I’m on vacation this week with Mrs. 1500. She’s attending Podcast Movement and I’m exploring Philadelphia with the children.
Reader note: Exploring means eating cheese steaks.
I’ve lined up some guest posts for you while I’m wiping the cheese sauce from my face. The first is a two-parter that comes from G. Brian Davis over at Spark Rental. There are a million and one ways to achieve early retirement. Mr. Davis’ favorite is real estate and his reasoning is sound. Accumulating $1,000,000 to live on $40,000/year will take most a while. However, put in a little elbow grease and you can achieve the same thing much faster with real estate. Take it away Brian.
In the 20th Century retirement model, you saved 5-10% of your paycheck and invested it in stocks, over the course of 40 years. You relied on having several decades for your equities to compound.
Then as you got closer to retirement, you started moving some of those equities into bonds, to mitigate sequence risk.
But you didn’t worry that much about any of it, because you had a pension from your employer (where you probably worked for the last 25 years). On top of that, you looked forward to significant Social Security income.
Man, do those days seem like a different era!
There is almost nothing in that model that applies to me. I want to reach financial independence within five years, not wait around for 40 years. I don’t have a pension. Social Security is a distant (and shrinking) dot on the horizon.
And something tells me I’m not alone.
So what are some options for stacking up investment income, beyond waiting decades for your equities to compound?
The Old Model: Safe Withdrawal Rates & The 4% Rule
You’re probably familiar with the 4% Rule – that a safe withdrawal rate from your nest egg is roughly 4% annually.
In most market simulations for a diversified portfolio made up of 60% equities/40% bonds spread over many industries, regions, and market caps, a 4% withdrawal rate will not empty your nest egg within 30 years.
But what if I want my portfolio to last indefinitely, not just 30 years? What if I don’t want to draw down my assets, but keep my net worth growing?
And while we’re on the subject, a 4% withdrawal rate is not very encouraging. That means that for a modest $40,000 of annual income, I’d need a million dollars!
If I had to save up a million dollars, I’d be back to a decades-long timeline.
How Rentals Affect the Numbers
To keep the math easy, let’s stick with $1,000,000 as an imaginary nest egg (even though we don’t actually want to have to save up $1,000,000).
Let’s assume you buy properties that rent for 1.5% of the purchase price. (Aside: some real estate investors follow the “2% Rule,” only buying properties that rent for 2% or more of the purchase price; I personally disagree with that strategy. It can lead investors to bad neighborhoods, where numbers look great on paper, but the reality proves quite different. While in some expensive coastal cities even 1.5% is unrealistic, in many parts of the country it’s not difficult to find.)
So, you go out and find markets and properties that rent for 1.5% of the price. Your imaginary million-dollar nest egg produces $15,000/month in rents. That’s $180,000/year!
Not all of that is profit, of course. Cut it in half to cover expenses like property taxes, insurance, vacancies, property management costs, repairs, etc. (At the risk of overwhelming you with “percent rules,” that’s called the 50% Rule, and it’s surprisingly accurate as a quick shorthand.)
Subtracting for expenses, you’re still looking at more than double your original income. Your $1,000,000 nest egg now generates $90,000/year in ongoing income, instead of a 4% withdrawal rate providing $40,000/year.
And you don’t have to sell off any assets to achieve it!
Not that you’d want to put all your nest eggs in the real estate basket. But more on that later.
Leverage & Rental Income
Most mom-and-pop stock investors don’t use leverage to buy more equities. It’s risky – you have no control over the performance of those equities. And in the time it takes for a news anchor to gleefully shout “Sex scandal!”, a company’s stock could become worthless.
But real properties’ value can’t simply disappear in a puff of smoke. Sure, the building could burn down, but that’s why property owners have insurance. And the land isn’t getting up and walking away.
That’s why financiers will lend up to 100% of the value of real estate: it’s a far more stable asset. No lender will cover 100% of your stock investments, no matter how sharp your past investments have been.
And even when property values dip in a housing crash, rents rarely follow suit.
Which is a long way of saying: leverage is lower-risk for real estate than stocks.
How Leverage Bumps the Math Even Further
Here’s how leverage can impact that imaginary $1,000,000 nest egg.
Say you buy rental properties with a solid 20% down payment – that means that with $1,000,000 in cash, you could buy $5,000,000 worth of real estate.
