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The Pros and Cons of Real Estate Investing for FIRE

The Pros and Cons of Real Estate Investing for FIRE
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Investing in real estate is something we want to pursue as soon as possible in order to build up a diversified income for FIRE. We have heard many horror stories about how hard it is to manage properties both financially and literally. However, some people have the game figured out.

That’s why we were happy to connect with Brian from Spark Rental who can shed some light on real estate investing for FIRE.

He is here to explain the pros and cons of investing in real estate for financial independence and early retirement. Additionally, he’ll cover how rental income makes a huge difference in the amount you need to reach FIRE and debunk any myths behind building FIRE income with real estate.

If you have a unique money-related topic to share, reach out to us! We love sharing fellow money nerds’ stories and experiences.

Take it away, Brian!

It takes a lot of money to retire on stocks and bonds alone.

At a 4% withdrawal rate, it takes a million dollars – $1,000,000 – just to create a modest $40,000 in annual income. And if you plan to retire young, a 4% withdrawal rate is too high. The 4% Rule was calculated to leave your nest egg intact for 30 years, rather than the 50, 60, 70 years you need for FIRE. More realistically, you’re looking at a maximum withdrawal rate of 3.5%, or $35,000 annual income from that million-dollar nest egg.

You also don’t get the benefit of decades of compounding returns to reach that million dollars. You’re trying to retire in 5-15 years, not 40-50!

Enter: income from rental properties.

Here’s how rental income changes the math behind how much you need for FIRE, and the other pros, cons, facts, and myths behind building FIRE income with real estate.

The Advantages of Real Estate for FIRE

Many of the benefits behind real estate for FIRE are more nuanced and complex than the cons, and require a touch of math to illustrate.

Your old TI-83 graphing calculator from high school can stay buried in your closet though. If you passed 6th grade, you’ll get it.

1. Ongoing Income with No Loss of Assets

The whole notion of safe withdrawal rates bothers me, as someone pursuing FIRE. It revolves around selling off assets over time, with the hope that your portfolio grows at a faster rate than you’re depleting it.

New retirees run into a particularly gruesome risk, called sequence of returns risk, or sequence risk. It’s the risk of a market crash early in your retirement, before your portfolio has had a chance to really pick up some steam from additional compounding. Because when you quit your job for FIRE, when you’re no longer contributing to your nest egg and are only withdrawing from it, your portfolio’s survival ceases just being about the long-term average of your returns.

The order, or sequence, of your returns suddenly matters. Here’s how two portfolios with the same starting balance and same long-term average returns look, with only one difference: when a market crash occurred in their retirement.

Sequence Risk at Work

When you’re selling off assets to produce income, your portfolio shrinks if it fails to reach “escape velocity” early in your retirement. That means having to worry about sequence risk and safe withdrawal rates, when depleting your portfolio.

Alternatively, rental properties keep generating income indefinitely. You don’t have to sell anything, to kill the golden goose. It keeps laying eggs, month in and month out.

And when you finance it with a rental property loan, that monthly cash flow accelerates even faster each month.

2. Leverage Other People’s Money with Rental Property Loans

When you buy real estate, you can finance 80-97% of the purchase with other people’s money. In other words, you can build your own portfolio of income-producing assets mostly financed by someone else.

The magic of leverage is that it can supercharge your cash-on-cash returns. Imagine two investments: an index fund averaging 8% annual returns, and a rental property also averaging 8% annual yield (we’ll ignore both appreciation and closing costs for simplicity). You can buy the property for $100,000, it rents for $1,250/month, and after non-mortgage expenses like repairs and vacancy rate, your monthly cash flow comes to $665/month, or roughly $8,000/year.

Equivalent returns from both investments, right?

Now imagine you finance 80% of the property purchase, with a 30-year rental property loan at 5.5% interest. Your mortgage comes to roughly $454/month, dropping your monthly cash flow to $211.

But you only invested $20,000 of your own cash, rather than $100,000. Instead of earning an 8% return on your cash, you’re now earning 12.6% on it: your annual cash flow amounts to $2,532, which divides over your $20,000 investment to yield 12.6%.

