Wealth vs. Saving – The Distinction
There are many different definitions of wealth. For this purpose I will define wealth as “a durable and perpetual source of significant income”. If you are planning on retiring, income is what you need. Many would consider one million dollars in the bank as wealthy, but let’s think of this one million as savings, not true wealth. Why am I making such a big distinction between money in the bank (Savings) and income (True Wealth)? Because income is now scarce, and it is income that that is true wealth.
Several decades ago bond yields or CD interest rates were around 6%. One could safely earn $60,000 of annual income from having one million in the bank. Today, you would earn less than $10,000 annually on that same million dollars. Imagine being a multi-millionaire and having only a poverty level income. Well you don’t have to imagine, this is the reality now.
Concept – The Goose and The Golden Egg
All investments can be broken up into two components. The underlying asset, the Goose, and the income the asset produces, the golden egg. Stocks are the Goose and the dividend from the stock is the Golden Egg. Similarly, apartment buildings are the Goose while the net rental income is the Golden Egg.
Problem – Traditional Retirement Plans Revolve around Savings not True Wealth (Income)
Traditional retirement income has you eventually eating the Goose. Saving for retirement has been made easy with large stock brokerages who can sell you stocks, bonds and advice. The government even encourages this with tax deductions. While, stock investment options are made convenient and easy, to invest in real estate you must venture off the beaten path. This takes time and effort, but the rewards are especially valuable in today’s low yield financial landscape.
Current Rule of Thumb for IRA Distributions (Eat the Goose)
There are two problems with the current retirement philosophy as it relates to today’s market. First, the standard retirement model has you bleeding away your capital and potentially running out of money before you die. Second, in today’s very low interest rate environment, bond yields and stock dividends are paltry. Currently, the 10 year treasury bond returns less than 1% and the dividend rate of the S&P 500 is just under 2%. If you were to have a blended account with stocks and bonds your income would only be around 1.5% of your portfolio. This simply isn’t enough income to retire on without eating into your capital.
The current rule of thumb for distribution of retirement savings is to withdraw about 4% of your nest egg per year. Simulation calculations say that your money will last you 90% of the time. I guess the other 10% of the time you just have to eat dog food. A decade ago, 5% was considered a safe withdraw amount, likely to drift down to 3%. But again, the whole retirement philosophy is flawed as it has you eating your goose. If you were to have a blended account with stock dividends at 2% and 10 year treasuries at 1% your income would only be around 1.5% of your portfolio. Clearly, we have a problem. There is a retirement crisis on the horizon.
Let’s say you have worked the last 20 years diligently saving and you have a $500,000 portfolio. Current investment advice says that you can safely (90% of the time) withdraw 4% of your portfolio a year for a whopping $20,000 of income, even less if you were to preserve your capital. Either way this plan just sucks! Today you can literally be a millionaire and be broke.
How does an apartment differ from a traditional retirement plan?
Let us look at an apartment building that I manage. The property is a 7 unit building with an estimated value of around 1.6 million. The gross rents are around $125,000 per year with expenses around $50,000 producing a net income of around $75,000. Notice in this real-life example, Net income is 60% of Gross Income with ongoing expenses at 40%, a good rule of thumb. Expenses include: maintenance, vacancy, management, taxes, insurance and utilities. Not the mortgage.
So what is so good about this investment relative to our IRA retirement savings? The quality and quantity of the income stream is MUCH BETTER. First off, the income stream is much larger. Secondly, you don’t eat the Goose and the Goose continues to grow with the rate of inflation, producing an increasing income stream. Finally, you can use leverage to increase capital growth early on and maximize income in later years. Exactly what a retiree needs.
Let’s first analyze the income stream. There is $75,000 of income on a $1,600,000 asset. This would be a yield of 4.7%. This is a pretty nice yield, especially when we factor in the stability and inflation resistant nature. This 4.7% yield would be comparable to the S&P 500’s current dividend yield of nearly 2%. Clearly the apartments income blows away stock market returns for an all stock portfolio. More realistically, if your portfolio included equal parts stocks and bonds then the total yield may only be 1.5%, only one third of the income from the apartment.
Why is it safer and more predictable?
In general, real estate is very boring and this is great news. Consider the history of stock and bond market returns. There have been 20 year periods of time when stocks had no capital growth. This would be devastating to your retirement plans if you retired on the eve of 20 years of no growth. Bond returns can be equally unpredictable. In the 1980’s you could have locked in on a 13% bond when throughout history, 4-6% have been more the norm. Today rates are 1% or LESS!. Should rates jump back up to historical norms, the bond value of your portfolio would be decimated. While real estate prices can be volatile, rents tend to move with about half the volatility of real estate prices, so any potential dips in rent would be minimal and likely not last for more than 3 years.
A big up side to real estate is that you can predictably and safely use leverage. In the above example there is $75,000 of yearly net income, or $6,250 a month. This cash flow would be enough to support a $1,300,000 mortgage at 4% interest, assuming a bank would let borrow that much. *Spoiler alert* they won’t.
