early retirement from rental investments

 

Why don’t more people dream of retiring young?  It could speak to how many people love their jobs, except that’s not true: 70% of people hate their jobs. More likely, most people just don’t think they can retire young.

Fortunately, anyone earning the median U.S. income can retire young if they want. But it requires discipline – not many people want to forego things like driving the fanciest car possible or living in the best house they can afford.

There is no shortage of personal finance bloggers on the web who have retired young. Some of them are quite excellent too; check out MrMoneyMustache.com or Retireby40.org for some good examples.

“Yeah yeah yeah, cut to the chase already! How much money does it actually take to retire young?”

Glad you asked. Let’s take a look at how the good ol’ 4% Rule holds up in today’s economy, and how rental income changes the math on its corollary, the 25X Rule.

 

The 4% Rule: A Quick Refresher

Rewind to the ’90s and a financial planner named Bill Bengen ran an interesting study: he analyzed stock market data from the previous 75 years and found that if retirees withdraw 4.2% of their nest egg each year, mathematically their savings is extremely likely to outlive them. This became simplified to the 4% Rule: retirees can pull out 4% of their savings each year to live on, and their savings should last at least 30 years.

This is called a “safe withdrawal rate,” and the concept is pretty simple. If the stock market rises by 7% on average each year, and you pull out 4%, and inflation peels off another 2%, then the 6% of your portfolio you’ve lost is still less than the 7% rise in value.

In this average-year example, your portfolio still rises in value by 1% in value! You can live forever on that nest egg, right?

On paper, yes. The problem is the stock market doesn’t rise by a uniform 7% each year – it drops by 23% one year, and surges by 29% another year, and wobbles its way upward by 9% the next year. This creates a risk called “sequence risk”: the risk that the stock market will crash within the first year or two of retirement. (We’ll dive into detail on sequence risk next week, and how rental properties can help you avoid it!)

 

Does the 4% Rule Hold Up in Today’s Economy?

“That’s all well and good Brian, but what if I live for more than 30 years after retiring?”

Good question. It has a lot of answers, most of which we’ll cover next week when we talk about sequence risk and how to mitigate it. But one answer we’ll get into below (psst: it has to do with rental income!).

“Does this 4% Rule even guarantee me those 30 years? It sounds like I could run out even before then!”

According to a study by T. Rowe Price, retirees have a 90% probability of their portfolios lasting at least 30 years, if they follow the 4% Rule.

“That leaves a 10% chance I’ll be in the poorhouse when I’m 95!”

Well, you should be so lucky to live that long, you cantankerous curmudgeon. But you can take comfort in the fact that over the last 150 years, there has not been a single 30-year stretch when someone following the 4% Rule would have run out of money in under 30 years. Financial planner Michael Kitces ran those numbers, not me – rest at ease.

And hey, most retirees use an asset allocation that only partially involves stocks. Bill Bengen assumed a 60% stocks, 40% bonds asset allocation. If you’re worried about a stock market crash, you can always throw your money in bonds. Or better yet, rental properties… but I’m getting ahead of myself.

The 25X Rule

Another way of looking at the 4% Rule is that it tells you how much you need to retire: 25 times your annual spending. If your annual spending is $40,000, then you need a nest egg of $1 million, if you want to withdraw 4% ($40,000) each year.

Annual Spending  x  25  =  Required Nest Egg

Note that spending is not the same thing as 25 times your annual income, and treating the two similarly is exactly why most people don’t retire young.

“So how does this look in real life?”

Let’s say Heidi wants to retire by 40, and she spends $30,000/year. By the 25X Rule, that means she needs $750,000 to retire.

Imagine she reaches her goal of $750,000, and her portfolio is made up of all stocks. Say her stock portfolio earns her a moderate 7% return this year, or $52,500. She didn’t work a day all year but still made $52,500, which is great! That’s $22,500 more than she spent, so her portfolio grew.

“Whoa there, what about inflation?” 

Heidi only withdrew $30,000 (4%) from her stock portfolio, the other 3% was reinvested. If the year saw “normal” inflation of around 2%, subtract that from her 7% return for a “real” return of 5%. Her nest egg is still 1% more valuable at the end of the year than when it started, even adjusting for inflation.

