Wednesday, July 22, 2020 / by Scott Shine
By Brian Davis
When I was 22 and working in a miserable cubicle, it occurred to me that if I had enough rental income, I could retire by 30. Life didn't work out that way, but not because the premise wasn't sound. Unfortunately, it didn't work out because I invested all my money without knowing what I was doing.
Whether you want to retire at 30 or 80, rental income can help you get there faster. Here's how:
In the traditional 20th Century model, you save for retirement over the course of a 40-45 year career. Then you stop working, and gradually spend down your nest egg in retirement, hoping all the while that you don't run out of money before kicking the bucket.
That model comes with all manner of complications. You have to choose a withdrawal rate: what percentage of your nest egg to spend each year on living expenses. You have to worry about sequence risk: the risk of a market crash early in your retirement. All this because you're spending down your nest egg, and shrinking your net worth over time.
But rental properties generate ongoing income. Like the golden goose, they keep paying you every single month, indefinitely. Rather than shrinking, your net worth actually grows over time as your properties appreciate and your tenants pay off your mortgages.
Returns Adjust for Inflation
When you buy bonds, you lose money to inflation. Imagine you buy a bond paying 3 percent interest and over the next year, inflation rises at 2 percent. You end up with a real return on investment of only 1 percent.
Rents and home prices, in contrast, rise to keep pace with inflation. In fact, rents actually drive inflation and often surpass it. You buy a property in today's dollars once, but you get to adjust the rent to tomorrow's dollars. And the year after that; and onward, continuing to raise rents every year to keep pace with or exceed inflation.
Rental Cash Flow is Predictable
When you buy stocks, you hope for the best based on historical performance and company management. But you don't really know what returns you'll earn.
With rental properties, you know exactly what kind of returns to expect. You can calculate rental cash flow with startling accuracy—you know the purchase price, you know the market rent and you know the long-term average of all expenses. Those irregular expenses often look like this:
Vacancy rate: 4-8% of rent
Repairs and maintenance: 10-15%
Property management fees: 12-16% (including both ongoing fees and new tenant placement fees)
Property taxes: 5-25%
Property insurance: 5-15%
Accounting, legal, travel and miscellaneous: 2-4%
However, this says nothing of any mortgage payment due. Use a rental property calculator to forecast cash flow for any property before buying and never make a bad investment again.
Rental properties are expensive. But with a purchase money loan, you can pay for most or even all of the cost using other people's money.
That could come in the form of a traditional 75-85 percent mortgage or you could negotiate seller financing, either as the primary mortgage or a second. Other options include HELOCs, unsecured business credit lines and even private notes raised from friends and family. I once bought a rental property on a credit card!
Best of all, you can even write off the interest as a tax deduction.
To score tax breaks with stocks or bonds, you typically have to invest in a tax-sheltered account like an IRA, 401(k), 529 plan or HSA.
But rentals come with inherent tax advantages. Every conceivable expense is deductible: maintenance, loan interest, accounting costs, legal costs and many closing costs. You can't deduct those expenses all in one year, but you can spread them over several years' deductions in the form of depreciation. This includes the entire cost to buy the property.
You can spread the deduction over 27.5 years, and when you eventually go to sell, the most you'll owe in taxes is the long-term capital gains tax rate, which you can defer with a 1031 exchange if you'd like.
Lastly, rental properties help you diversify both your income and your asset allocation. Instead of simply relying on stocks and bonds, you spread your eggs into the third basket of real estate.
A significantly less volatile market than stock or even bond markets. And in most cases, real estate markets move with little correlation to stocks—one being up or down rarely affects the other much.
As you plan your financial independence and retirement, don't ignore rental properties! They bring unique retirement advantages to your portfolio mix and can help protect you against a sudden stock market crash, particularly one early in your retirement.