In the classic 20th Century retirement model, people saved and invested money in stocks and bonds to create a nest egg. Once they retired, they gradually sold off those paper assets to generate enough income to live on.
It left a lot to be desired, as a retirement strategy.
First, it forced retirees to set a withdrawal rate – the rate at which they drain funds from their portfolio – with the hope that they don’t run out of money before they kick the bucket. Second, it left retirees vulnerable to “sequence of returns risk”: the risk that the market crashes early in their retirement, decimating their portfolio before it had a chance to build a healthy buffer.
Which resulted in a third huge disadvantage. To mitigate sequence of returns risk, investors moved their money out of high-return stock investments and into lower-risk, lower-return bond investments as they got older. It required them to save more money to reach the same nest egg.
And that was back when Social Security paid higher benefits, too. A 2019 study by The Senior Citizens League found that the buying power of Social Security benefits declined 33% from 2000-2018.
All of which make excellent reasons to diversify your retirement investments and add real estate. Rental properties play a huge role in my own retirement planning, because they bring so many advantages for retirees.
As you plan for your own various income streams in retirement, consider the following advantages to including rental properties in your portfolio.
Advantages To Including Rental Properties In Your Portfolio
1. Ongoing Income Without Having to Sell Off Assets
Rental properties work like the golden goose: they keep laying golden eggs every month in the form of ongoing income.
You don’t need to sell off any assets to produce that income, to slaughter the goose. That means you don’t need to worry about “safe withdrawal rates” like the 4% Rule with your rentals, which in turn means you don’t have to worry about sequence of returns risk with your rental properties.
In fact, with rental properties your net worth typically rises over time, rather than falls. Real estate tends to appreciate over time, even as your tenants pay down your mortgage for you.
Rental properties generate “forever income” that continues streaming in until the day you sell them. Or until you shuffle off this mortal coil, should you decide to keep your golden geese indefinitely.
2. Returns Adjust for Inflation
Imagine you buy a US Treasury bond that pays 3% interest. If inflation runs at 2%, then you only earn a net return of 1%; not exactly a thrilling return on investment.
When you invest in a rental property, you can (and should) raise the rent every year to keep pace with market rents. And not only do rents keep pace with inflation, but historically US rents have outpaced it. In fact, rents make up a primary driver of inflation.
That means that rental property returns tend to get better over time, not worse.
3. Predictability of Returns
When you buy a stock or index fund, you hope for the best based on historic returns. When you buy a rental property, you forecast the exact return you can expect to earn each year.
You know the purchase price, you can accurately pinpoint the rent through market research tools like Rentometer, and you can accurately forecast all expenses. For example, say you buy a property for $100,000 that rents for $1,300. You estimate the expenses as follows:
- Vacancy Rate: 4% (one month vacancy every other year)
- Repairs & Maintenance: 13%
- Property Management Costs: 12% (8% ongoing management, plus a one month tenant placement fee every other year)
- Property Insurance: 8%
- Property Taxes: 10%
- Administrative, Bookkeeping, Miscellaneous: 3%
- Rental Property Loan: $0 (you bought in cash)
All in all, that comes to 50% of the rent going to non-mortgage expenses. In this case, you earn an average cash flow of $650 per month, or $7,800 per year. That means an annual return of 7.8% on your $100,000 investment.
Keep in mind that these expenses are based on long-term averages of expenses. In most months, you won’t have any repair or maintenance costs. Then one month you’ll get hit with a $3,000 repair.
4. More Control Over Returns & Risk
You have virtually no control over a stock’s performance and returns. In most cases, your only option is to sell the stock if you don’t like its returns.
With rental properties, you control the management, and you control risk mitigation. Rental properties come with three main risks:
- Risk of the tenant defaulting on the rent,
- Risk of the tenant damaging your property, and
- Risk of extended vacancies.
Real estate investors can and should mitigate these risks in several ways. First, they should intentionally buy properties in areas with consistently strong demand. That protects against vacancies, and it ensures a wide pool of rental applications.
With a wide pool of rental applications, landlords can choose the best qualified, most reliable renters. That in turn protects against rent defaults and property damage. And, of course, your property insurance also protects you against damage.
Investors can now protect themselves even more thoroughly with rent default insurance. For a few hundred dollars per year, landlords can buy insurance that pays them the rent if the tenant stops paying.
5. Leveraging Other People’s Money Can Improve Your Returns
When you borrow a rental property loan, you leverage other people’s money to build your own portfolio of appreciating assets.
In the example above, you wouldn’t need $100,000 to invest. You’d likely need $20,000 as a 20% down payment.
Granted, the monthly payment on the rental property loan would reduce your monthly cash flow. But leverage can actually increase your cash-on-cash returns: the returns you earn on your personal cash invested.
