Good morning everyone! I’m on an international adventure right now, so Ask the Readers will return next week. Today, my friend Chad Carson steps in.
Chad is an accomplished fellow and someone you should pay attention too. He was a division 1 football player and Rhodes Scholar finalist. Chad decided to skip medical school and focus on entrepreneurial pursuits. Today, he owns 90 properties with his business partner.
Real estate is a diverse investment strategy with many different methods to make money. Some strategies may be good for you, some may not. Chad’s goal in this post is to explain the best strategies and help you figure out which may work for you. I hope you enjoy Chad’s article today!
Right now Mr. 1500 is probably roaming around in an Ecuadorian cloud forest at the 2016 Chautauqua with Jlcollinsnh, the Mad Fientist, and Mr. Money Mustache. While he and other early retirement luminaries solve the world’s problems from a mountain top, he has trusted me with the keys to his site for a week. Lucky me!
Recently I had the pleasure of hanging out with Mr. and Mrs. 1500 while drinking craft beer at Stone Brewery in San Diego. Frugalsaurus and Spend0saurus even made a surprise appearance. I quickly took a picture for proof before Spendosaurus scurried off to buy overpriced t-shirts at a tourist trap nearby.
When fellow early retirement bloggers get together, the conversations are always fun and lively (especially while drinking beer). Of course, we talked about our families, outdoors, travel, personal finance, and philosophies on life. But inevitably we came back to a passion we share – real estate investing.
Different Strategies, Same Goal of Early Retirement
Real estate investing has helped each of us build wealth and move towards early retirement. I wrote another guest post about the specific benefits of using real estate to retire early.
The interesting thing about Mr. and Mrs. 1500’s story and mine is that we’ve used real estate in different ways.
Over the last 14 years, a business partner and I bought and sold (aka flipped) properties to pay the bills and to build cash savings. Along the way we bought rental properties to grow our wealth, and we’ve used those rentals to replace our need to actively earn income. Today we own 90 rental units in a small college town in South Carolina.
Mr. and Mrs. 1500 worked jobs outside of real estate, but on the side, they flipped their residence every two years and took advantage of the most lucrative section of the U.S. tax code. In the process, they built massive wealth tax-free. They currently invest most of that wealth in the stock market.
It turns out there are many different strategies to retire early using real estate investing. Our stories are only two specific examples. Real estate early retirees vary from people like me with many rental units to extremely part time investors with one or two properties.
The common theme with all of the real estate strategies is the wealth and income produced. These real estate investments free you from the need to “make a dying” at a job. And although real estate investing has the reputation for being less passive than alternatives, I can assure you from personal experience that with a little preparation and a few systems you can be as free and flexible as you like.
In the rest of this article, I’d like to give you a list of my favorite strategies for using real estate to retire early. And if you’re so inclined, I’d like to help you pick the best strategy for yourself.
But before we dig into the real estate investing details, let’s first look at the fundamentals of building wealth.
What’s Your Wealth Stage?
I see my own wealth building journey like climbing a mountain. I’ve been progressing (and occasionally sliding backward) from stage to stage something like this:
Stages 1 and 2 would have been the same whether I invested in real estate or not. They included steps like getting my bills paid, saving cash reserves, learning to live frugally, and increasing my income by improving my job skills.
Stage 3 was all about increasing my savings rate (thanks, Mr. Money Mustache), which is the primary driver of early retirement no matter what strategy you use.
Although real estate could be used as a full-time or part-time job in the first three stages, for most people it’s actually not the best time to begin buying investments.
Instead, real estate investing really shines in stage 4 (growth) and stage 5 (income).
Growth is taking a $100,000 nest-egg and turning it into $1 million. In this article, I’ll share some specific real estate strategies to accomplish this.
Income is turning a chunk of existing wealth into regular income that can be used to fund your lifestyle. It’s the stage that forever breaks the bonds of trading hours for dollars at a job. I’ll also share some examples of using real estate to accomplish this goal.
So, which wealth stage would you place yourself in?
Just pick whatever seems the best fit for now. This choice will help you focus as we explore the different real estate strategies for growth and income below.
Real Estate Growth Strategies
Remember that the goal for growth strategies is to turn a smaller nest egg into a much bigger one. This objective is one part offense, as in making good returns. But the second part is defense, which means avoiding risky moves that will send you sliding back down the wealth building mountain.
