Today’s article is extra-nerdy. Pull on your Coke-bottle reading glasses and let’s run through a little bit of math.
Ready? Let’s go.
If you’re retiring on index funds, you might plan your retirement on the 4 percent withdrawal rule.
But if you’re retiring on rental properties, you could use the equivalent to a 6 percent withdrawal rule.
This holds true even if total returns on the two investments are the same.
Why? Two reasons: (1) the returns on a rental property bias towards an income stream rather than capital appreciation, and (2) rental properties don’t hold the same risk of withdrawing the principal.
If you’re thinking, “Ummm, Paula, I have no idea what you just said,” that’s cool.
Here’s a breakdown:
4 Percent Breakdown for Index Funds
Let’s assume your entire portfolio consists of stocks and bonds, split 50/50 into each bucket. According to the Trinity Study, an industry-shaking retirement study conducted by three Trinity University finance professors in 1998, you can safely withdraw 4 percent in Year One of retirement, and 4 percent adjusted for inflation every subsequent year, while maintaining a strong likelihood of not running out of money.
This means that a $1 million portfolio would allow you to withdraw $40,000 in Year One, and $40,000 adjusted for inflation every future year.
Of course, the portfolio would grow at a rate that’s higher than 4 percent. Let’s assume that the portfolio grows at the rate of inflation, which is 3 percent, plus it accumulates real growth (after inflation) of another 6 percent.
In this example, the portfolio enjoys a total return of 9 percent, but it’s risky for you to realize those total gains. Markets are volatile, and in retirement, your first objective is to not risk the loss of your initial principle. You don’t want to tap your nest egg in retirement. In order to curb this risk, you restrain your withdrawals to only 4 percent.
(As a side note, there are many modern retirement experts, like bestselling author and podcast guest Larry Swedroe, who believe that future total returns may be closer to 6–7 percent, which means that when it comes to safe withdrawal rates, “3 percent is the new 4 percent.” Eek. That’s a scary idea, but it’s worth considering. At any rate, that’s a different discussion for a different article.)
That’s the 4 percent breakdown for index funds. How does that compare to rental properties? Let’s take a look.
Rental Properties: A Comparison
Let’s take that same $1 million portfolio. You sell out of your stocks and bonds, and reinvest the entire balance into rental properties.
(BTW, I would never recommend doing that – I recommend diversifying between both index funds and rental properties – but let’s run with this thought experiment for the sake of example.)
You buy rental properties that meet the one percent rule, which states that the gross monthly income must be at least one percent of the initial purchase price. This means that your $1 million rental investment brings you $10,000 per month in gross rent, mortgage-free.
Of course, “gross revenue” and “net profit” are not the same thing. Your properties have overhead, including property taxes, homeowners insurance, repairs, maintenance, management, capital expenditures, and vacancies. These operating expenses follow the 50 percent rule, which states that half of your gross rent will go towards this operating overhead. This means you spend $5,000 per month on overhead, and the other $5,000 is your monthly net cash flow. That’s $60,000 per year.
That’s a supremely nerdy way of saying that the same $1 million will produce cash flow of $40,000 per year if it’s invested in index funds, but cash flow of $60,000 per year if it’s invested in rental properties.
In the world of rental investing, 6 percent is the new 4 percent.
What About Total Return?
Let’s conservatively estimate that the rental properties keep pace with inflation, but nothing more. That’s another 3 percent, which brings the total return on the properties to 9 percent.
(Since you bought the properties mortgage-free in this example, there are no additional returns in the form of equity growth through principal payoff.)
In this example, the total returns on the index fund portfolio and the rental portfolio are the same. But the rental returns bias towards cash flow, rather than appreciation, which gives you the ability to enjoy harvesting those returns at the 6 percent rule, rather than the 4 percent rule.
In addition, you don’t risk tapping the principal when you live on the cash flow from a rental property. The principal, which is the equity in the home, stays intact, as long as you don’t borrow against the equity and as long as there’s no major housing crash as there was in 2008 (which also crashed the value of index funds, as well.)
Imagine the concepts of growth vs. dividend. The rental properties are analogous to a stable, blue-chip stock that pays a 6% dividend, but only grows at the rate of inflation. Your index fund portfolio, by contrast, pays a much smaller dividend, but grows at a rate that’s higher than inflation.
The two baskets of assets may have the same total return, but those returns are expressed in different ways. The expression of the returns on a rental property are more suited to retirement. That’s why rentals are a great store of wealth; they’re a lower-risk and higher-cash-flow form of wealth preservation than equities.
(If those above few paragraphs sounded like “whoomp-whoomp” Charlie Brown’s teacher to you, don’t worry about it. I’m trying hard to write this in a way that’s not-too-jargony, but I think I need more coffee. The big-picture idea here is that in rental investing, 6 percent is the new 4 percent.)
Yeah, but I Don’t Have a Million Dollars!
If you’re thinking: “Great, Paula, but I don’t have $1 million in cash” – the percentages apply, no matter what amount we’re talking about.
Let’s say you have $100,000 in cash. You invest this $100,000 in index funds. You withdraw 4 percent, or $4,000, in Year One, and that same amount adjusted for inflation every subsequent year.
You invest this $100,000 into a single-family rental property in the Midwest, which you purchase free-and-clear. Your property manager rents it out for $1,000 per month, which is $12,000 per year. You spend $6,000 on operating overhead. You keep the other $6,000. The property value, and your rent, keeps pace with inflation in the following years.
It’s the same $100,000. In one example, it brings you $4,000 per year. In the other example, it brings you $6,000 per year.
That’s why I like rental investing. If you’re looking for the next “hot growth stock,” like Apple in 2005, go elsewhere. But if you’re looking for a stable investment with a strong dividend, rental properties are the way to go.
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