When your passive income from investments can cover your monthly living expenses, you reach financial independence. In other words, working becomes optional.
While the FIRE (financial independence, retire early) movement has its share of critics, the simple fact is that anyone can retire early. It takes a high savings rate of course – you can’t retire at 35 with a humdrum savings rate of 10-15%. But it doesn’t take as much money set aside as most people think.
Especially if you invest in rental properties in addition to the more traditional stock portfolio.
As you form your own plan for reaching financial independence and retiring, consider the following perks to rental properties as a source of income. You might just find you can retire far younger than you think.
One of the core advantages to rental properties as a source of retirement income is that the income flows in each month without you having to sell off any assets. Contrast that against a stock portfolio and the 4% Rule, which involves gradually selling off your portfolio over time.
A strategy that leaves you at risk for running out of money. In particular, relying on stocks for retirement income leaves you vulnerable to sequence of returns risk: the risk of a stock market crash early in your retirement.
Rental properties are the golden goose, laying eggs every single month. Not only do you not need to sell off assets to generate the income, but rentals actually cause your net worth to rise over time rather than dwindle. The properties appreciate in value, even as your tenants pay down your mortgages for you.
When you buy a stock, you cross your fingers and hope it rises in value.
When you buy a rental property, you calculate the exact return on investment you can expect that property to yield in the form of rental cash flow. You know the purchase price, you know the rent, and you can forecast all expenses accurately.
Say you buy a property for $75,000 that rents for $1,000. The property taxes are $1,200 per year, the insurance is $900 per year, and the neighborhood vacancy rate is 4%. After screening local property managers, you find one you like that charges 8% of the rent, plus one month’s rent for new tenant placement. You estimate 12% of the rent for maintenance and repairs (a reasonable industry average).
That leaves you with a monthly cash flow of $545, if you buy the property in cash: a return on investment of 8.72%.
Keep in mind that in most months, you won’t have any maintenance or repair expenses, or any vacancy expenses. But they do happen, and you need to budget for them if you want to calculate rental cash flow accurately.
Use a free rental cash flow calculator to run these numbers yourself, and forecast the returns for any rental property before buying.
You need to subtract for inflation to calculate the real returns on your stocks and bonds. If you buy a one-year bond that pays 3% upon maturity, and inflation devalues your money by 2% that year, then real return on that bond is only 1%.
But rents rise alongside inflation, and in many cases rise faster. That’s because rents are a primary driver of inflation.
Your property rents for $1,000 the year you buy it. The next year, you raise the rent by a reasonable 3%. And then you do the same next year, and the year after that. Your real returns stay the same, or even improve over time.
Say you have $75,000 in cash to invest in real estate. You could buy that one rental property above, and earn a healthy 8.72% return on your money.
Or you could buy five properties, each for $75,000, by financing 80% of the purchase price and putting down the other 20% with your cash.
Beyond helping you scale five times as fast, leverage can also improve your returns. Imagine that for each of those $75,000 properties, you borrow $60,000 for a 30-year mortgage at 6%. Your mortgage payment comes to $359.73, which drops your monthly cash flow to $185.27 per property. But since you only had to put down $15,000, your cash-on-cash return jumps to 14.82%!
Instead of earning $545 per month on your $75,000 investment, you earn $926.35 ($185.27 from each of the five properties). Your tenants pay down your mortgage for you, even as your property values and rents appreciate.
And those returns actually improve even more over time. That mortgage payment stays fixed as the years and decades pass, even as your rents rise. That means that the spread between your mortgage payment and your rent actually grows much faster than the rise in rent alone. If you raise the rent by 3%, that comes to a $30 total increase. But a $30 increase in the spread between your mortgage payment and your rent ($641.27) marks a 4.7% increase in your margin.
And that’s just in the first year; over time, your rent increases compound on one another, even as your mortgage payment stays fixed.
Rental properties come with outstanding tax benefits.
Every conceivable expense is deductible, from your mortgage interest to maintenance and repair costs to property management fees. All administrative costs, such as tenant screening fees, legal fees, bookkeeping fees, and accounting costs are also deductible.
You can even take paper deductions that you don’t actually incur, such as depreciation.
Best of all, these remain completely separate from your personal deductions. That means you can take the standard deduction, and still deduct all rental property expenses.
Rental properties come with their own unique risks, just like stocks or any other asset.
The property could suffer damage of course, from a storm or a fire. Which you can plan for by buying comprehensive property insurance.
A more common risk comes from bad tenants. Tenants could decide to stop paying the rent, or they can damage your property. You can mitigate this particular risk with three preventative tactics: thorough tenant screening, rent default insurance, and strategically buying properties in areas with a respectful, reliable tenant population.
Thorough tenant screening starts with collecting a rental application and running credit reports, criminal background checks, and eviction reports. But it doesn’t end there. You should also verify income, employment, and rent payment history, by calling employers and previous landlords.
Rent default insurance pays you the rent if the tenant stops paying it. That way, you still get paid even if you have to file for eviction.
The only other major risk with rental properties comes from vacancies. By choosing high-demand markets with low vacancy rates, you can effectively mitigate that risk too.
Investors understand that another way to mitigate risk lies in diversification. If you invest your life savings in one stock, you run the risk of that company declaring bankruptcy and losing a massive amount of money.
Yet the more diverse your assets, the less you exposed you are to any one disruption in the market. Among stocks, diversification strategies include buying small-, mid-, and large-cap companies, in multiple industries and sectors, across many regions in the world.
Real estate allows you to diversify your investments even further. The real estate market moves largely independently from the stock market; just because stocks drop, it doesn’t mean home prices and rents follow suit.
In retirement, you can lean on your rental income during stock market corrections, perhaps deferring maintenance until next year, or incentivizing a wavering tenant to renew their lease. When the stock market is strong, you can lean more heavily on your dividend income, or sell off a few stocks, as you make those needed rental property repairs or suffer a vacancy.
The more baskets you can spread your nest eggs among, the less likely you are to be broken by any one disruption.
While I don’t recommend rentals making up your entire retirement income, they can help you reach financial independence faster than stocks alone.
Take advantage of the perks above to scale your passive income faster. Yes, rentals do require more knowledge and more labor to invest in than stocks. But it’s that same barrier to entry that keeps every Tom, Dick, and Harry from investing in them, and which keeps the returns strong.
Invest the time to learn how to find good deals and how to calculate rental cash flow. Once you know how to do that, you can create ongoing sources of passive income, that only rise in value and income with every year that goes by.
When do you plan to retire? What investments do you plan to live on after retiring? Do rental properties figure into your plans at all?