Real Estate FIRE Escape, Part II: Diversifying Your Income Streams

Today’s guest post from G. Brian Davis is a continuation of yesterday’s. If you haven’t yet, make sure you read Part 1.

In Part 1 of this two-part series, we looked at the 4% Rule and how rental properties can generate more income from a smaller nest egg.

Not convinced that real estate returns can rival equities?

Consider a joint study by several US and German universities, along with the German central bank, that found that residential rental properties were the highest-performing asset class of the last 145 years.

One of the greatest advantages of real estate over equities? Stability and lower volatility, which translate to lower risk.

Beyond the basic math, rental properties boast some fascinating advantages for FIRE-seekers. Today we’ll look at a few of those advantages, and how a diversified income-producing portfolio might look.

Tax Advantages of Rental Properties

IRAs and 401(k)s are great. You get to invest tax-free… up to an annual contribution limit.

Rental properties come with dozens of tax advantages, built right into our normal tax law. Besides being able to deduct every single real expense you incur as a landlord, from insurance to property management expenses to gas mileage and travel to a home office, you also get to deduct borrowing costs and paper expenses.

Mortgage interest? Tax-deductible, even if you use the new, higher standard deduction; interest on rentals is deducted directly from your profits on a different schedule.

In fact, under the new tax law, most landlords also get to write off an automatic 20% as a pass-through deduction on their rental income.

You can also deduct for depreciation on the building – even as it appreciates in value.

And when it comes time to sell, if you use your proceeds to buy another rental property, you can use a 1031 Exchange to avoid paying any taxes on your capital gains.

Rentals as a Hedge Against Inflation

The trouble with bonds (besides their less-than-thrilling returns) is that you have to subtract inflation from your returns.

Even equities suffer similarly. If the stock market rises by 7% this year, but inflation runs at 2.5%, then the real return on the stock market is 4.5%. (Inflation is even more depressing when the stock market plummets by 17%, dropping your effective return even lower. But I digress.)

A nice perk of rentals is that rents rise alongside inflation. In fact, rents are one of the driving forces behind inflation.

So while your mortgage payment stays the same, your rents will rise… and rise… and rise some more.

Which is a stronger perk than it sounds at first. Say your total expenses sit at $800/month for a property, and it rents at $1,000/month, for a $200/month cash flow. As rents rise to $1,200 (a 20% increase), your returns actually double – a 100% increase from $200 to $400/month.

Counterbalancing Equities & Real Estate

In Part 1 we touched on the fact that no one should put all their retirement savings in real estate. Yet few people bat an eye at putting all their retirement savings in equities.

Equities come with some fantastic advantages. They are truly passive, unlike rental properties. Over time, they tend to perform well. It’s easy to diversify with equities, since investors can buy broad mutual funds or ETFs with as little money as they like.

But for all their strengths, equities come with downsides, too. They’re more volatile than a psycho ex-boyfriend. Investors have no control over their performance. For that matter, their performance can’t be predicted, either. And investors are effectively limited to buying, holding, or selling them.

Mr. 1500 note: While I’m smiling at Brian’s writing, I wanted to mention that volatility is the enemy of the short-term investor. For those in it for the long-term (and you should be long term), volatility isn’t a worry. The ride can be rough over the short term, but long term, the markets go up. Additional reading here: http://jlcollinsnh.com/stock-series/

With that said, the decision to invest in real estate versus equities comes down to temperament and personality. With equities, your portfolio is subject to the whims of Mr. Market and some folks don’t have the stomach for it. With real estate, you have control and this is very appealing.

Perhaps worst of all, equities tend not to perform well as income-producers. Sure, some stocks and funds pay dividends. But typical dividends fall in the 1-3% range – hardly worth writing home about.

To generate more income, equity owners must sell off their assets, which brings us back to safe withdrawal rates and shrinking portfolios.

I don’t want my portfolio to shrink, or an expiration date on my net worth. I want it to keep growing in value.

