By G. Brian Davis, SparkRental.com
Once upon a time, workers saved up a nest egg over the course of a 40-50 year career, and then spent it down in retirement. And hoped they didn't run out money before kicking the bucket.
That drawdown model raises all sorts of questions about safe withdrawal rates and how much you need to save for retirement. As you approach retirement, it also forces you to move money into lower-risk, lower-return investments to mitigate the sequence of returns risk (the risk of a market crash early in your retirement).
Nor should you expect much help from Social Security. A 2020 study by the Senior Citizens League found that the buying power of benefits have fallen 30% since 2000.
Enter: rental properties.
How Rental Properties Can Help You Retire Early
While I have no intention of ever retiring, I do plan to reach financial independence by age 43. I'm currently 40.
Financial independence is the ability to retire, to live on investment income alone. You reach it by building passive income from your investments.
As you build passive income and work toward your own financial independence and retirement, don't write off rental properties. They come with some impressive advantages for post-work income.
1. Ongoing Income
When you buy a rental property, it starts generating income for you immediately. And never stops.
Best of all, it doesn't require you to sell off any assets.
Because in the traditional nest egg model, you build up a portfolio of paper assets like stocks and bonds — then gradually sell them off to generate money for you to live on each month. Which means your net worth shrinks over time, and you risk running out of money.
And property values aren't alone in rising over time, either.
2. Rents Rise, Countering Inflation
Not only do rents rise to keep pace with inflation, rents are a primary driver of it. That means you don't have to worry about inflation sapping your returns as time goes by, as you do with bonds.
Imagine you buy a bond paying 5% annual interest. If inflation runs at 2%, then your "real" return is only 3%. Which doesn't exactly inspire popping Champagne corks.
In most cases, your rental cash flow and cash-on-cash returns rise over time — especially if you use leverage.
3. Leverage: The Power of Other People's Money
You can use other people's money to fund the majority of your costs to buy real estate. Their money, your asset.
When you take out a rental property loan, your principal and interest payment locks permanently. So as time goes by, your rental income rises, but your loan cost stays the same.
Consider a quick example. You buy a turnkey rental property for $100,000, and borrow $80,000 of it at 5% interest for a 30 year term. That puts your principal and interest payment at $429.46.
The property rents for $1,500, and your total average monthly expenses come to $1,100, leaving you with $400 in monthly cash flow. That comes to a cash-on-cash return of 24%: $4,800 net annual rental income over your $20,000 down payment = 24%.
Five years later, the rent rose to $1,950. But your monthly mortgage payment remains $429.46. Instead of earning $400 in monthly cash flow, you now earn $700 or $800 (your other expenses do rise along with rents, sadly).
In turn, your cash-on-cash return has risen as well. If you now earn $700 per month in net cash flow, or $8,400 per year), that comes to a whopping 42% return on your $20,000 down payment.
Which says nothing of the property appreciation over those five years.
That's the power of leveraging other people's money to buy your own appreciating, cash flowing assets.
4. Predictability of Returns
When you buy an index fund, you hope for the best based on average historical returns.
But you don't just hope for the best when you buy a rental property. If you calculate the cash flow right, you know precisely what return it will earn you.
You know the purchase price, you know the market rent, and you either know or can accurately forecast all your expenses. For instance, you know the property taxes, the cost of rental property insurance, the cost of property management. You know the vacancy rate in the neighborhood. You can forecast the average annual maintenance and repair costs accurately.
That means you never have to make a bad investment, if you run the cash flow numbers accurately.
5. Control Over Returns & Risk
Not only can you predict rental property returns, you also have a degree of control over them. Control that you don't have at all when you invest in stocks.
You can improve the management of the property to reduce the vacancy rate and turnover rate. You can improve the quality of your renters by renovating the property to attract better tenants. For that matter, you can avoid bad tenants all together with thorough tenant screening. Just make sure you know how to read a credit report, and that you look beyond the score to the actual payment history.
6. Diversification of Asset Classes
If all your money is tied up in stocks, what happens when the stock market crashes?
Real estate values and rents have low correlation with the stock market. They're also far more stable.
With a hefty portion of your investment income generated from rents, you don't have to gnaw your nails every time the stock market dips. That diversification into another asset class reduces your risk and exposure to one asset.
And sure, you could buy REITs. But as assets that trade on stock markets, they correlate more closely to stock prices than brick-and-mortar real estate does.
Let the stock market go through its gyrations. As a real estate investor, you can sleep at night knowing that you have predictable passive income elsewhere.
7. Tax Benefits
Among the many other reasons to invest in real estate, it also comes with tax advantages.
Every conceivable property-related expense is either deductible or depreciable. That includes expenses such as meals, travel, and a home office — which W2 employees can no longer deduct.
Best of all, these deductions are "above the line," meaning that you can still take the standard deduction in your personal return even as you deduct these rental-related expenses.
Depreciation even lets you deduct the cost of the building itself over time. You can deduct the cost of the building, and the cost of any capital improvements you make, over the first 27.5 years you own the property.
As you plan your tax strategy, make sure you understand all the tax benefits of rental properties.
Downsides of Rental Properties
Rental properties come with their fair share of risks and downsides, like any investment.
To begin with, they come with an extremely high cost of entry. Even if you take out a rental property loan, you still have to come up with a down payment. That alone usually costs you tens of thousands of dollars, which says nothing of closing costs. You can accept a gift to cover the down payment, and with rental property loans you can even borrow the down payment. But if you borrow it, that additional debt eats into your returns.
Tying up thousands of dollars in each individual investment leads to diversification challenges. When you buy an index fund, you can spread $100 out over hundreds or even thousands of companies. When you buy a rental property, you might put $50,000 in a single asset.
Rental investing also requires a degree of knowledge and skill. To invest without learning the ropes invites extra risk, to put it mildly. In contrast, anyone can invest money in an index fund and simply mimic a stock index.
Once you buy a rental property, it requires some ongoing labor. Rental income isn't completely passive — even if you hire a property manager, you still need to manage them.
Finally, real estate is an inherently illiquid asset. It takes time and money to buy or sell, unlike stocks. You can buy or sell shares in an index fund instantly, with no commission. Real estate can take months to sell, and requires you to pay thousands of dollars in Realtor commissions.
Before investing a cent in real estate, make sure you understand all the risks. And expect to put in many hours of education, learning skills like how to accurately forecast cash flow, how to score great deals, how to identify profitable markets for investing, and even how to invest long-distance if you don't live near one of those markets.
As you mull over investing in rental properties to build ongoing income, consider starting by house hacking.
It involves buying a small multifamily property to live in, and renting out the other unit(s). You can use the rents from the other units to qualify for the mortgage, and take out a conventional homeowner mortgage. Ideally, the rents from your neighboring units cover your monthly mortgage payment entirely, and you get to live for free.
Which is awfully useful in retirement, too.
Contributor Profile: G. Brian Davis is a real estate investor and founder at SparkRental.com, which helps middle-class people replace their day job with rental income. He and his family spend 10 months out of the year overseas, practicing the travel- and FIRE lifestyle he preaches.
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