Using the same numbers as above (including 50% for expenses), that comes to $450,000/year in rental income, instead of $90,000.
Minus borrowing costs; at 7% interest for a 30-year term, that means $26,612/month in financing costs, or $319,345/year.
Which still comes to over $130,000/year in net income. That’s more than triple the 4% Rule’s withdrawal rate of $40,000/year.
Faster Results Require More Aggressive Investing
I interviewed Mark Ferguson of InvestFourMore a few weeks back, for a piece about how to play catch-up on retirement to reach the finish line within five to ten years.
He made a great point:
A lot of investors want to pay cash for their properties to be ‘safe’, however buying more properties with loans will get you where you want to be faster.
But that doesn’t necessarily mean higher risk. Why did Mark put “safe” in quotations? Because using leverage to buy five properties instead of one helps diversify your portfolio, helps you create more cash flow, offers more tax benefits, more potential for appreciation.
People often say “safe” when they really mean “conventional.” If you don’t mind waiting around for a few decades, you can invest like every other Tom, Dick, and Harry.
If you want to reach financial independence in under five years, you need to approach your investing differently.
Is it for everyone? Of course not. Many investors simply don’t feel comfortable with debt of any kind, even 80%-LTV secured real estate debt.
…But It’s Less Risky Than It Sounds
Mark argues that in many ways it’s less risky, to invest more ambitiously with leverage rather than timidly investing just cash.
Aggressive investing doesn’t have to mean high-risk. It also means aggressive budgeting, to put the maximum possible capital into investments. It means pursuing high-return, income-producing investments.
And it means carefully leveraging other people’s money to help you make the most of what cash you’ve managed to save.
In Part II we’ll talk more about equities and where they can fit into the equation. I love equities. I would never urge anyone to ignore them or any other asset classes, and invest solely in real estate.
But investors can’t predict equities’ returns. Even the best-informed minds in finance can’t predict what this year’s stock market returns will be, much less next year’s, or the year after that.
As long-term equity investors, we simply buy with the knowledge that over the long term, the stock market will likely rise in value.
The same logic doesn’t apply to rentals. Oh, they almost certainly rise in value over the long term, too. Yet the real advantage is that you can accurately predict cash flow and returns.
With minimal training, anyone can learn how to forecast rental cash flow. Even if you used the shorthand 50% Rule mentioned above, with no finer expense forecasting, you’d still end up with roughly accurate cash flow forecasts for the average property.
Safe Withdrawal Rates & Selling Off Assets = My Last Resort
If it would take $1,000,000 to create $40,000/year in income using a 4% withdrawal rate, then using the sample math above it would take around $307,000 to create the same $40,000/year with leveraged rental income.
Not trivial, but far easier than seven figures of savings.
At the end of 30 years in the 4% withdrawal scenario, you may well have drained your entire nest egg. After 30 years in the leveraged rental property scenario, you will pay off your mortgages, exponentially increasing your net income.
Mr. 1500 note: While equities are less predictable than real estate, in most cases, historical data states that you’ll have more money after 30 years than what you started with.
With that said, will the 21st century look like the 20th? No. One of the main issues I have with the 4% Rule is that it’s based on historical data. Big changes are coming and they’re coming fast. Technologies like autonomous vehicles and artificial intelligence are going to change life as we know it. Brace yourselves folks.
The stock market may be a better or worse deal in future decades, but it will not be the same.
Rental investing is not as passive as equity investing. It requires some work up front to research and buy properties, and some property management labor if you choose not to hire a property manager. But for those willing to put in that work, rentals generate sustainable income without having to sell off assets.
In Part II of this piece, we’ll break down some of the other advantages of rentals as sources of early retirement income. Finally, we’ll look at how your passive income might come together, from sources ranging from rentals to dividends to note interest and beyond.
Mr. 1500 note: I think this post is excellent. I love the idea of using real estate and leverage to achieve early retirement because of the time involved. It’s gong to take most people quite a while to accumulate enough equities to fund early retirement. However, if you’re willing to do a little work, real estate can get you there much faster. One extreme example (2 years) which I love is Zeona McIntyre’s.
What’s your plan for reaching financial independence? Does it involve real estate? Why or why not?
G. Brian Davis is a real estate investor, real estate and personal finance writer, and co-founder of SparkRental.com. Spark Rental provides free training for rental investors, state-specific lease agreements, and a service to deduct rent directly from the tenant’s paycheck.
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