But what happens if the stock market crashes right after Heidi retires? Turns out you’re not the only one who asked. The Trinity Study looked at a wide range of theoretical scenarios, for someone like Heidi who invested their whole nest egg in stocks and retired at a 4% withdrawal rate.  (Spoiler alert: in almost all scenarios, Heidi’s nest egg lasted nearly indefinitely.)

Maybe the stock market crashed 18%. Or maybe it surged 23%. More likely, it grew in the historically average 7-10% range.

Granted, the last decade’s volatility has made some financial advisors more cautious. Many recommend factoring in the P/E 10 ratio before taking the full retirement leap, to avoid a crash right after you retire. Even going part-time and withdrawing less than 4% for the first year or two can make a huge difference in your stock portfolio’s chances.

I don’t know about you, but I invest with one eye on diversity, and don’t have my entire investment portfolio in stocks. Which is exactly where rental properties enter the picture.

 

How Rental Properties Change the Math

Say Heidi invested $50,000 apiece into three rental properties ($150,000 total investment). They rent for $1,000 apiece, and after subtracting out property taxes, landlord insurance, vacancy rates, maintenance and CapEx, Heidi is left with $500 apiece each month in profit. That’s $1,500/month total from the three properties, or $18,000/year in income from her rental properties.

Wait a second – Heidi just made more than half of her annual budget, but it cost her a lot less than she was planning based on the 25X Rule.  She invested $150,000 in rental properties, and it covers $18,000 of her $30,000 annual budget! The rest of her nest egg (in her stock portfolio) only needs to provide the $12,000 difference.

The math just changed dramatically. According to the 25X Rule, to safely withdraw $12,000/year she needs a stock portfolio of $300,000. She’s now hypothetically invested $150,000 in rental properties and $300,000 in stocks, for a total of $450,000.

Because of her rental investment properties, she dropped her required nest egg from $750,000 to $450,000. Hot diggity dog! (Heidi can use 1940s expressions because she’s now a proud retiree.)

Like stocks, Heidi’s rental investments may have a bad year, perhaps caused by vacancies or high repair costs. Or they may have had a great year with no repairs or vacancies. The important thing is that she’s properly calculated her average costs.

Unlike stocks, rents rise with inflation, so Heidi does not have to adjust for inflation when calculating her real returns on her rental investments. Double bonus.

 

real estate investing and early retirementThe Full Picture

So wait, why doesn’t Heidi buy nothing but rental investments for her retirement income then?  Diversity for one reason. Do you really want all of your eggs in one basket, when the entire income for the rest of your life is on the line?  And if we’re being honest, rental properties are not 100% passive income – they require some work, even with the best rental automation software available (cough).

But there’s another reason as well: when Heidi’s stock portfolio has a bad year, she simply draws more money from her portfolio.  When her rental properties have a bad year, she can’t draw more money from them – she’s left with whatever her net revenue was.  But with a mixed portfolio, she can draw money from her stock portfolio if she has a bad year with her rental properties, and invest more money into her stock portfolio when she has a good year.

Heidi can also invest in bonds, to add stability to her portfolio, but keep in mind that bonds suffer from inflation losses. High quality bonds may not give her a 4% real return, above the inflation rate.

Do you know the best part about retiring young? You can still work when and how you want, bringing in some extra income in the process so that you don’t need the perfect 25X nest egg. When you don’t need a job with a huge salary, you can go do whatever makes you happy… and still get paid for it. Tutor children. Do some consulting. Take on freelance work that you love. Teach a college course. Volunteer or add pro bono work to the mix. Travel and blog about it. Travel and work for a summer. Work at a winery a few days each week.

Retiring young doesn’t mean never working again, it just means being financially independent enough that you don’t need a high-octane job to continue living. And with a balanced investment portfolio, perhaps with a few keenly-chosen rental investments, you can retire far younger than you think.

How are you making out on your own road to financial independence?  We love stories of all stripes; failed attempts, missed opportunities, slow ‘n steady progress… tell us your experience in your retirement savings and rental investments!

 

 

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