Safe Withdrawal Math with Real Estate Investments – SWR Series Part 36

Welcome to another installment of the Safe Withdrawal Rate Series. This one has been requested by a lot of folks: Let’s not restrict our safe withdrawal calculations to paper assets only, i.e., stocks, bonds, cash, etc. Lots of us in the early retirement community, yours truly included, have at least a portion of our portfolios allocated to real estate. What impact does that have on our safe withdrawal rate? How will I even model real estate investments in the context of Safe Withdrawal and Safe Consumption calculations? So many questions! So let’s take a look at how I like to tackle rental real estate investments and why I think they could play an important role in hedging against Sequence Risk and rasing our safe withdrawal rate…

Before we get started, though, I like to give shoutout and endorsement for a neat personal finance planning tool: NewRetirement.com. Steve Chen, the founder of NewRetirement was on the ChooseFI podcast last week (starting at around the 39:40 mark) to talk about his product and I thought I’d quickly weigh in on that discussion. What I like about the New Retirement planning tool is that will do several tasks that I don’t offer with my Google toolkit:

  • Planning the path toward retirement. With my Google Sheet, I only cover the simulations starting at the start of retirement. But I know that lots of people in the FIRE community are years, maybe even a decade or more away from FIRE and would benefit from a tool like NewRetirement.
  • A much easier interface than my Google Sheet. You can enter a lot of the inputs through a Q&A format at the beginning and all of the inputs are factored into the subsequent calculations.
  • Much more comprehensive tax planning. The tool is a one-stop-shop for modeling Roth conversions, keeping track of Required Minimum Distributions and it estimates federal and state(!!!) taxes over time. That would require a lot of “hacking” in my Google Sheet, but here you have it all integrated into one single tool. Pretty neat!
NewRetirementScreenshot01
New Retirement Screenshot: Tracking cash flows over time: income (top) and expenses (bottom), factoring in RMDs, taxable drawdowns, Social Security, taxes, etc.

If you find this interesting and a useful complementary tool to my Safe Withdrawal Rate toolbox, please check it out —> at this link <— and you can use the “PlannerPlus” tool for free for two weeks (afterward $6/month, billed annually). For the record, this is an affiliate link (see disclaimers here), but if you know my site you’ll agree that I’m very stingy with affiliate endorsements. I reject 99% of all affiliate link offers and I only recommend services that I really enjoy and use myself (e.g., AirBnB, M1Finance, etc.). Oh, and while you’re there, also make sure you check out his Steve’s awesome podcast, including episodes 6 and 32 with yours truly.

 

But back to the main topic for today…

100% Real estate portfolio – no mortgage

Let’s start with a relatively simple, albeit slightly unrealistic case. Imagine our sample retiree has a $1.5m real estate rental portfolio, completely debt-free. Imagine furthermore, just for a minute, that our final asset target is exactly 100% of the initial net worth. If we assume that our rental properties maintain their real, inflation-adjusted value over time because we repair, maintain and update the properties regularly then this case becomes trivial: your safe consumption rate is exactly equal to your rental “Cap Rate“, defined as your Net Operating Income (NOI) divided by the value of the property. The emphasis here is on the word “net“! Your NOI is defined as your Gross Rental Income net of all those pesky costs that go out the window, such as property taxes, insurance, repairs, maintenance, utilities, management (if applicable), vacancies, delinquencies, etc. For more information on this calculation, please check out “Cap Rate Explained (And Why It Matters With Rental Properties)” on the excellent “Coach Carson” blog.

If we assume a 4% cap rate, then your safe consumption rate is exactly that: 4% or $60,000 every year. And if we further assume that the rental income keeps pace with inflation, then your rental property portfolio will exactly satisfy your retirement cash flow needs: a level consumption for the duration of your retirement and the capital preservation target at the end of the retirement horizon. Sweet! (Side note: If you think that a 4% cap rate is way too conservative, please bear with me. I’m fully aware that many real estate investors will target significantly higher rates. But I like to be on the safe side and demonstrate that even with this underwhelming rental return, this asset class is still extremely attractive compared to a 100% paper asset portfolio! Paula Pant at Afford Anything goes through an example of a rental with a 17% Cap Rate!)

But what if your bequest target is only 50% of your initial net worth, i.e., you like to explore how much you can consume on top of that cap rate if you’re comfortable leaving less than your current net worth to your heirs? Or leave nothing to your heirs?

Actually, before we even get into the “how much” we’d first have to consider the “how!” How should we (partially) liquidate our rental real estate over time? Well, two options jump to mind here:

  1. You sell half of your properties over time and use the proceeds to fund the additional consumption.
  2. You keep the properties but leverage your properties, i.e., you’d slowly go into debt and target a final loan-to-value ratio of exactly 50%. So, this would involve acquiring mortgages and/or tapping lines of credit over time.

Method 2 seems to have several important advantages:

  • A mortgage or home equity line will most likely have a lower interest rate than your expected real estate return. Think about it this way, the opportunity cost of selling your properties is your real rental yield, 4% (real) in this case. But a mortgage or equity line will likely have an interest rate in the neighborhood of 2-3% above inflation. For example, at the time of writing this, CPI inflation is running at around 2% and you can get a 30-year fixed-rate home mortgage for under 4% and a HELOC for under 5% p.a.
  • Tax planning: Selling appreciated rental properties will trigger capital gains taxes. It’s ideal to hold on to the properties and then bequeath them to your heirs who will then enjoy the so-called step-up basis, i.e., they can walk up the cost basis to the market value at the time of your death.
  • Your real estate holdings are likely too “lumpy.” It’s much easier to simply draw on an equity line, pulling out exactly how much you need every month to pay the bills. On the other hand, it’s much harder to sell $5,000 worth of real estate every month.