Here are several real estate strategies that I think meet both of those criteria.
You may be familiar with this strategy. It’s the one that Mr. and Mrs. 1500 used to accumulate a large chunk of their own million+ dollar net worth. A recent guest post on my site shares the details and before-after photos of their house-flipping story.
With live-in flips, you purchase a house that needs work or that has the potential to add value in some other way. For example, you could remodel the kitchen, open up the floor plan, improve curb appeal, or upgrade the baths, flooring, paint, light fixtures, plumbing fixtures, and other cosmetics of the house.
I’ve also known people who look for smaller houses in popular neighborhoods that can be added onto. If you can add a master bedroom suite for $125 per square foot and the addition adds $200 per square foot of value to the home, it’s a profitable project.
The bonus for live-in flips is their tax advantages. As of this writing in the U.S., gains up to $250,000 for an individual and $500,000 for a couple filing jointly can be earned tax-free. I’m not as familiar with Canadian tax laws, but Canadians seem to enjoy a similar benefit.
You probably already know the power of tax-free compounding of growth. It’s the reason so many people invest in 401ks and IRAs. This is a real estate strategy that benefits from the same principle.
House hacking is my favorite way to get into the rental property game. It just means that you live in a property that allows you to rent part of it to others.
For example, you could live in one apartment of a duplex, triplex, or quadruplex and rent out the other units. Or you could get more creative and rent your garage apartment to a grad student, use AirBnB to rent out your basement, or install a Yurt in your backyard for vacationers (yeah, that’s a thing).
My second residence was a house hack. I lived in one unit of a 4-unit building, and I rented the other three out. Instead of a housing expense, I actually had a housing profit of over $200/month!
This is not an isolated example, by the way. See my friend Brandon Turner’s popular article on Bigger Pockets, How to Hack Your Housing and Get Paid to Live for Free.
Of course, this strategy requires some sacrifice. You’ll have to live next to other people, and those tenants will know you’re the landlord. But I actually made wonderful friendships with some of the tenants who were also my neighbors. And the elimination of a housing expense makes up for any potential headaches.
Once you’re ready to stop house hacking, the property transitions perfectly into a long-term rental. Your owner occupant financing can be kept in place, and the building should cash flow even better now that you can rent the extra space.
Rental Debt Snowball
A basic rental strategy is to buy a rental, hold it, amortize your loan, and let rents and prices appreciate over time. This is not a bad strategy. In the right locations, it will work very well over 20-30 years.
But there is a better way for those seeking early retirement. The approach is called a rental debt snowball. I’ll explain it briefly here, but I also wrote an article with a more detailed example of a rental debt snowball (including spreadsheets).
Essentially you buy a certain number of rental properties that will meet your goals. As an example, let’s say you buy three. I’ll assume each rental has positive cash flow of $200/month ($600/month total) and that you use long-term, 30-year mortgages with $500 payments to buy the properties.
The snowball comes into play when you reinvest all of the extra cash flow (plus any other cash you can spare) to attack one debt at a time. The extra principle payments quickly pay off the first loan, which then frees up another $500/month to add to the next loan. Like a growing snowball, each loan gets paid off faster than the one before until all properties are owned free and clear of debt.
The beauty of this strategy is steady and then accelerating progress towards a goal. It’s not uncommon to complete a snowball plan within 7-15 years instead of the typical 20-30 year real estate plan. In this way, rentals basically become a vehicle for you to invest and grow your upfront and ongoing savings. The end result is a portfolio of low-risk, high cash flow properties.
Are you a debt-averse investor? Has all of this talk about mortgages made your palms sweaty? If so, real estate can still work just fine to grow your wealth. You’ll just need to use an all-cash plan where you pay cash for properties, save up all of your net earnings, and reinvest them into more properties.
I have personally used debt to grow my non-retirement account portfolio of rentals. But Dave Ramsey and many other wealthy real estate investors have done incredibly well by simply paying cash for properties. This article I wrote shows how well this simple, all-cash plan can work over time.
Investing with all cash may limit the size, location, and timing of the properties you can buy because your cash funds are limited. This may work fine if you’re patient and don’t mind building up your cash before buying. But you can also consider getting more creative by using partners. If you have $75,000 and a partner has $75,000, you could buy a $150,000 property together and start much sooner.