To create $35,000 in annual FIRE income, it would take around 14 of those leveraged properties, each costing you $20,000. That comes to $280,000 total cash invested – a far cry from the $1,000,000 you’d need with stocks and bonds, following a 3.5% withdrawal rate

3. Returns Adjust for Inflation

To determine the real returns of a stock or bond or fund, you have to subtract for inflation. If you invest in a one-year bond paying 4%, and inflation runs at 2.5% that year, your real return is 1.5%.

Rents rise alongside inflation however. In fact, rents are a primary driver of inflation, and typically rise faster than inflation.

That means you can raise the rent every single year, and your returns inherently adjust for inflation.

4. Leveraged Returns Disproportionately Expand Over Time

Returning to the example above, you raise the rent after the first year, from $1,250 to $1,290. That’s a modest 3.2% raise in rent, so if you bought the property in cash you see a 3.2% rise in cash flow.

Alternatively, say you financed it with a rental property loan as outlined. Your monthly cash flow rises from $211 to $251: a whopping 19% increase in cash flow!

And it only accelerates over time, because your monthly mortgage payment stays the same for the next 30 years, even as you raise your rent 2-5% every year. Here’s how it looks visually:

Rent Margin Over Mortgage

That example is simplified; in real life some of your non-mortgage expenses (like vacancy rate) do rise alongside rents. But you get the idea.

5. Rising Equity and Net Worth Over Time

In the traditional retirement model, your nest egg gradually shrinks over time as you sell off stocks and bonds per your safe withdrawal rate.

With real estate investments, your net worth actually goes up over time. You build equity from two directions: first, your property rises in value through appreciation (usually), and second, the principal balance on your rental property loan shrinks as you pay off your mortgage.

Or more accurately, as your tenants pay off your mortgage.

Eventually, that mortgage balance disappears entirely when you pay off your rental property loan for good. And when that happens, your monthly cash flow jumps up even further.

6. Predictable Returns and Yield

When you buy stocks, you simply buy and hope they go up in value. With bonds, you do know the face value, although returns fluctuate along with interest rates if you want to sell before maturity. And, of course, there’s the risk that the borrower defaults on you.

Rental properties are a different animal. You know the purchase price, you know the market rent, and you can calculate the long-term average of all expenses.

Take the example above. Of the $1,250 rent, we set aside $585 for non-mortgage expenses, which might look like this:

  • Vacancy rate: 5% ($62.50)
  • Maintenance & repairs: 12% ($150)
  • Property management: 10% ($125)
  • Property insurance: 5% ($62.50)
  • Property taxes: 10% ($125)
  • Miscellaneous: $60

Some of those expenses you pay every month, such as property management fees. Others, like vacancy rate and maintenance, you simply set aside every month for when they pop up irregularly.

But none of these expenses are mysterious. You know the neighborhood’s vacancy rate. You know the property taxes, the insurance costs, the long-term average of maintenance and repair costs, all before you buy.

That means you can run the numbers for any purchase in a rental property calculator before buying. Because you know the returns you’ll earn, you can make nothing but high-yield investments, and never make a bad investment again.

7. Tax Benefits

Every expense you incur for buying, owning, and managing your rental properties is tax-deductible. Better yet, they’re deductible “above the line,” meaning you can take them even if you take the standard deduction rather than itemizing.

That includes interest on your rental property loan, by the way. So even as you earn a profit every month on the property, even as your tenants pay down the loan balance for you, you can deduct the expense of mortgage interest.

Even some paper expenses that you don’t actually incur can be deducted, such as depreciation. And if you ever decide to sell, you only pay taxes on the profits at the lower capital gains rate, since you owned the property for more than a year.

Or not – you could defer all capital gains taxes by using a 1031 exchange rules and buying another, higher-earning rental property.

8. You Can Mitigate the Risks

Rental properties do come with risks. The three most common risks for landlords are rent defaults, property damage, and vacancies.

Fortunately, all three of these risks are easy to mitigate.