Of course, there are also some caveats. Most importantly, we can only mortgage our rental properties up to a limit. In the extreme case, where you plan to completely liquidate your net worth over 30 years, you will probably run into leverage constraints. Specifically, you’ll have trouble getting a 100% mortgage in the end. So, for a zero or even very low final asset target you may have no choice but to – at least partially – liquidate your real estate holdings. But with a 50% target, you’re probably safe to keep and leverage your rental portfolio.

So, how much can we extract out of the rental portfolio if we’re happy to walk down our net worth? It’s pretty easy to compute in Excel, utilizing the Microsoft Excel PMT function. If we assume a 3% annual real interest rate on the line of credit we’d calculate:

=PMT(0.03/12,360,0,-750000,1)

The inputs in this function are 1) the monthly interest rate (use “1.03^(1/12)-1” if you prefer, not much difference in the results), 2) the term, i.e., number of months, 3) today’s value of the debt (i.e., zero), 4) the future target value, i.e., negative $750,000, and 5) finally the input “1” to indicate that the withdrawals occur at the beginning of the month.

In this case, with a 3% real interest rate on the loan, we could tap an additional $1,284 per month or over $15k per year to factor in the partial depletion of our net worth over the 30-year retirement horizon. That’s pretty neat! We’ve just increased the safe “withdrawal” rate from 4% to 5%! In the table below I also display the results of the formula for different real interest rates ranging from 1% to 5%. Also, notice that this formula is “linear” in the final real debt target. So, for example, if our sample retiree likes to target a $1m final net worth, i.e., liquidate only $500,000 of the rental portfolio, you’d get only two-thirds of the additional consumption.

SWR-Part36-Table01
Amortizing the excess final real estate value over 30 years for different real interest rates.

That’s one of the beautiful features of real estate investments. You can pretty easily read off your safe “withdrawal” rate if you know your net rental yield. And then you simply raise your safe consumption rate by simply amortizing the portion of real estate equity you like to liquidate over time! Both are relatively simple calculations and require no advanced simulation tools!

100% Real estate portfolio – with a mortgage

In the second case, let’s still maintain the assumptions of zero other (paper) assets. But let’s now assume the rental properties still have mortgages. Specifically, let’s assume our sample retiree now has a $3m rental real estate portfolio with a combined $1.5m mortgage debt, so the total net worth is still $1.5m as before. Also, assume that the mortgage has a 4% (nominal) interest rate and a remaining 20-year term. This real estate investor now faces a cash flow problem. Specifically, your $3m portfolio generates a $120k per year net operating income but you’d still have to pay the mortgage. The $1.5m combined mortgage at a 4% annual rate for 240 months will cost you $9,089.70 per month (use “=PMT(0.04/12,240,-1500000,0,0)” in Excel), or just over $109k per year. That leaves you only $11k a year to live on!

Notice of course, that the cash flow improves a little bit between months 1 to 240 because the mortgage payments stay constant in nominal terms while your real rental income keeps up with inflation, so with an assumed annual inflation rate of 2% your net cash flow rises to about $45k per year or about a 3% rate compared to the initial portfolio. Of course, after you pay off the mortgages your cash flow jumps to $120k a year (8% of the initial net worth) for the last ten years and you have a $3m real estate portfolio with no mortgage at the end of your retirement horizon, so you doubled your net worth!

SWR-Part36-Chart01
Net cash flow of the rental portfolio

That sounds like a bit of a lopsided cash flow pattern for most retirees. But a lot of real estate investors who asked me about advice on whether they are ready to retire face exactly this cash flow problem. So, what is a retiree with a preference for flatter spending pattern in retirement supposed to do? Pretty straightforward: this is also the perfect application for a line of credit and/or mortgages. I built a spreadsheet to determine what kind of flat consumption profile, financed through a line of credit, would exactly hit a $1.5m final net worth. It turns out that target is $81,300 per year, or about 5.42% of the initial net worth. So, you’d draw on the HELOC for 20 years, then (partially) pay back the balance after your rentals are mortgage-free (though not HELOC-free!).

SWR-Part36-Chart02
Draw on the HELOC during the first 20 years, then start paying back in months 241-360 to generate a flat consumption profile over the entire 360-month retirement horizon.

With this method, you’d hit a HELOC level of just around $1.5m (real) at the end of the 30-year retirement, so, you’d have kept your Net worth level about where it was at the start, but you smoothed out your consumption level to a completely flat profile. And the level is even slightly higher than in the unleveraged version: 5.42% instead of 5.00%. Makes sense because you get a fixed safe return of 4% (real) from the rental portfolio but you lever that up with debt at a 3% real interest rate. The beauty of leverage!

SWR-Part36-Chart03
Real, inflation-adjusted Net Worth over time.

Real estate plus paper assets

Much more realistic than the 100% real estate portfolios we looked at in the sections above would be a mixed portfolio: Most real estate investors will likely still have sizable paper asset portfolios. And a lot of paper asset fans diversify with a sizable portion of real estate assets, yours truly included.

