance. And so, unless they don’t want to do business with us, they have to keep doing business in our currency. And that’s true for any country that has a trade deficit around the globe. Now, when you get into scenarios like what’s happened in most of Europe, and what happened in Greece, they’re an entirely different scenario. They actually did surrender control of their currency. They don’t get to issue it; they’re merely users of the Euro. So, they’ve got a whole other scenario that frankly, neither we nor Japan are dealing with. Because for better or for worse, we can keep expanding our currency. But as we’re looking at it—you know, granted, at any point we can still ultimately get this thing wrong, go off the deep end, and trigger some kind of really nasty inflation. But we don’t see much inflation for the environment that we’re in right now. We haven’t for several years, and we really haven’t had it.
JASON HARTMAN: I just gotta ask you—do you believe that the official inflation numbers are legit, or do you believe that it’s higher than the official numbers?
MICHAEL KITCES: Our kind of gut from looking around is that it’s probably somewhat higher than the official numbers.
JASON HARTMAN: Like what percentage? Would you say—I mean, I say 9-10% real inflation. Would you say 6%? For example?
MICHAEL KITCES: Yeah, I guess that’s probably where we’d come at. My issue is actually less with—so, in the short term, we tend to focus on—we get really worried about the cost of things like food and energy. So we pound the table whenever it’s up, but then we get suddenly very quiet when it falls back down. And you know, it’s had some very big negative months as well. That’s part of the weird thing that we get when oil prices rocket upwards and then rocket down, and a whole bunch of commodities rocket upwards and then rocket down. It’s nasty, volatile, and frankly, that’s got a whole other set of problems with it for people in the real world. But it doesn’t necessarily mean that when you look back at it a year or two later, you’ve suddenly compounded 20% price returns over two years. It’s more like you went up 5% and then down 3 and then down 2, and you had this horribly volatile ride, but you didn’t add up to much.
JASON HARTMAN: It’s a saw blade.
MICHAEL KITCES: Yeah. And it’s an ugly one. Now, the one that worries us, and frankly, the one that I know certainly bothered me for several years, was feeling like inflation was very understated through much of the real estate boom, because of the way we calculate CPI with imputing the cost of housing—
JASON HARTMAN: The rental equivalent, right.
MICHAEL KITCES: Right, so, owners’ equivalent rent was kind of a—there are some good reasons for doing it, but when we got into an environment like ’02 to ’07 where real estate prices went up so far, that we ended up drastically understating things. Now, from the flip side, as we’re slowly working off some of the real estate excesses and we’re seeing a little bit of the shift now, where the rental market is starting to pick up, frankly, we see an environment where it’s possible in a few more years—we’re going to be saying the inflation is pretty high because the rental market is actually booming more than the purchase market. And we can see some environment there where now people are actually going to be having a legitimate reason to pound the table to say, CPI is actually overstating inflation. I don’t think we’re there yet, don’t get me wrong. But those are the kinds of scenarios that we can see playing out. And those are just kind of distortions, because we’re doing the best at how we measure inflation, but certainly we put some things in there that have kind of morphed it from what was once a pure measure of prices, and what now is becoming more like a measure of standard of living, where we got other adjustments in there that have kind of shifted what it’s really measuring.
JASON HARTMAN: Right. Just one comment on that, and I know we gotta wrap up here, so, you’re just so interesting, I want to keep you on! But that’s a good thing, it’s a compliment. But I saw that personally happen so many times over the years: when housing prices would skyrocket, people would be forced to accept a lesser and lesser home. And so that inflation caused a decline in standard of living.
MICHAEL KITCES: Which didn’t show up anywhere.