Loan Money from a Self-Directed IRA
Most people invest their 401k and IRA retirement accounts in traditional assets like stocks, bonds, and mutual funds. But few people realize that they can also be self-directed to invest in alternative assets like private loans, tax liens, limited partnerships, and real estate. Smaller, more specialized custodians offer these options, so it’s not as widely known. I use American IRA, but there are also many others.
If you do choose to invest your self-directed IRA in real estate (I have done it for almost 14 years), I recommend focusing on loans. Being a lender is more passive and exposes your retirement account to fewer risks and hassles associated with actual ownership. This works by finding other real estate entrepreneurs who need loans to fund their own deals.
For example, with some of my first real estate deals, I was the entrepreneur who helped another local investor grow his IRA. I bought a property to fix and flip, and his self-directed IRA funded my purchase and repairs. I paid his IRA 10% interest, and when I sold the property, I paid his IRA the principal back.
More recently I’ve done a similar arrangement with rental properties. The IRA of a private investor funds between 50-70% of the purchase price on rental properties. Then I pay the IRA a steady monthly payment at 6% interest.
The private investor enjoys the completely passive returns, and he also sleeps well at night knowing his investment has good collateral in the form of real estate at a low loan to value ratio. I tell them that if I get run over by a bus (likely on one of my international adventures), he will have a solid margin of safety to recover his capital.
This strategy works well for growth because 100% of the earnings stay inside of your IRA account and grow tax-free. If the interest was earned outside of your IRA account, you’d be subject to ordinary income tax rates without any of the typical shelter provided by depreciation from rental properties.
Real Estate Income Strategies
By switching to a new game … time becomes the only possession and everyone is equally rich in it by biological inheritance. Money, of course, is still needed to survive, but time is what you need to live.”
Ed Buryn, as cited in Vagabonding, by Rolf Potts
In the last section, all of the strategies were about growth. But what is the goal of this growth? Is it just to get a big net worth to brag about?
At least in my case, the goal is to live more and do more of what matters! And for that, I need time and flexibility. And to get time and flexibility using real estate, I need income.
This shift is sometimes harder than it sounds. Slowing down the chase after growth and switching to a focus on income and stability is not natural. It’s easy to rationalize the status quo and just keep growing for years.
Luckily, real estate transitions well between the two stages. During the growth phase, that income was reinvested to pay off debt or to buy more properties. But during the Income phase, you can optimize your real estate portfolio to produce income to cover your personal overhead.
Here are a few strategies to do that.
Free and Clear Goal
More than a strategy, this is a goal that helps guide you in the growth strategies above. It also gives you a quantifiable target that helps you to say “enough” once you reach it.
The free and clear goal begins by figuring out how much money you need to live. Then you figure out how many rental properties, free and clear of all debt, you need in order to pay for those living expenses.
For example, if you need $3,000 per month to live, how many rentals will you need? Let’s assume you have rentals with $1,000 per month rent and 50% goes out the door to expenses, vacancy, management, etc. So, each property gives you $500 per month.
Your free and clear goal would be 6 rental properties free and clear of all debt ($500 x 6 = $3,000 per month). I’ve ignored income taxes in this case because I assume you’re in a lower tax bracket and also benefit from depreciation shelter of some of that rental income. But you can bump your goal up if you need more cushion.
Some people will also not like the idea of zero debt. They want the benefit of some leverage to hedge potential inflation or to continue growing. You can still use the same principle and adjust your goals using more properties with some leverage.
But the point is that you work all of your real estate activity backward from an income goal. And you arrive at a place that has much lower risk and a much higher income.
That clarity, focus, and practicality serves your early retirement plans very well.
Finish the Debt Snowball
Using a debt snowball was first and foremost about growing your wealth. But it actually served another purpose because the end result was income and equity from free and clear rental properties.
So, the snowball plan would also transition nicely into the Income stage. You would just need to finish the debt snowball and make sure it meets your free and clear goal above.
Buy 3, Sell 2, Keep 1
Some of you won’t or can’t do the debt snowball. Maybe your rental properties don’t cash flow enough because the prices are too high. Or maybe the loans are just too big to get them paid off before your target date to start using the income for early retirement.