Then, how do we implement real estate in the Google Sheet I created? And how much of a benefit do we get from an allocation to real estate? Let’s look at the following case study:

  • A retiree has a 30-year horizon, a $1.5m initial portfolio value and targets a 50% final target value. Again: this could be traditional retirees who like to leave half of their net worth to their heirs. Or early retirees who plan a two-stage retirement, i.e., an initial phase living entirely off their assets, but then have pensions and Social Security and like to keep half of their assets to generate income to supplement their second half of retirement.
  • The paper asset portfolio is invested in 75% stocks and 25% bonds.
  • We look at five different initial portfolio allocations (all with a $1.5m initial net worth):
    • Case 1: the base case without any real estate. The entire $1.5m portfolio is paper assets. This is just for comparison to gauge how much we can gain from allocating to real estate!
    • Case 2: A $500k real estate portfolio, mortgage-free. Plus $1m in paper assets.
    • Case 3: A $1m real estate portfolio, mortgage-free. Plus $500k in paper assets.
    • Case 4: A $1m real estate portfolio, with a 50% mortgage. Plus $1m in paper assets.
    • Case 5: A $2m real estate portfolio, with a 50% mortgage. Plus $500k in paper assets.
  • Throughout we assume again that the mortgages have a 4% (nominal) interest rate, with 20 more years to go.
  • And again, throughout I assume that the Cap Rate is 4% and the value of the rentals and the rental income both exactly keep up with inflation.
SWR-Part36-Table02
Real Estate plus paper asset assumptions.

Before I even run any SWR simulations, we can already make a few observations:

  • The final Net Worth target (50% of the initial = $750,000) implies that in Case 2 we should target a $250k final paper asset portfolio value. So, this case boils down to a scenario we’ve already studied before, i.e., a 25% final value target.
  • We already know that cases 3 to 5 will all have to utilize selling properties and/or borrowing against them. That’s because the final value of the RE portfolio in all three cases ($1m, $1m, $2m, respectively, after paying off the mortgage) is higher than our $750k Net Worth target. Since we can’t “short-sell” the paper portfolio to the tune of $250k, $250k, and $1.25m, respectively, we’d probably need to use a line of credit to tap the equity in the rental units and/or sell a portion of the rentals before the end of the 30-year retirement horizon.
  • One way to tap the equity is to use a line of credit. I assume a 3% real rate (so, 3% on top of 2% inflation).
    • In case 3, I assume we tap the HELOC over time to the tune of $1,000 every month.
    • In case 4, I assume we draw $2,000 from the HELOC for as long as we still pay back the mortgage, after which we start paying back $2,000 a month
    • In case 5, I assume we draw $4,000 from the HELOC for the duration of the mortgage, then pay back $3,000 every month
  • In each case, we’re then able to push the final real estate equity value below $750k so we avoid the issue with the negative paper portfolio at the end of the retirement horizon. In cases 3 and 4 we’d end up with a roughly 60% loan-to-value ratio and in case 5 with just under 70%. I think that’s potentially pushing the leverage constraint, so this might necessitate liquidating a portion of the rental portfolio before the end.
SWR-Part36-Table05
Tapping the home equity in the rental units to push the final RE equity value below $750k.

So, let’s look at the safe withdrawal rates case by case. I used the SWR Google Sheet and “hacked” the Supplemental Cash Flow tab to accommodate the different real estate assumptions. Again, for the original Google Sheet, check out Part 28 of this series. For the sheet with the rental real estate calculations, please see this sheet:

—> Rental Properties – SWR Sheet <—

As always: Please save your own copy. You won’t be able to edit my clean copy posted on the web! 🙂

So, how do we implement the real estate investments in the cash flow sheet? It’s really straightforward. All rental investments in cases 2 through 5 can be expressed as nominal and real supplemental cash flows in the tab “Cash Flow Assist” – see here for the parameters in Case 5:

SWR-Part36-ScreenShot01
Supplemental Cash Flow parameters in Case 5.
  • The rental income is 4% of the gross rental value ($80,000 p.a. = $6,666.67 per month)
  • The initial rental investment shows up as a negative $1,000,000 flows (= $2m investment net of $1 mortgage) and the sale of the properties in month 360 shows up as a positive flow again: +$2,000,000.
  • The mortgage shows up as a negative $6,059,80 nominal flow for the first 240 months.
  • Tapping the HELOC: positive amounts indicate you borrow from the HELOC, negative means you pay back the mortgage. I assumed that the HELOC interest rate is 3%+inflation, so roughly 5% in today’s environment, see below
SWR-Part36-ScreenShot02
HELOC parameters: Borrow $4k per month for the duration of the mortgage payments, then pay back $3k per month.

