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Using Rental Properties to Create Retirement Income

A few months ago, I crossed paths with real estate investor G. Brian Davis who asked if he could write a guest post for Can I Retire Yet? Using rental real estate to create retirement income is a topic of interest for many readers, and a topic Darrow and I have little personal experience to share. So I said yes. (We have no financial relationship with Brian or his company SparkRental.)

This is also a topic of personal interest for my wife and I. After a successful one year experiment as landlords, we recently started studying different real estate markets as we decide whether we want to pick up a few properties and get into real estate investing for the long term.

Brian does a nice job of summing up the pros and cons of investing in real estate for others pondering whether to diversify their portfolios. So I’ll let him take it away . . .

I love to interview people who reached financial independence and retired using rental properties. 

One of my favorite such stories? The story of Ashley and Kevin Thompson, who retired last winter. 

Ashley was 29 years old. Kevin was slightly older in his thirties. 

Among the many reasons their story resonated with me is that Ashley is a teacher, who spent several years working abroad at international schools (like my wife). Neither Ashley nor Kevin ever made six-figure incomes, won the lottery, inherited money, or had any other “unfair advantages.” 

They just lived frugally and funneled as much money as possible into income-producing investments. In their case, rental properties. 

But even they would be the first to tell you that, like any other investment, rental properties have pros and cons as a source of retirement income. Here are those pros and cons, to help you decide if rentals are the right fit for your retirement income portfolio.

Pro 1: Ongoing Income with No Withdrawals or Selloff 

Any discussion of equities as a source of retirement income quickly veers toward safe withdrawal rates

Heard of the “4% Rule”? That’s the classic safe withdrawal rate, based on a study by financial advisor William Bengen back in the ‘90s. The theory goes like this: if retirees pull out no more than 4% of their nest egg each year, the nest egg should last at least 30 years, based on historical stock market data.

Notice how the core concept revolves around a dwindling net worth. Around making sure that you expire before your wealth does. 

That entire notion, of gradually selling off my assets, sits badly with me. I want wealth that will keep growing indefinitely. An elevator that only goes up. I want income that will keep on coming, month after month after month. 

Rental properties fit that bill. 

You don’t need to sell off any assets to rake in rental income. You can sell off properties of course, but the income generated by rental properties doesn’t cost you anything, beyond predictable expenses like repairs and maintenance. 

Editor’s note

Brian hits the nail on the head here. Building the assets that enable early retirement requires you to be a very good saver. Traditional retirement planning utilizing paper assets requires either a.) selling off a portion of your assets to meet retirement spending needs or b.) saving far more money to live on only the income produced by dividends and interest without spending down principal. Many people (including my wife and I) don’t give this enough thought until we approach retirement. 

It is a huge psychological shift to go from saver to spender. This can be scary and uncomfortable. It’s the primary reason we’re considering diversifying into real estate.

Spending income from a job, business, or a rental property just feels different than selling off assets to produce income. Don’t underestimate your psychology!

Pro 2: Appreciation

Not only does your portfolio of rental properties not decline in value as you cash in on the income, it nearly always appreciates in value. 

In fact, you build equity over time, from two directions. The value of your properties rises from appreciation, even as your principal balance drops from paying down your mortgage. Or more accurately, your tenants paying down your mortgage.

There are exceptions of course. Your local town could decide to build a freeway right through your backyard. But no investment is without its risk, and that risk is lower than most. 

In most cases, your net worth continues to rise in value, rather than shrink.

Editor’s note

This is my one point of contention with Brain’s article. To be fair, Brian is not alone among real estate professionals over-selling the idea of appreciation.

Much of the appreciation in real estate prices is simply inflation. And while land tends to appreciate, homes and apartment buildings actually depreciate. Depreciation provides a tax benefit to real estate investors who can deduct the depreciation on their taxes. But that is because they are incurring real expenses over time as roofs, furnaces, flooring, etc wear out.

Housing markets vary considerably with regards to increases in prices. I’ve witnessed the extremes first hand. Houses in our current home town of Ogden, UT have been increasing by 10+% annually for years, while in our former hometown of Johnstown, PA we experienced no appreciation in our home value in over a decade.