JASON HARTMAN: Yeah, and that’s what just bugs me about so many “economists,” is they think that the standard of living is some fixed concept! Well, if people don’t have jobs, and I’m a real estate investor, who’s gonna be able to afford to rent my house? They say. Well, they’re going afford to rent some house, they’re just going to rent a lesser house. And the person that rented a nicer house, or owned a nicer house, will rent your house. Because people move down the economic ladder, and you catch them as they’re moving down. And you supply housing to them. So that’s what happens. And then the other thing that drives me nuts about the deflationist argument—and you know, I’ve had Harry Dent on the show a few times, and Bob Prechter, and those are the two major deflationists—is that kind of the concept of, the government can’t print enough money to reverse the deleveraging problem. Well, that’s not true! The government can print an unlimited amount of money! I don’t know, those arguments just kind of don’t hold water for me.
MICHAEL KITCES: Well, and I’ve had trouble with some of those as well, and I’m familiar with their work, and Dent’s whole angle on this that he’s really been talking for 20 years is this pullback in consumption that’s going to occur as Baby Boomers transition into the later years of their lives and start winding things down. And you know, I just keep looking and saying, if Boomers are liquidating all their portfolios so they can go and buy all this stuff that they enjoy in their retirement, the amount of earnings that’s going to plow into companies—I can’t wait to buy those stocks. And I can’t wait to buy the houses of the people that work at the companies that are getting all the earnings from those stocks. I mean—
JASON HARTMAN: Michael. You—that is so great, that you said that, because I have always, for 15 years, I’ve had that trouble. And I like Harry Dent, don’t get me wrong. I’m a big fan. I like studying economics from a demographic perspective. But the hole in his argument there is, you just alluded to it—is this. It’s the question of, if 2012 and 13 are the cliff where Baby Boomers start taking their money out of stocks, and what do they do when they take it out? Well, they ultimately spend it. If they’re going to need to take it out of there to spend on their living expenses, then it just begs the question, and nobody addresses this but maybe you and I—here’s the question: is it more important for a company to have shareholders or customers?
MICHAEL KITCES: Well, they flow circularly.
JASON HARTMAN: Of course they do.
MICHAEL KITCES: When the shareholders liquidate to buy the company’s products, the company makes a whole bunch of earnings, pays a whole bunch of wages to a whole bunch of people who go and buy the company’s stock because it’s so darn profitable.
JASON HARTMAN: Right, and on the other side of it, 72% of consumption is spent in the S & P 500!
MICHAEL KITCES: Now, at the same time, and I do think there’s validity to a lot of what Dent does when you come down to, okay, but how does that start shifting some of the fabric of our economy? What sectors do really well, what parts of the country do really well and poorly? I think all of that demographics work is absolutely dead on.
JASON HARTMAN: I do too.
MICHAEL KITCES: And accurate. But this whole idea of people are going to start liquidating their stocks, and suddenly all stock markets are going straight down, and apparently houses are gonna go right with them, as everybody sells their second homes and consolidates down on their first homes. As long as they’re spending the money, they’re pushing the money back into the economy, it’s causing company earnings and wages and profits and jobs and dividends and all of those things that ultimately flow right back into the economy of people who take them and feed them in again. That’s sort of the virtue of the economic cycle. If you told me they were going to liquidate all their stocks and put it under their mattress and take it out of the system, that creates a problem.
JASON HARTMAN: No question about it. It’s this concept of looking at things like there’s some zero-sum game that just, it never made sense to me. So. Very interesting. Well, Michael, listen, I’ve kept you longer than I said. But you’re too interesting, so thank you—
MICHAEL KITCES: No problem, I thought it was an interesting conversation.
JASON HARTMAN: Very interesting. Please give out your website, tell people where they can learn more about your work.
MICHAEL KITCES: So you can find me two places. www.kitces.com, that’s k-i-t-c-e-s.com, where I write and blog and share thoughts like this on other stuff. And also, Pinnacle Advisory Group—that’s www.pinnacleadvisory.com, where we provide private wealth management service for individuals looking for some help.
JASON HARTMAN: Excellent. Michael Kitces, thanks for joining us today.
MICHAEL KITCES: My pleasure Jason, you have a good afternoon.
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Transcribed by David
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