So, let’s look at the results. I start with the fail-safe consumption targets by decade, see the table below:

  • As expected, you get the lowest sustainable consumption levels in the 1920s, right before the Great Depression and the 1960s due to the flat performance in the late 60s and early 70s and the bad recessions that followed taking down both stocks and bonds.
  • Without any real estate holdings (Case 1) your safe withdrawal rate is only 3.32%, or just under $50k. That’s really underwhelming but as expected. If you’re unlucky and retire right at the peak of the stock market, Sequence of Return Risk will push down the sustainable withdrawals to significantly below 4%. The 4% Rule looks not so safe anymore!
  • Adding even modest levels of real estate vastly improves the sustainable consumption amounts. That makes perfect sense! The unleveraged real estate portfolio had a safe retirement income rate of about 5% (4% for capital preservation, and 5% taking into account partial depletion of the assets) and 5.42% with 50% initial leverage. So, it’s no surprise that mixing in real estate will improve the results.
  • Specifically, going from zero real estate to one-third and two-thirds real estate without leverage (cases 2 and 3) will raise your fail-safe amounts by 12% and 36%, respectively. That’s
  • Adding leverage further improves the results. Going from Case 2 to Case 4 or Case 3 to Case 5 increases the fail-safe withdrawal amount by almost 20%. So, Case 5 offers a 63% improvement in the fail-safe consumption amount. Very impressive! And that’s with a relatively modest cap rate of 4%!
SWR-Part36-Table03
Fail-safe consumption targets by decade in the 5 cases. In real, CPI-adjusted dollars (top) and in % of the initial net worth (bottom).

We can also display the failure rates of different initial withdrawal rates. Again the same picture. Failure rates greatly improve when shifting the portfolio to real estate. Notice the large the failure rates of the all-paper portfolio when using a 4% or even 5% initial consumption rate (12.19% and 35.31%, respectively), especially conditional on an elevated CAPE ratio (32.53% and 51.57%). The higher the real estate allocation, the lower the failure rates under the 4% Rule. It’s also noteworthy that the failure rates of the 5% Rule don’t exactly improve in Case 2 and Case 3 because the real estate portfolio doesn’t exceed the 5% withdrawal rate. To get a noticeable difference in the 5% failure rates you’d need to replace your paper assets with an asset that has a higher than 5% SWR, i.e., leveraged real estate as in cases 4 and 5 in this numerical example.

SWR-Part36-Table04
Failure rates of the 4% and 5% Rule. All starting dates vs. elevated CAPE ratios (CAPE>20).

A few caveats

  • I modeled the real estate portfolio as a completely risk-free asset here. That doesn’t mean that it is actually risk-free. Ask yourself, if we have a repeat of a Great Depression or the 1970s stagflation or a Great Recession, are you sure that your rental income won’t take a hit? Most real estate investors will obviously budget for some vacancies and delinquencies but the losses during an economic downturn may be much larger than you budgeted. Case in point: a lot of real estate investors got burned, even wiped out in 2007-2009.
  • In most of the country, a 4% Cap Rate seems quite low. But looking at our neighborhood, Vancouver and Camas in Southwest Washington State, that 4% rate looks unattainable. Gross rental yields are around 7%, maybe 7.5%. Once you subtract all the overhead you’ll be below 4%! So, forget about looking through the MLS for attractive rental properties. To raise the cap rate to an acceptable level you’d have to go off-market, e.g., take your chance with a foreclosure, go through wholesalers, etc.
  • It’s conceivable that in a repeat of the 2007-2009 recession and financial market meltdown, you’ll have trouble getting a line of credit. Home prices will be depressed and banks will tighten their lending standards. You can’t borrow against your home equity and you don’t want to sell at depressed prices either. So, just like a paper portfolio is exposed to Sequence Risk, your real estate portfolio may face an analogous risk and might force you to tighten the belt if the economy goes South! As juicy as the extra returns from leverage may look like, they may not be worth the additional risk!
  • A passive paper portfolio will take much less work than a real estate portfolio. Sure, you can hire a management company but that will eat into your profits. If you’re a hands-on landlord, expect phone calls about clogged toilets on Christmas Day!
  • Real Estate will clearly raise your “fail-safe” withdrawal rate. But it’s also very likely that the bull market keeps chugging along and your paper assets will outperform real estate. So, the potential protection of the downside may come at the cost of giving up a bit of the upside. Not a fatal problem but still worth pointing out!

Real Estate investments, ERN-style

People often ask me how I personally invest in Real Estate. My wife and I invest through Private Equity funds. It’s a form of crowdfunding that has been around since before the internet and before crowdfunding platforms became cool. The advantage of this route is that it’s a hands-off, passive approach for us.

The disadvantage is that we have no control over the investments and most importantly over the cash flows. Funds will pay regular (quarterly) dividends but we have no control over when and how much. The return of capital is also completely unpredictable. You can kiss your money goodbye for around 7-10 years! The minimum investment is also not exactly peanuts, usually $100k to $250k per fund. But for that, we get a share in a large fund – sometimes more than $100m in investor equity – that will diversify over several multi-family properties, so we’ll have plenty of diversification over several properties even different cities and states.

I will probably write a more in-detail post about the Private Equity route and our experience at a later date.

More info about the providers we use (only for accredited investors):

Conclusion

Real estate is an attractive asset both for folks trying to achieve financial independence but also for generating income in the “withdrawal” phase. I can’t go through all the different possible scenarios for how people might have implemented real estate in their portfolio. You’d have to get your own hands dirty to run your personalized analysis. But in the limited time and space I have here, going through some simple examples, the results certainly look promising. Even with relatively modest return assumptions, real estate looks like a very attractive asset to generate reliable and stable income in retirement. Real Estate certainly works as a standalone asset but also “plays well” with the paper assets in our portfolio.

Thanks for stopping by today! Please leave your comments and suggestions below! Also, make sure you check out the other parts of the series, see here for a guide to the different parts so far!

Title Picture Source: Pixabay.com

36 thoughts on “Safe Withdrawal Math with Real Estate Investments – SWR Series Part 36

  1. Thank you for the fantastic and well thought out information, as always! A pleasure to read.

    Which private equity funds/firms do you use? If you don’t mind the question….