Counting on appreciation is speculation, which is generally unwise for investors. I would consider any appreciation above inflation to be icing on an already sweet cake.

Pro 3: Income Adjusts for Inflation

Remember Matthew McConaughey’s sleazy character in Dazed and Confused, and his famous line? “That’s what I love about high school girls: I get older, they stay the same age.”

Rental cash flow is kinda like that. Except, you know, without the sleaziness. 

Rents go up over time, in nearly all cities. In some cases, they can rise staggeringly fast, as San Francisco saw earlier this decade. If a property’s rent is $1,500 today, it may be $4,000 in 25 years from now.

But your mortgage payment? That stays the same. If you borrow a 30-year fixed mortgage, with a $1,000 monthly payment, you’ll still be paying $1,000/month in 25 years from now, when $1,000 is likely worth half as much as it is today. 

Not only do rents rise with inflation, rising rents are a leading cause of inflation. And they often rise much, much faster than other costs.

Editor’s note

Regular inflation adjusted income is a great benefit of paid off real estate, without the risk of leverage.

This benefit can be magnified through the use of leverage, but it is worth emphasizing that this assumes using fixed rate fully amortizing loans. If the numbers on a property work at the beginning of the term, they should only get better over time as rents should rise regularly and equity will build. This gives you progressively increasing cash flow and/or equity, while having less of your loan payment going to interest over time. Win-win.

Pro 4: Diversification from Other Financial Markets

Stock markets go through corrections, even crashes, quite regularly. It’s far less common for housing markets to dip.

And when housing markets do dip, it’s often independent of what’s happening in the stock market.

In other words, every investor’s favorite concept, diversification, plays out beautifully with rentals.

If you own both a portfolio of rental properties and a portfolio of equities, you can lean on one portfolio more when the other is struggling. Bad month for your stock prices or dividends? Keep more of your rental income. Good month for your dividends? Put more of your rental income aside for repairs, or invest it in more equities.

Editor’s note

Improving risk management through diversification is another motivator for us to expand into real estate in these times of high stock valuations and low interest rates. Unfortunately, in many local markets (including ours) real estate prices are becoming overvalued for the rents they will produce as well, making it hard to find good deals to buy.

This is a challenging time for all investors. I think Brian makes a good point here regarding diversification, but we’re being careful not to reach on a real estate purchase, just to add an overvalued property to our overvalued paper portfolio.

Con 1: Rentals Take Work to Buy & Manage

One of my favorite things about buying equities? I can just park money directly in a low-cost index fund. Or many funds, as the case may be, but it takes almost no work to buy and none at all to manage. 

Unfortunately, that’s not true of rental properties.

Finding good deals on rental properties is not trivial. It takes work. And once you’ve found a good deal and put it under contract, the work is just beginning. 

You have to find financing (unless you’re buying in cash). Then come the appraisal, the home inspection, stressful settlements, perhaps coordinating repairs with contractors. 

Once you own the property and it’s ready to rent, you need to price it out, advertise it, show it, collect a rental application from every prospect, run tenant screening reports, call employers to verify income and employment, call former landlords. You need to sign a lease agreement, collect rent, enforce the lease, make inspections, file evictions.

And do it all over again when the tenants move. 

A far cry from clicking a few buttons to buy shares in an index fund, eh?

For all that, there are ways around the work. You can buy turnkey rental properties from trusted sellers. You can hire a property manager or bring on an active partner, so you can sit back as the silent partner. 

Still, the work can’t be ignored, and you need a plan for how you (or someone else) will oversee it.

Editor’s note

I appreciate Brian pointing out that increased returns and income that come with real estate are not a free lunch. 

My wife and I frequently discuss the desire for more income than our paper portfolio provides. But as is the case with many pondering the early retirement decision, we don’t need a lot of income.

So the question becomes, do the benefits real estate provides justify the efforts required to be a real estate investor. I think the answer depends on how great those benefits are and what other income alternatives you have available, such as part-time work, consulting, or a hobby business or job.