You can mitigate the risk of rent defaults through thorough tenant screening. People with stable income and high credit, with a history of paying every bill on time, are extremely unlikely to default on you. People who never saw a bill they wanted to pay on time? They’re another story.

You can also buy rent default insurance for a few hundred dollars a year. If the tenant stops paying the rent, the insurance kicks in and pays it until you find a replacement tenant.

Similarly, you can mitigate the risk of property damage through a comprehensive insurance policy, through tenant screening, and through collecting a security deposit. When in doubt, charge a higher security deposit – or just rent to someone who takes better care of their house.

You can avoid vacancies by screening for long-term tenants who tend to stay put for a long time. But even more importantly, you protect against vacancies when you buy the property, by choosing neighborhoods with low vacancy rates. In general, the better the neighborhood, the easier it is to fill vacancies.

Pros and Cons of Real Estate Investing for FIRE

Downsides of Rental Properties for FIRE

Landlording risks aside, real estate does come with several inherent drawbacks. Here’s what you need to know before investing in a rental property.

1. Labor and Knowledge

Anyone can buy stocks. After choosing a series of index funds or a robo-advisor, you can literally automate your investments and never think about them again, letting your robo-advisor take care of asset allocation and rebalancing for you.

It takes knowledge and work to buy real estate. That’s why you can earn better returns: because there’s a barrier to entry, preventing the masses from buying.

Above I outlined how to run the numbers in a rental property calculator. It doesn’t take long to learn how to do it, but many new real estate investors just assume their cash flow is “rent minus the mortgage.” They fail to learn the knowledge they need to succeed, so they end up buying bad investments.

Knowledge aside, it takes work to find a good deal. You have to crack open a lot of oysters before you find a pearl. And then you have to negotiate a price, find an investment property loan, get an appraisal and home inspection, settle.

Once you own the property, it takes ongoing labor to manage. You can outsource that labor to a property manager, but it’s still required labor.

Not everyone is interested in taking the time to learn how to invest in real estate, or spending the time required to do so successfully.

2. High Minimum Investment and Diversification Challenges

With $100 in your bank account, you can buy shares in an index fund.

To buy a property, expect to shell out tens of thousands of dollars between the down payment, closing costs, and possibly repairs.

That has several implications for you as an investor. First, it means you have to save up much more money before you can make an investment. It could take years to save up the money required.

Second, it makes it hard to diversify. That $100 you invested in index funds could be spread over thousands of companies all over the world. But if you have to invest $20,000 in each real estate asset, it’s much harder to diversify your assets.

Want to get started investing in real estate without the high up-front costs? Try a REIT like DiversyFund with a minimum investment of $500.

3. Poor Liquidity

You can buy or sell stocks instantaneously. But real estate is notoriously illiquid.

Selling a property typically takes months. You have to hire a real estate agent, spruce up the property, list it for sale, go through showings, and so forth. Even when you find a buyer and negotiate a price, it still usually takes another 30 days to actually settle and get your money. If you’re lucky, and the deal doesn’t face delays or fall through entirely.

Plus you have to pay closing costs, including a hefty Realtor fee.

While real estate makes an excellent long-term investment, you can’t access your equity easily, quickly, or cheaply.

Final Thoughts

Should you stop investing in stocks and bonds, and invest exclusively in real estate to reach financial independence?

Of course not. While I love real estate as a source of income for FIRE, it makes up only one part of my investment portfolio and independence plan. I invest in equities for growth, liquidity, and diversification. I invest in real estate for ongoing income, and for all the other reasons outlined above.

Stocks and real estate balance each other well. Personally, I automated my stock investments with a robo-advisor, so they require no work whatsoever on my part. I then devote my investing energy toward real estate, because it does require more work.

In return for that work, I get predictable, inflation-adjusted, ongoing passive income with no loss of assets and plenty of tax benefits. And by leveraging other people’s money, I can build that rental income far faster than I can build income from dividends or bonds, which means faster FIRE.

Do you own any investment properties? What have your experiences been with them? Let us know in the comments!

Courtesy of SparkRental.com and FIRE from Real Estate!