      1. Thanks for this! I would love to hear your thoughts on why you picked those companies and why you didn’t work with others.

        1. There are many companies out there. And add to that the gazillion providers on the crowd-sourcing platforms.
          I liked the two provierds because they’ve been around for long enough so I’m sure they survived multiple business cycles.
          Also I initially met them because I knew some of the people working there so I had more confidence that this isn’t some Bernie Madoff scam… 🙂

      2. Great article and I’m in the process of adding a few single family rental properties to my portfolio for exactly the reasons you mention (although I may not have been able to articulate them as precisely). I would like to further diversify with potentially more passive options. Would you mind also share the links you mentioned? Thanks in advance, Tim

    1. Any tips for a 50 year old that plans to retire in 4 years that currently owns no real estate but has $600k of invested assets (half in tax advantaged accounts). Can anything be done if you don’t already have 50% equity in a property portfolio?

      1. The problem you might face is that you might have to liquidate the taxable assets with large capital gains. Probably it’s easier to organically get into RE over time, one small property at a time. It’s hard to shift large amounts all at once when you retire.
        Take a look at the two RE Private Equity proviers I mentioned above. They accept $100k minimum investments if interested.

  2. Big ERN,
    Always a pleasure to read your sage analysis.

    We have held individual rental properties for almost 20 years as part of a diversified portfolio. Overall, very happy with how things have worked out financially. With all the hysteria and market reaction to COVID-19 this week, there is a nice comfort level knowing that my property manager will continue the healthy monthly cash auto-deposits.

    For folks that invest in individual properties, there are some tax nuances/complexities that need to be pointed out. First is the relatively new tax law that allow you to exclude a portion of your rental property income from federal taxes. This is above and beyond the shielding of income due to non-cash depreciation charges.

    And, now, I brought up the “d” word. Depreciation. Oh, how I love thee. Oh, how I hate thee.

    During my asset building years, we had essential zero taxable income from our rental properties despite them being consistently cash-flow positive. The buildings (not the land) for residential rental property are depreciated over 27.5 years per the current tax code resulting in TAX LOSS despite the positive cash-flow. Now that the buildings are mortgage free, I have a few more years of non-cash depreciation charges left to take before the taxable amount of my net rental income increases substantially.

    Now, we all know there is no free lunch in economics. In the case of depreciation, the downside is when you sell an investment property, you not only owe capital gains tax on the increase in the value of your property since your purchase, you also owe Depreciation Recapture Tax. The actual depreciation recapture tax calculation for a given property can be quite complex, especially if you have multiple buildings, sell them off in different tax years, and if you have carry forward tax losses due exceeding to income limits or rental loss amounts. Lest I forget the Depreciation Recapture Tax is 25%!!!!

    At one point, I met an accounting professor that sat on the governing board that administers the CPA exam; I had just done an extensive analysis of a rental property sale and was looking at tax minimization strategies. Who better to ask, right?!?! Nope, this well regarded accounting prof was off by a country mile on their back of the envelope estimate of our tax liability! Fortunately, TurboTax saved the day from an IRS perspective when we sold an investment property many years ago. Net: if you use an accountant, make sure they regularly work with other clients holding individual investment properties so that they understand all the nuances of the tax code wrt rental properties.

    This leads me to how you can “indefinitely” postpone depreciation recapture tax while you are building wealth. A 1031 tax exchange allows you to roll-forward the depreciation (technically you roll-forward the basis) into another real estate asset when you sell an investment property and purchase another investment property of equal or greater value within 180 days. There’s a lot of moving parts here, which means somebody is going to get a small cut of the action beyond the typical real estate transaction costs and you definitely need good advice from an experienced lawyer and accountant if you go down this path.

    While you point out very attractive alternatives to outright selling investment property in retirement, rental properties do require more mental horsepower to manage. In helping a relative that is nearing 90 manage her finances, it is clear to me that many folks with not have the mental acuity to properly manage a small portfolio of individual rental properties in their later years even with a property manager. Because of this, we are currently looking at unloading our rental properties before 70. Not sure what we will move the resulting cash into, but we have quite some time as we sort through available alternatives.

    The lumpiness of liquidating investment property holdings leads to some “interesting” tax calculations that impact ACA subsidies before we hit Medicare age, not losing tax credits such the AOTC and minimizing EFC on FAFSA as we put our dear children through college, and our Roth conversion strategy. This list is not exhaustive and will be very different for other folks.

    Lastly, holding incoming producing properties has made me question the need to allocate a portion of our asset allocation to bonds. Haven’t thought this one fully through enough to disclose my machinations, but perhaps Big ERN can shed some much needed light on the alternatives!

    1. Oh, wow, thanks for that detailed comment! Very valid and important points, all of them! There are nice tax advantages for landlords, chiefly the depreciation. Even if the D is recaptured later, the government will give you essentially a years/decades-long interet-free loan.
      And I’m not 100% sure that the tax liability for the past depreciation will also be wiped out with the step-up basis once you bequeath your properties.
      But I also see the point about very old retirees (90+ years old) having to manage a rental portfolio. That’s probably a time to weigh the benefits of the step-up basis vs. realizing gains to load off the landlord-hassles and the tax liability now.
      Thanks so much, DrFIRE!!!