In those cases, you could adjust your strategy to the Buy 3, Sell 2, Keep 1 plan. With this plan you buy 3 properties, sell 2 in order to generate profits, and reinvest the gains to pay off the loan on the remaining property.
Instead of rental income, this plan focuses more on the built-in equity from buying properties below their full value. It also benefits from amortization of loans and from any passive appreciation in the overall real estate market.
My business partner and I used this strategy very heavily in the first 10 years of our real estate business. We bought many more properties than we needed, we held them short-term as rentals, and we sold them within 2-5 years in order to capture our profit.
After we sold, we typically used the net profits to pay off debt on properties we wanted to keep. As a result, we ended up with a smaller number of properties, less debt, and a larger amount of income.
There is risk in this strategy because it typically involves more leverage during the acquisition of the larger number of properties. You also face a tax liability on the final sale which eats into your profits. But both challenges can me minimized with careful planning.
For example, some of my properties were sold when I was in a low tax bracket and I paid 0% capital gains in those years. In other cases where my income was too high, the end benefit was still often worth paying the relatively low capital gains tax (in comparison to ordinary income rates at that time) .
Seller Finance to Your Tenants
During 2009 in the depths of the recession, my wife and I actually took a 4-month mini-retirement trip to Spain and South America. During that time, our real estate business produced some income to sustain us without having to flip houses. We did this by converting some of our rentals with average cash flow into seller financing with much better cash flow.
This strategy works well if you are transitioning to early retirement or even at an earlier stage when you want to take a break (which was our situation).
For example, let’s say you have a house that rents for $1,000 per month. Your tenants have paid you well for 5 years, and they would like to buy the home from you. But their self-employed income and lack of 20% down payment limit their options in the traditional financing market.
So, you agree to sell to them under the following terms:
- $150,000 price (the full value)
- $15,000 down payment
- $135,000 seller financing
- 6% interest
- 20-year amortization
Your tenants get to buy a house they love and lock in long-term financing with only a 10% down payment.
You convert a rental that probably produced $500 per month (assuming no debt and 50% rule on $1,000 rent) into a 20-year income stream of $967 per month. That’s basically double the monthly income!
You now own a promissory note secured by a mortgage on your old property. And you also get $15,000 cash up front to use for current needs or for reserves (definitely a good idea in case of non-payment).
If you owned three properties like this, you could build a $3,000/month income stream to support you for a long time. In my market, I would probably only have to invest $300,000 – $330,000 to acquire those three properties.
Not bad income for a relatively small nest egg!
Loan Money to Others
Just like the growth strategy of loaning money from your self-directed IRA, you could choose to loan money outside of your retirement accounts in order to produce income.
I already described how the loans work above, but in this case, you get to use the interest income before the traditional withdrawal age of 59.5 years old in retirement accounts. Remember, the whole point is to free you from the need to produce income at a job.
While my experience has only been making direct loans to individuals locally, many others, including Mr. and Mrs. 1500, use a variation of this through online crowd funding outlets like Lending Club. There are also many real estate focused crowd funding companies that allow you to make loans or invest as equity partners.
I don’t have any experience yet with online lending, so definitely do your homework. And with direct loans or crowd funding, make sure you get expert advice before beginning. Despite its potential benefits, it’s not a strategy to take on lightly.
What’s the Best Strategy For YOU?
Writing blog articles, even ones as long as this (thanks for sticking with me!), are relatively easy compared to real life. Because in the real world, you have to match these strategies to the unique constellation of factors called your life.
So, to help you find the best early retirement real estate strategy for you, I’ll close with a few final thoughts:
- Choose a wealth stage to help you focus.
- Choose a strategy that gets you excited. If it’s not fun, you probably won’t stick with it.
- Learn more about that strategy using the links I provided or other online real estate resources.
- Write a short business plan (like 1 page) with the likely next projects and next actions.
- Get started!
This form of investing in real estate is very entrepreneurial. That means it’s not for everyone. But for others, like the 1500s and me, it’s been a central tool in our journey to early retirement.
I wish you must success in your real estate and early retirement adventures!
Is real estate the right tool to help you reach early retirement? If so, what strategy is best for you? Have you had experience with any of the strategies I’ve shared?
I’d love to get your thoughts or questions in the comments section below.
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