Say you borrowed $80,000 for a 30-year mortgage at 6%. That puts your monthly mortgage payment at $479.64, and reduces your monthly cash flow to $170.36. Annually, that comes to $2,044.32, or a 10.2% return on your $20,000 cash investment (compared to a 7.8% return if you bought in cash).
Over time, your returns improve even faster when you use leverage. Your monthly mortgage payment remains fixed over time, even as you raise your rents 2-5% per year. That gap between your fixed mortgage payment and your rising rents accelerates and compounds over time, increasing faster than the overall pace of rent hikes.
All the while, your tenants pay down your rental property loan balances for you. Even as you still earn cash flow every month. And eventually, the day comes when your loan disappears entirely, causing your monthly cash flow to skyrocket.
Real estate investments help diversify your investment portfolio, of course. Instead of having all your investments in stocks and bonds, you add a third asset class.
An asset class that largely moves independently from the stock and bond markets.
When a stock market correction comes along, you can lean more heavily on your rental income, perhaps deferring maintenance or incentivizing tenants to renew their leases. When the stock market does well, you can lean on it more and invest money back into your rentals. But by having your nest eggs in many different baskets, you reduce your month-to-month dependency on any one asset.
Even within your real estate portfolio, leverage helps you diversify your real estate investments. Continuing the example above, if you have $100,000 to invest, you could buy one $100,000 property in cash – or you could buy five $100,000 properties with $20,000 down on each, covering the rest with rental property loans.
7. Tax Benefits
Rental properties come with a slew of tax deductions. And you can deduct all of them “above the line,” independent from your personal itemizing or use of the standard deduction.
You can deduct or depreciate your closing costs, your maintenance and repair costs, your property management costs, your advertising costs, your insurance costs, your travel costs, and every other conceivable expense related to owning or managing your rental properties. If you take out a rental property loan, you can deduct the interest on that too.
You can even deduct for paper expenses like depreciating the property’s cost itself. And if the day ever comes when you want to sell, you can use a 1031 exchange to defer paying taxes on your gains.
Best of all, you can still take the standard deduction for your personal returns. Your rental property income and expenses go on a separate schedule (usually Schedule E), and don’t require you to itemize your personal deductions.
Downsides to Investing in Rental Properties
While I love rentals, they come with their own unique downsides that all investors need to understand before shelling out thousands of dollars.
First, they require knowledge and skill to invest in, unlike stocks. You can buy low-cost index funds that give you broad exposure to US and international stocks, that just mimic the broad indexes. In today’s world, you don’t even need to pick those index funds yourself; you can open an account with a robo-advisor service and they pick funds for you based on your age, goals, and risk tolerance. I personally use Charles Schwab’s robo-advisor service, which is free, but there are plenty of other outstanding options available on the market.
Beyond skill, investing in real estate also requires labor on your part. It takes work to find good deals, to arrange a rental property loan, to manage the property (if you don’t outsource it to a property manager). Contrast that against your robo-advisor just automatically deducting money from your checking account every two weeks and investing it on your behalf.
Third, real estate is notoriously illiquid. It costs a great deal of time and money to buy or sell it. Stocks, on the other hand, you can buy or sell instantaneously, often with no commission.
Finally, real estate comes with its own diversification challenges. It usually costs tens of thousands of dollars in cash to buy a single property, even when you take out a rental property loan and only put down 20%. In other words, each property requires a large cash commitment, unlike index funds which let you spread a small amount of money across hundreds or even thousands of different stocks.
Rental properties by themselves do not make a balanced or diverse portfolio for retirement income. But then again, I would argue that neither do stocks or bonds by themselves.
As you plan for retirement, or perhaps financial independence at a younger age, start by setting a target monthly income. Then brainstorm different streams of passive income that you can combine to create it.
For example, say you want $5,000 in monthly income in retirement. Perhaps $1,500 of that comes from stocks, and another $500 comes from bond interest. You could bring in another $1,500 from rental property cash flow and the final $1,500 from Social Security.
As someone pursuing financial independence (FI) at a young age, my income plan looks different. I’m not counting on Social Security at all, but I do plan to continue earning post-FI income from passion projects for many decades. Because I have rental income and income from passion projects, I don’t have nearly as much to worry about from sequence of returns risk, so I don’t have to accept the low returns of bonds.
Instead, my own post-FI income sources look something like this:
- Dividends from Stocks: 20% of monthly income
- Rental Cash Flow: 40%
- Private REITs & Notes: 10%
- Passion Project Income: 30%
I plan on continuing to work on passion projects for several decades after “retiring.” Because I’m not selling off any stocks or properties, they continue appreciating and growing in value. When and if the day comes when I no longer feel like working on passion projects, I can always start selling off stocks, or go on Social Security.
Stop thinking of your retirement solely in terms of your nest egg. Instead, start thinking holistically about combining many diverse income sources, including income from both real estate and passion projects.
How do you plan to generate income once you reach financial independence or retire? Does real estate play a role? Share your thoughts below!