Mr. 1500 note: I have to chime in here because there is more to this argument. Over the long term, with dividend reinvestment, the S&P 50o returns about 10%. It is true that you have to sell off assets to generate income, but if my portfolio is gaining 10% and I’m cashing out 4%, my net worth is still growing even if the amount of shares I own is shrinking.

Income from real estate can be less stomach churning. A seasoned landlord can count on a steady stream of income that increases as rents go up.

Beyond Direct Investing

There are dozens of ways to invest directly in real estate for early retirement (the ever-excellent Chad Carson breaks down some of them here).

Just last month, I interviewed a guy who reached financial independence in 17 months, by investing in land and signing lease-purchase deals with tenant-buyers.

But what if you don’t have the time or interest in becoming an active rental investor and landlord?

No sweat.

The options to passively invest in real estate are just as limitless. You could become a silent partner, with an experienced rental investor. You provide some (or all) of the funds, they do the work.

Or you could invest through real estate syndication. You invest funds in a larger-scale investing project, for a small ownership interest in a wide range of properties.

Mr. 1500 note: I love syndication and am currently invested in 7 deals!

Have you ever invested in private notes? You can lend money directly to investors, large or small, for excellent returns. I’ve lent money to real estate investors I know and trust, at 10-12%. I have yet to have a default.

Mr. 1500 note: I’m a private lender too and similar to Brian, my experience has been perfect. It takes work to find good lendees, but after that, you just watch the money roll in every month.

For that matter, you could invest in real estate crowdfunding services. Or in peer-to-peer lending platforms.

Your goal? Stacking up diverse streams of passive income.

Diversified Income Sources

That $40,000 of annual income we’ve been using as an example come $3,333/month (we’re doing advanced math here, can’t you tell?). You could save up $1,000,000 and put it all in equities and bonds, then spend it down over the next 30 years on a 4% withdrawal rate.

Or you could aim for something like this for your monthly income:

• Rental Income: $1,500 (Cash Investment: $150,000)
• Dividend Income: $500 (Cash Investment: $150,000)
• Private Note Interest Income: $833 (Cash Investment: $100,000)
• “Fun” Income: $500 (Making money from something you love doing anyway)

For starters, that’s $400,000 in capital, rather than $1,000,000.

Also, notice that none of that income involves selling assets and dwindling your portfolio. Over time, your net worth would grow rather than dwindle, as your equities and properties appreciate.

Brian I don’t trust your math. I don’t think I could earn $1,500/month net income from a $150,000 cash investment.

Sure you could, if you took the time to learn how to invest in income properties. Imagine you buy three triplexes, putting down $50,000 on each. That’s nine units, which means a cash flow of $167/month per door.

Hardly unreasonable for a knowledgeable investor. And besides, you’re bogging down in the details, rather than the bigger picture of diversifying income streams.

As I’ve mentioned throughout, real estate should not be the only egg in your FIRE basket of income-producing investments. But it makes for an excellent source of ongoing income, with predictable cash flow in the long term.

Start stacking up different streams of passive income. As you bring more streams online, you can keep funneling it right back into buying more income-producing investments, and snowball your income until you catch FIRE.

I bet you can even do it in less than 1500 days.

Mr. 1500 note: Whoah, hey there Brian! No need to hurl stones! Just kidding.

Brian is completely right. More right than he knows because it took me a lot longer than 1500 days. At my 1500 day starting point, I already had $586,000 in investments and another $150,000 in home equity. It actually took me two decades to accumulate enough to retire!

Achieving early retirement completely passively through index funds is the long road. I agree with Brian; if you’re willing to do the research and put in some work, you can get there much faster with real estate.

G. Brian Davis is a real estate investor, real estate writer, and co-founder of SparkRental.com. Among other free landlord resources, SparkRental offers a free video course on building passive income from rentals. Brian spends most of the year living and traveling overseas, partly based on his rental income, and loves it.