  3. Really interesting article.
    Unfortunately, where I live in the UK, the Cap rate is currently under 3% . That does make the sums harder and, obviously, less attractive.
    Your approach using Private Equity is worth further research.

  4. Very interesting! As expected, diversification of asset type / risk profile has some very material benefits for an investor.

    One mechanism for smoothing the leveraged consumption could be using margin or futures in the securities portfolio. Margin rates and implied interest are often lower then mortgage and HELOC rates. A key benefit is that they can be “interest only” loans for the purposes of cash flow, narrowing the range cash flow changes over the duration of the model. Of course, these leverage sources have their own unique risks as that will need to be accounted for and shouldn’t be exercised to the levels of leverage [“safely”] attainable via mortgages.

    Takeaway is: diversification of leverage instruments can add value just as diversification of income sources can.

    PS: hang in there with the short options! No doubt the last few days have been… potentially expensive.

    1. Thanks! Good point! Margin rates are potentially even lower if you have the luxury of a margin trading account.

      Yeah, it’s been challenging this year. But coming off of a record-breaking year last year, I’m not yet worried… 🙂

  5. Great post – thanks very much.

    Would echo the question from DR FIRE on bonds.

    If you held enough Real Estate to fund your retirement needs, then would you invest all your paper assets in stocks? If you didn’t need to access the paper assets for 20 years (real estate is providing all your retirement income) then seems like you would be 100% in stocks (no bonds) to maximize the long term return of that portion of your portfolio?

    1. Not sure if I’d be comfortable with the all-stock portfolio. Your paper portfolio is still an almost traditional retirement challenge, i.e., deplete your portfolio over the next 30 years.
      You could obviously say that you can take more risks because much of the cash flow is (mostly) safe from the RE portfolio. So, for a RE investor without mortgages, yeah sure, go 100% equities.
      But if you have to bridge the first few years because the RE is not yet cash-flowing much, you face a lot of Sequence Risk! Better be cautious with the paper portfolio…

      1. Thanks

        RE portfolio is all without mortgages – no debt.

        We aggressively paid off debt over the last 10 years. My thought process was that paying off mortgages on revenue producing real estate would create a cash flow… essentially replacing bonds in my portfolio.
        Now we have a cash flow from the property that will fully fund retirement, actually fund about 120% of projected retirement cash flow needs.

        The bulk of our paper assets are in 401K and Roth – currently 100% stocks. We are in our early 50’s and don’t anticipate needing the money until early 70’s. At which point we will sell the RE portfolio or hire a manager. If we were to sell the RE – then I would anticipate shifting some of the portfolio to bonds at that time.

        Side note – we started the RE portfolio 25 years ago, and self manage, so we are confident in the cash flows. We have also seen a lot of cycles. Even in the worst times we still get good occupancy. True rents did take a hit when the market crashed but I have calculated that into my projections.

        Thanks again for your response and the great blog. It has been an inspiration for me over the years.

  6. I don’t think this is honest modeling. You handwave any concerns regarding volatility by saying you modeled a low cap rate, but that’s like saying you can ignore stock volatility by just modeling 5% real returns instead of 7%.

    Any asset you model as a risk-free guaranteed 4% real return with nigh-unlimited risk-free leverage will of course come out looking amazing. But there’s a long tail of risk to real estate – both with individual assets, individual tenants, etc. You can diversify some of that risk away, but not all of it. For example, prices of homes (per the Case Shiller index modeled in real terms – https://www.multpl.com/case-shiller-home-price-index-inflation-adjusted/table/by-year ) fell by 40% from 1900 to 1942 – and while they did go back up, the entire 1900-1952 period was flat. If that occurred in any of your leverage scenarios, you’re potentially screwed, because you either run out of cash flow or have to sell when the market is down.

    A drop like that is a black swan at least as likely as 1929 or 1966 reoccurring again – and yet the message we take from your series is to predicate retirement planning assuming 1929 happening – while ignoring the possibility of an equivalent event in home prices (which can occur nationally, regionally, or locally!)

    1. I think your calculations aren’t honest either.
      Over a 40-year horizon, the real rental TOTAL return has never dropped below 4.41%:
      http://www.macrohistory.net/data/
      That low-point is actually at the window ending in 1942. So, during periods when the real PRICE return is low, apparently the rental yield was high enough – evidently way above 4% – to compensate for the low price return.

      But just to be sure, I absolutely agree that RE is not risk-free. Hence the caveats. I personally would prefer to have debt-free RE properties, and would not rely on depleting/leveraging the properties, so Cap Rate = SWR would be the max I’m comfortable with if I had an individual rental property.
      But it’s not really in the cards right now. We use the Private Equity funds with some leverage. But the expected returns of 10+% look really nice! 🙂

      1. Hi ERN,

        Great post! Thank you for shedding some light in this area. One quick question: You mentioned that you use private equity funds with some leverage. I understand the requirements (being an accredited investor) to invest in these types of deals. How does one use leverage to participate? Do you take out a HELOC or a different type of loan? Thank you for your time and thoughts to put all this together 🙂

        1. I would absolutely never leverage the investment in the private equity fund. The funds already use leverage. Don’t double-up on the leverage!!! Especially because the money in the funds is tied up and can take years to come back. 🙂

      2. Hei folks,

        I want to throw some arguments in the ring.

        First @ RARVYN:
        I think that’s pretty right! You can’t model real estate returns that way.