Hypothetically, if you could buy this building with $300,000 down, the building would just break even after factoring in the mortgage payment. While break even is great, it is also kind of a bummer because you will spend $300,000 and technically won’t be making an income from the property. However, the wonderfully predictable part is that in 30 years the mortgage will be paid off and your income will be $75,000 in inflation adjusted dollars. “But I don’t want to wait 30 years to pay off the mortgage to have an income!” you say. Well this is also the great thing about rental property. Your rents will increase at a predictable rate while your mortgage stays the same. You will not have to wait 30 years to receive a predictable increase in rents resulting in positive cash flow.
Let us take the above example, a $1,600,000 apartment with a very small $300,000 down, a very aggressive scenario. To start, The $1,300,000 loan payment will be exactly equal to the positive cash flow of $75,000 per year. When will the building start to generate true wealth? Assuming a conservative 3% growth in rents and expenses, income becomes significant after only 5 years. (See table below)
| Year | Net Income | Mortgage | Positive |
|---|---|---|---|
| 0 | 75,000 | 75,000 | 0 |
| 5 | 87,000 | 75,000 | 12,000 |
| 10 | 100,800 | 75,000 | 25,800 |
| 15 | 116,800 | 75,000 | 41,800 |
| 20 | 135,500 | 75,000 | 60,500 |
You Don’t Have to Wait 30 Years to Retire!
As you can see in the above table, even with a large mortgage, the property will start cash flowing reasonably well at 10 years with over $25,000 of annual income and after 20 years the positive cash flow will be over $60,000. This income is durable and inflation protected. It is true wealth because you never eat the goose. The goose just gets fatter as you improve the property and rents increase.
What are the downsides?
Rental real estate is not liquid like stocks and bonds. You are stuck with what you bought. Changing up your investment is possible, but will not be something you want to do with any regularity.
It takes work. Learning the business of apartment ownership is no small task. In the above example, you get the privilege of putting down a minimum of $300,000 and don’t reap any real benefit for 10 years, all the while having to deal with the stress and hassle of being a landlord. Certainly not fun, but how much money would we need to save in the stock market to produce the equivalent of the $75,000 in cash flow from the apartment?
If you didn’t want to cook your Goose that laid the golden eggs and you wanted to preserve your stock portfolio, you would have to own $3,750,000 of stock in the S&P 500 for the 2% dividend to produce $75,000 in income. Or if you were willing to risk running out of money and accepted a 4% draw on your portfolio, you would still need to save $1,875,000 in stock. Either number is daunting and likely out of reach for most savers.
The downside is effort and work. Work to learn the rental market, funds to invest in the rental market and then the time to babysit and manage your investment. Not nearly as sexy as owning Tesla stock! The upside is income 2 to 3 times greater than stocks and bonds, with predictable growth. Coupled with the wise use of leverage, you actually stand a fighting chance of retiring with a reasonable income.
What are the additional upsides?
The first big advantage is that the underlying asset grows tax deferred. This allows your Goose to keep getting fatter without the government trying to eat your goose through taxes. The second big advantage is that you can borrow funds from it tax free while your tenants pay back the loan.
It is not for everyone
Being a landlord is a pain in the ass! It is stressful. It is not glamorous. It is about as exciting as watching paint dry. But it may be one of the few ways left to retire with a predictable income, hopefully, still safe from the grasp of the governments taxation and inflation theft. Though it’s hard work, for me it is certainly easier than starting a business like a restaurant, with less time and risk.
The Perfect Compliment to Traditional Retirement Savings
Stocks and bonds can be quite volatile. In addition, retirement savings distribution has your retirement savings depleted. An apartment building is exactly the opposite, it is slow, steady and more predictable, and one doesn’t eat the goose. It is the perfect complement to a portfolio of stocks and bonds.
How Old is Too Late to Consider Investing?
When you consider that it will take 30 years to pay off the mortgage, you might think that 50 years of age or even 60 years of age is too old. This may be the case. However, if you have at least 10 years left in the work force you can see that even a property that only just breaks even starts to make serious income after just 10 years. Often times people that do retire don’t just go cold turkey, so part time work can fill in the gap, until your apartment kicks in.
Hire Professional Management or Self Manage?
Hiring a professional management company will run around 6% of gross rents. There isn’t a right or wrong answer here. Just consider how you best spend your time and if your skill and desire aligns with that of being a property manager.
Are there any good deals out there?
Well not really. “You just got me all pumped up to buy an apartment and now you tell me that the above example would be hard to find?” Yes, this is true. The financial markets have been in desperate need of financial instruments that produce positive cash flows and have driven up the cost of apartments. It takes a lot of searching to find a property that can generate a 4% return or better. It takes effort to create a viable profitable business. It is possible, just not easy.
About the Author: John Dumke bought his first rental property at age 23, only 1 year out of college, has extensive experience managing rental real estate and evaluating investment returns. Have any questions about your unique situation? Please contact John at 562-572-2296 for your investment questions.