Guest post by G. Brian Davis at SparkRental
I was 23 when I first realized I didn’t have to work until the ripe age of 65.
At the time, I worked for a lender and specialized in loans for real estate investors. After issuing my hundredth rental property mortgage, it finally dawned on me: these investors are building enough income from rental properties to live on. Once they acquire enough of them, they can retire!
Thus, began my infatuation with financial independence and retiring early (FIRE).
When you can cover your living expenses with passive income from investments, you reach financial independence. At that point, working becomes optional – you can keep working your job if you love it, or volunteer full-time, or find a job you love, or go travel the world.
And it turns out that real estate actually comes with a slew of advantages for reaching financial independence.
Stocks, Bonds, and the 20th Century Model of Retirement
In the 20th Century, retirement worked like this: you’d save up a nest egg over your 45-year career, invest that nest egg in stocks and bonds, then retire and gradually sell off those investments to live on in your golden years.
But it came with a risk, known among financial professionals as superannuation. It’s a fancy word that means “running out of money before you kick the bucket.”
Because in this model, you have to decide how much of your nest egg to sell off each year to live on. This gave rise to a concept called “safe withdrawal rate” – the percentage of your portfolio that you can safely sell off each year. You may have heard of the 4% Rule, the classic safe withdrawal rate of 4% per year, which is largely considered safe to last at least 30 years in retirement.
I find two problems with this model. First, I don’t like the very premise of getting poorer every year that goes by in retirement, of worrying about running out of money before I die. Second, you have to save a lot of money; a $1 million nest egg only produces $40,000 per year based on the 4% Rule!
How Real Estate Helps You Retire Early
Don’t get me wrong, I love stocks and invest heavily in them. But I invest in stocks for long-term growth and diversification, while I invest in real estate for income starting right now.
When you buy a rental property, it starts generating income for you immediately. And it never stops.
In fact, if you take out a rental property mortgage, eventually your cash flow jumps up even higher when you pay off that loan. Or rather when your tenants pay it off for you.
You don’t have to worry about selling off any assets to generate that income. You don’t get poorer with each month that goes by. Quite the opposite: you get richer, as the property appreciates in value. Which real estate historically does, far faster than incomes rise.
Every year, rents go up. Not only do rents rise with inflation, but rents are one of the foremost drivers of inflation. In many markets, rents rise significantly faster than inflation.
Add in a rental property mortgage and the math looks even better. For example, say you bought a property 20 years ago that rented for $1,200, with a $100,000 mortgage. At 5% interest for a 30-year loan, your monthly payment would have been $536.82, leaving $663.18 as a margin for non-mortgage expenses and cash flow. Today, you rent the property for $1,900 – and the monthly mortgage payment is still $536.82.
Your monthly margin today would be $1,363.18, more than double your original margin.
The same can’t be said of other investments. If a bond pays 4% interest annually, and inflation runs at 3%, then your real return on that bond is only 1%.
When you buy stocks, you hope for the best. When you buy a rental property, you can accurately forecast the returns with a rental cash flow calculator.
You know the rent amount, you know the purchase price, you know the cost of initial renovations, and you know the long-term average of all your expenses. If you buy fixer-uppers, you learn how to spot common wiring issues or diagnose a leaking hot water heater. And if you miss an issue in your initial walk through the property, your home inspector will note it, so you can include it in your quotes from contractors.
Some ongoing expenses, such as property taxes, insurance, and property management fees, you can pinpoint exactly. Others include a long-term average. For instance, if a neighborhood has a 4% vacancy rate, then even if you don’t have any vacancies in a given year, you know to budget for a 4% vacancy rate as a long-term average. The same goes for ongoing repairs and maintenance.
The upshot? You know what kind of return you’ll earn before buying, which means you never have to make a bad investment again.
Control Over Returns
Beyond being able to cherry-pick strong investments, you also control your rental property returns far more than other types of investments.
Investors have almost no control overstock returns. They can choose when to buy, and choose when to sell, but can’t influence the company’s performance in the interim.
With rentals, investors can aggressively screen applicants to only rent to the most reliable tenants in the market. They can make property upgrades to attract higher quality tenants, and to justify higher rents.
Landlords can even buy rent default insurance to protect against tenants failing to pay the rent. In the event of an eviction, you keep getting your rent payments.
Real estate investors get to build a portfolio of income properties largely with other people’s money. They put down 15-30% and borrow the other 70-85% of the purchase price.
In doing so, they often increase their cash-on-cash returns. Say you could earn an 8% annual return by buying a $100,000 rental property in cash. If you take out a rental property mortgage for $80,000, you may actually earn a higher return on your $20,000 down payment, even after accounting for the monthly mortgage payment.
With each property you add to your portfolio, you earn more passive income each month. Even if you borrow most of the money with a rental property mortgage, you rapidly add to your passive income. And in recent years, historically low-interest rates have made it even easier for investors to leverage other people’s money cheaply to build a portfolio.
The stock market typically plummets during recessions. But real estate values don’t generally fall much, if at all. Here’s a snapshot of the last 60 years, per the Federal Reserve:
Home values only fell significantly in the wake of the Great Recession, which was largely caused by a housing bubble to begin with.
Rents prove even more stable, usually flattening during recessions but almost never dipping:
Real estate helps diversify your portfolio, so your net worth doesn’t crash alongside the stock market every time equity investors get the jitters. And the stability of rents further reinforces just how predictable rental returns really are.
As a real estate investor, you can write off nearly every conceivable expense.
From closing costs to property taxes, insurance to mortgage interest, travel to maintenance, and more, you can deduct it all. And you can even take advantage of paper expenses such as depreciation.
When you go to sell a rental property, you pay the lower long-term capital gains tax rate. Or not; you can defer it indefinitely through a 1031 exchange, where you roll your profits into the purchase of another rental property.
A Few Words of Caution
If rental properties are such great investments for retiring early, why isn’t everyone a landlord?
First, because they come with high barriers to entry. It takes knowledge and skill to invest in rental properties: you have to learn how to find good deals, how to calculate rental cash flow, how to manage tenants, how to work with contractors, and a dozen other micro-skills. And it takes money – even if you take out a rental property mortgage, you still have to come up with thousands of dollars for a down payment.
Real estate investing also takes work, unlike investing in stocks. You can buy an index fund in 30 seconds through your brokerage account. But even after you’ve learned the ropes, it takes labor to find good deals on investment properties.
Similarly, real estate is infamously illiquid. It can take months to buy a property, and months more to sell it. Which says nothing of the thousands of dollars in closing costs you incur on both transactions.
So while real estate makes a great investment for reaching financial independence and retiring early, it takes more effort on your part than investing in paper assets. If you harbor a genuine interest in real estate investing, I highly encourage you to pursue it. But if you only want to diversify your investments, consider easier options like private or publicly-traded REITs, private notes, or real estate syndications.
How quickly are you looking to reach financial independence? How do rental properties fit into your strategy, if at all?