        Second @ EARLYRETIREMENTNOW.COM:
        Let’s take a step back. The Jorda et al study is full of mistakes and no good academic scientist would quote it. This is consensus in Germany. They didn’t really calculate the maintenance costs.
        Good quality data for asset returns are Elroy Dimson, Paul Marsh, Mike Staunton. They made several studys, I am sure you’ll find something! to make it short take a look in yearbook from the credit suisse 2018.
        https://www.investorvillage.com/uploads/83380/files/CSFB.pdf
        … there are the results and the return for real estate are not so good.

        The typcially landlord hast 1-3 properties and he manages them beside his normal job (40 hours a week, maybe). So there is no economies of scale. The typical landlord has much higher costs for a workman, because he doesn’t get special treatment from his supplier. He has to pay about 30% more than a proffessinal property company for these services. AND we know the price leader makes the price, so the proffessionals can offer the same product (apartment) much cheaper like a normal person could do it. So what happens? the return of the normal-guy-investor decreases, otherwise he couldn’t survive on the market – because no one would pay a higher price for a poor quality product.

        ///

        a personal note:
        Of course I love this blog here and it’s just crazy how much work you put in it and thank you so much for that.
        But don’t make the mistake & think because the last few years were pretty nice for properties, that it will be the same in the future. Specially the maintenance cost are very very difficult to plan. I made the same mistake 😀 … I am holding some apartments and REITS in my portfolio, and it worked out very well for me, but the percentage of my real estate investments are about 20-30 % because of the reasons I mentioned before . The science tells me something different (That real estate is not as attractive as equitys). the is no solid data for real estate returns before 1900. I am wondering about the this fact. I think the banks all the property lobby don’t want to know that exactly 😉 So hope we find here a broad discussing.

        I am studying Controlling & Finance, so I am not a pro. 😉 But everyone I have shown the Jorda et al Study (The return on Everything) told me that it’s useless 🙁

        1. Can’t say I agree with you. I think there are many aspects of the Dimson, Marsh, and Staunton study that look really fishy:

          Junk Science Alarm #1: A -2.1% real return for real estate? Really? You’re telling me that globally, real estate had a minus 2.1% annual price return over the last 100 years? -88% in 100 years? What do they mean by quality bias? Certainly, a house built in 1920 where no updates were ever made, with the same kitchen, bathrooms, electrical, plumbing, roof, etc. would not have appreciated by +1.3%. But maintenance, repairs and depreciation are factored in as costs in the Jorda Study. So, you can’t cherry-pick and exclude all quality improvement in the price returns but you subtract the costs of all home repairs and improvements in the cap rate.

          Junk Science Alarm #2: Adjustments for population weight and supercity bias. That may indeed lower your price return. But:
          1: for me as an investor who does own real estate in some of the supercities, why do I want to lower the weight of the supercities?
          2: Do you also adjust the stock returns for “superstocks bias” (AMZN, GOOG, FB, etc.). Why do we compare the real estate returns adjusted for “supercity bias” with the unadjusted equity return?
          3: Aside from the points in 1 and 2, keep in mind that rental yields are also lower in the “supercities” and the population centers. So, you may indeed lower your price return, but by how much would that raise my cap rate? What is the net impact on the total return? Just posting the impact on the price return seems disingenuous.

          So, long story short, I certainly don’t claim that the Jorda study is to be considered scripture. They may very well have overestimated the returns. Insurance will probably cost around 0.25% of the value of the structure per year. The “true” numbers are somewhere between Jorda and the CS study. But if I had to pick, the truth will probably be closer to the SF Fed study, and not very close to the CS study. I mean, since you’re in the industry, you do know that this kind of Wall Street sell-side research is mostly just BS, right? When I worked in Finance, we had these kinds of clowns visiting at least once a week. I can tell you that if they had come to visit my group and claimed that RE price returns were -2.1% real they would have laughed out of our conference room.
          Anyway, I still believe that with a 4% cap rate and 0% real appreciation I’m on the safe side and far enough below the Jorda study. What kind of return assumptions would you make for U.S. real estate over the next 30 years?

          1. @ ERN:
            thank u for your quick and extensive answer.
            the real returns on real estate is 1.3% p.a. / take a look on side 20. It’s not negative … in the study, it’s just clearly lower then the jorda et al study. They say the return for housing is between equity and bonds on side 21. I think so too, the truth is something in between, but isn’t it interesting that they have so different conclusions?
            When I am talking about real estate I mean housing, sorry 🙂

            I think they compare the 1.3% real return with the equity returns. the adjustments are just for playing around for your individual case (for example when your property is not in a supercity or the population is not growing at your place). AND here is a very important point: if you compare an investment in Housing with an investment in equity, you have to look what is doable, right? In reality you can diversify your equity and bond portfolio world wide by ETFs – very easy. So your investments goes almost the same way as an index. But you can’t do it with a “housing-portfolio”, if you even have a portfolio. Most of the people have one property (the one they live in), so that’s no good diversifycation. Some super-rich can buy properties world-wide, of course, but that’s not the normal case. AND in Germany there is a law, which prohibit investments in “Housing-REITS”, that would be a opportunity to invest in a broader portfolio, right? In Germany you are just allowed to invest in office-REITS, but it’s not housing. 🙁 Another fact, the real estate indexes are not based on demand & supply like a S&P500, they are priced by a survey from experts, so of course you have less volatility in these indexes, because they glaze the oscillation of prices. but in reality the portfolio would be less worth in a bad market situation – if you would sell it – than it seems in the shop-window..

