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,” you say. “How much money does it actually take to retire young?”

 

The 25X Rule

A growing consensus among personal finance experts: it takes a nest egg of roughly 25 times your annual spending.  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.

Why 25 times your annual spending?  Glad you asked.  If you pull out 1/25th of your nest egg in a given year, that makes your annual withdrawal rate 4%.  On average, you can expect to earn more than a 4% real return on your investments.  Thus, in an average year, you make more on your investments than you spend.  That’s worth reiterating: even after you retire, your nest egg is growing rather than shrinking every year.

That’s important if you’re going to potentially live for another fifty or sixty years after retiring!

You know what time it is: math o’clock.  But as always we’ll keep it simple.

 

How It Looks in Real Life

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,” you say.  “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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