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7 ways rental properties can help you retire early
By G. Brian Davis, SparkRental.com Once upon a time, workers saved a nest egg and then retired over the course of a 40-50 year career. And hoped they didn’t run out of money before stepping in the bucket. This drawdown model raises all sorts of questions about safe withdrawal rates and how much you need to save for retirement. As you near retirement, you will also be forced to invest money in lower-risk, lower-return investments in order to reduce the return risk sequence (the risk of a market crash at the beginning of your retirement). You shouldn’t expect much help from Social Security either. A 2020 study by the Seniors’ League found that the purchasing power of benefits has fallen by 30% since 2000. Enter the following: rental properties. How Rental Properties Can Help You Retire Early While I do not intend to ever retire, I plan to achieve financial independence by the age of 43. I am currently 40 years old. Financial independence is the ability to retire and live on investment income alone. You can do it by building residual income from your investments. Don’t write off rentals as you build residual income and work towards your own financial independence and retirement. They offer impressive after-work income benefits. 1. Current Income When you buy a rental property, income is generated for you immediately. And never stop. Best of all, you don’t have to sell any assets. Because in the traditional nest egg model, you build a portfolio of paper investments like stocks and bonds and then gradually sell them to make money that you can live on every month. Which means that your wealth will shrink over time and you are at risk of running out of money. Rental properties are not associated with this risk due to their sustained passive income. On the contrary, real estate usually appreciates over time and increases your wealth higher rather than lower. And real estate values do not increase alone over time. 2. Rents rise, counteract inflation Rents rise not only to keep up with inflation, rents are also a main driver. That said, you don’t have to worry about inflation affecting your returns over time like you do with bonds. Imagine buying a bond at 5% annual interest. When inflation is 2%, your “real” return is only 3%. Which doesn’t exactly inspire you to pop champagne corks. In most cases, your rental cash flow and cash-on-cash return will increase over time – especially if you use leverage. 3. Leverage: The Power of Other People’s Money You can use other people’s money to fund most of your real estate purchase costs. Your money, your wealth. When you take up a rental property, your principal and interest payments are permanently blocked. Over time, your rental income will increase, but your loan costs will remain the same. Consider a quick example. You buy a turnkey rental property for $ 100,000 and borrow $ 80,000 for 30 years at 5% interest. This brings your principal and interest payment to $ 429.46. The home rent is $ 1,500 and your average total monthly cost is $ 1,100, so you have $ 400 monthly cash flow. This equates to a cash-on-cash return of 24%: $ 4,800 annual net rental income from your down payment of $ 20,000 = 24%. Five years later the rent rose to $ 1,950. However, your monthly mortgage payment remains at $ 429.46. Instead of making $ 400 a month in cash flow, you are now making $ 700 or $ 800 (unfortunately, your other expenses go up along with rents). In return, your cash-on-cash return has also increased. Now, if you earn a net cash flow of $ 700 per month, or $ 8,400 per year, that would give you a whopping 42% return on your down payment of $ 20,000. Which says nothing about the increase in the value of real estate in these five years. That is the power of using other people’s money to buy your own cherished, flowing assets. 4. Predictability of Returns When buying an index fund, you hope for the best based on average historical returns. But you don’t just hope for the best when you buy a rental property. If you calculate cash flow correctly, you will know exactly what rate of return you will get from it. You know the purchase price, you know the market rent, and you know or can accurately forecast all your expenses. For example, you know property taxes, rental property costs, and asset management costs. You know the vacancy rate in the neighborhood. You can accurately forecast the average annual maintenance and repair costs. That means you never have to make a bad investment if you run out the cash flow numbers accurately. 5. Control over return and risk In addition to being able to predict the return on rental properties, you also have some control over those returns. Control you don’t have at all when investing in stocks. You can improve the management of the property to reduce the vacancy rate and turnover rate. You can improve the quality of your tenants by renovating the property to attract better tenants. Incidentally, you can avoid bad tenants along with a thorough tenant screening. Just make sure you know how to read a credit report and that you look beyond the score to actual payment history. 6. Asset Class Diversification If all of your money is tied up in stocks, what if the stock market collapses? Real estate values and rents have little correlation with the stock market. They’re also much more stable. With a high chunk of your investment income from rentals, you don’t have to gnaw your nails every time the stock market collapses. This diversification into another asset class reduces your risk and exposure to an asset. And sure enough, you could buy REITs. However, as assets traded in the stock markets, they correlate more closely with stock prices than stationary real estate. Let the stock market go through its spins. As a real estate investor, you can sleep at night knowing that you have predictable residual income elsewhere. 7. Tax Benefits Among many other reasons to invest in real estate, there are also tax benefits. Every conceivable real estate-related expense is either deductible or depreciable. This includes expenses such as meals, travel and a home office that W2 employees can no longer deduct. Best of all, these deductions are “above the grain,” which means you can still use the standard deduction in your personal return even after subtracting those rental-related costs. Depreciation allows you to even deduct the cost of the building itself over time. You can deduct the cost of the building and the cost of any capital improvements for the first 27.5 years that you own the property. When planning your tax strategy, make sure you understand all of the tax benefits of rental properties. Disadvantages of rental properties Like any investment, rental properties have a reasonable proportion of risks and disadvantages. Initially, they are associated with extremely high entry costs. Even if you take out a rental loan, you will have to make a down payment. That alone usually costs you tens of thousands of dollars, which doesn’t tell you anything about closing costs. You can accept a gift to cover the down payment and even borrow the down payment with rental loans. But when you borrow it, that extra debt gobbles up your returns. Tying thousands of dollars on every single investment creates diversification problems. When you buy an index fund, you can spread $ 100 across hundreds or even thousands of companies. When you buy a rental property, you can invest $ 50,000 in a single asset. Rental investments also require a certain level of knowledge and skill. Investing without learning the ropes comes with added risk, to say the least. In contrast, anyone can put money into an index fund and easily mimick a stock index. Once you’ve bought a rental property, some day-to-day labor is required. Rental income is not entirely passive – even if you hire a property manager, you still need to manage it. After all, real estate is an inherently illiquid asset. Unlike stocks, it takes time and money to buy or sell. You can buy or sell shares in an index fund immediately with no commission. Real estate sales can take months and require payment of thousands of dollars in brokerage commissions. Before investing a dime in real estate, make sure you understand all of the risks. And expect hours of training, learning skills like accurately forecasting cash flow, getting great deals, identifying profitable markets to invest, and even investing in long distance calls when you don’t live near those markets. Final Thoughts If you are considering investing in rental properties for ongoing income, the first thing to do is start with house chopping. It involves buying a small apartment building to live in and renting out the other unit (s). You can use the rents from the other units to qualify for the mortgage and take out a traditional homeowner mortgage. Ideally, the rents of your neighboring units fully cover your monthly mortgage payment and you can live for free. This is terribly useful in retirement too. Contributor Profile: G. Brian Davis is a real estate investor and founder at SparkRental.com who helps middle-class people replace their day jobs with rental income. He and his family spend 10 months a year abroad practicing the travel and FIRE lifestyle he preached. For more information on Benzinga, click here for information on Benzinga’s option deals. An exclusive interview with Safe-TTop 3 Retirement Mistakes People Make in the Pandemic © 2021 Benzinga.com. 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