For now, my wife’s part-time work, my forthcoming book and working on this blog are more appealing and have more upside potential with less financial risk and undesirable work than buying rental properties, which is keeping us in window shopping mode for now.

Con 2: High Barriers to Entry

Those index funds I mentioned a few sentences ago? You can invest in one with $100. 

Investing in rental properties with $100 isn’t quite so easy.

It takes a significant amount of cash to invest in real estate, even if you’re financing the deal. Most rental property mortgages require at least 20% down, plus you’ll have closing costs to boot.

And that’s just the financial barrier. It also takes some knowledge and skill to invest in rental properties – at least if you want to actually make money. 

That means investing not just capital but also time in learning the ropes of investing in and managing rentals.

Lastly, it’s worth noting that diversification cuts both ways, with rentals. Yes, they are a great alternative to stocks or bonds. But if you have to invest tens of thousands of dollars in a single property, that’s a heavy concentration of funds in a single investment.

Editor’s note

This produces a considerable challenge for early retirees looking to diversify into real estate. Darrow has written about the challenges of getting a mortgage when you have assets but no income. While I haven’t gone too far down this road yet, getting a mortgage for a rental property is generally harder and with less favorable terms than a primary mortgage.

Early retirees with considerable assets could use some of those assets to pay cash for a rental property, but selling off enough assets to buy a property will likely come with tax consequences and this eliminates the benefits of using leverage. And as Brian points out, having a large chunk of your capital tied up in a single property or two actually decreases diversification.

Con 3: Expenses

Your index fund won’t call you up at 3:00 AM to tell you “The furnace broke and will need to be replaced. It’ll be $5,000. Thanks.”

That happens sometimes with rentals. 

Landlords need to keep a thick cash cushion available at all times because large, irregular expenses do come along. The good news? You can budget for them and forecast them. 

Knowing exactly when a major repair or vacancy will come along is not possible, but you can know the long-term average of those expenses. You can set aside 5% of the rent each month for vacancies, 10% for repairs, etc. 

Veteran landlords know this and plan accordingly. Which circles back to the necessity of education for successful rental investing!

Editor’s note

This is another challenge that I appreciate Brian pointing out as it is often overlooked by real estate investors. Do you really want a large sum of money sitting in savings accounts where you’ll be lucky to earn 2%? You may, but that cash drag needs to be factored in when calculating the benefits of owning rental properties.

Do Rental Properties Make Good Sources of Retirement Income?

Yes. But.

Rental properties offer unique advantages for anyone looking to retire young. In many ways, they are the passive income gift that keeps on giving forever. 

But they are not simple to buy and manage, unlike many other types of investments. A friend asked me a few months back about buying rentals, and the first question I asked him was: “Are you just looking for a high-ROI place to park your money, or are you actually interested in real estate investing itself?”

There are plenty of alternative investments, even real estate-related investments, where you can park money without the work required for rental properties. You can invest in REITs, in private notes, in real estate syndication. All have their own pros and cons. None perform as predictably as rental properties. 

But they don’t require nearly as much education, skill, or work, either.

If you’re genuinely interested in learning about real estate investing, rental properties come with incredible benefits you won’t find anywhere else. You truly can retire after a few years of successful rental investing, like Ashley and Kevin Thompson did. 

Just be prepared to work for it in the meantime.

How about you? Do you own any rental properties in your portfolio? Are you thinking about buying any to accelerate your path to early retirement or build more income in retirement? If not, what’s stopping you? Share your thoughts, plans, and experiences below.

G. Brian Davis is a real estate investor, landlord, personal finance writer, and co-founder of SparkRental.com. Check out SparkRental’s free landlord tools, which include a free video series for beginner rental investors, a comparison chart for rental property lenders, free webinars and more. 

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[Contributing Editor Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris’ writing has been featured in MarketWatch, Doughroller, Business Insider and RockStar Finance. He is also the primary author of the forthcoming book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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About Virgie Powell

Virgie B. Powell writes for Reiterment Planning and Tax Advice sections in AmericaRichest.

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