            But here is an argument for Housing. Housing / real estate is not as liquid as equity, right? Most of the time it is a lot of work and it takes a quite long time to sell a property … so shouldn’t there be a market premium for illiquidity in the housing market compare to the equity market?

            ///

            So to your #1:
            You think they “forgot” to reinprice the better quality after a renovation?

            So to your #2:
            I don’t know if I fully get the third point.

            ///

            Haha, if I take a look at my real estate investments I couldn’t believe that the DMS-study is right, too ^^ I am siting on a quite big profit and I have been cash-flow-positiv from the first day – so, I have no selling preasure. But it took me a long time to find properties like this in a B city in Germany – that was hard work. And at the end my net rental return is not thaat big.
            I can’t speak for the US housing market, because I don’t live there and I have no statistical informations about several cities – (chicago could be interesting from a cashflow perspective, because the rental yield is quite high). I would expect that it will be a little bit better than Germany. in the past we had several decades within a negativ real return for housing in Germany. The last one was from the mid 90s to 2009 (-20 to -30% from peak). In nominal terms the market magically rose at this period. Since 2011 the prices are rising dynamically. 🙂 Actually I don’t know the future. I think if you invest directly in a property, it is not that interesting what the hole market is doing, you should concentrate on this property, because everyone is different. And maybe the prosperity of the region is important.

            1. They do exactly what I feared they do:
              They first compare the TOTAL return (roughly same for housing and equities). Then they drill into the price return and claim that with their adjustments, the price return goes from +1.3 to -2.1% which is preposterous. Again: they ignore quality improvements, which SHOULD be factored in because the maintenance/repairs/improvements is factored into the Cap Rate.
              And then they do the re-weighting in a very sneaky way, not factoring in that the cap rate would likely increase in their reweighted portfolio, so the impact of the different weighting on the TOTAL return is not clear.

              So, I maintain that maybe the Jorda study is not the best and most complete result on this. But it’s the best we have. I’d rather wait for a response of Jorda et. al. and/or a revision of their paper than listen to the DMS study with really apparent flaws.

  7. Super interesting as a professional expat and serial accidental landlord I find this exceptionally useful. In your caveats you didn’t discuss how you are overlaying current finance costs against a historical background of performance where those rates were worlds apart from today. Does this strategy rely on being able to lock in current rates for both the HELOC and mortgage? At what point would this break down if interest rates, within our life times, were to ever go up again?

    1. True. I should add that caveat. I use today’s real mortgage rates but historical real returns. there is a bit of disconnect there. The same disclaimer as in Part 21 if the series applies here:

      Simulations and Limitations
      The 30-year mortgage as we know it today didn’t even exist before the Great Depression. What’s worse, I don’t have a very long time series of 30-year mortgage rates. Even if I had a time series for mortgage rates I’d have to make assumptions, lots of assumptions, about if and how each of the cohorts since 1871 would have handled changing interest rates and potential prepayments and/or refinancing of mortgages. A can of worms!
      So, studying the pros and cons of a mortgage-free early retirement would have to take a few shortcuts and hacking of my simulation engine. And once you start hacking, always keep in mind one of Big ERN’s fundamental rules:
      There is a fine line between doing a hack and being a hack!
      So for full disclosure, today’s simulation results are mostly a thought experiment with the following assumptions:
      I calculate the mortgage payment of a 30-year and 15-year mortgage with today’s market rates and assume that the real, inflation-adjusted mortgage payments decay due to a projected 2% annual inflation rate going forward, see chart below.
      Given the mandatory real mortgage payments, what would be the experience of a retiree today if the real stock/bond returns of all the past retirement cohorts were to repeat themselves?
      In other words, I don’t simulate how a retiree in 1929 with a mortgage in 1929 would have experienced the 1929-1989 equity and bond returns. I calculate how a retiree today with today’s mortgage parameters would fare if we hit him/her with the 1929-1989 real, CPI-adjusted stock/bond returns. And the 1928-1988 returns and the 1927-1987 returns, and the 1930-1990 returns, and so on.
      You be the judge if this crosses the line. But remember, before yelling at me, please keep in mind another one of Big ERN’s fundamental rules:
      It takes a model to beat a model!
      In other words, unless you have a better way of evaluating the mortgage vs. no mortgage tradeoff please don’t call me a hack.

      https://earlyretirementnow.com/2017/10/11/the-ultimate-guide-to-safe-withdrawal-rates-part-21-mortgage-in-retirement/

  8. ERN, thank you for this: “use “1.03^(1/12)-1” if you prefer”! At some level I knew that a 3% annual interest rate that is compounded monthly is not the same thing as 3% / 12. Yes, they are close, close enough that we may choose to ignore the difference, but in some situations we may not be safe to ignore the difference.

    Thank you for your continued attention to detail and mathematical precision, where it makes sense.

    1. Glad you found this useful. It depends on the context. A 4% traditional mortgage payment is indeed calculated with the 0.04/12 version, not the 1.04^(1/12)-1 version. Back when we had a HELOC on our condo, I believe the monthly and daily % were also computed linearly.

  9. Krasten, I believe you are referring to equity syndicated deals. I dipped my toes into debt crowdfunding deals and documented my losses with lessons learnt. The equity deals are riskier so need to account for that when analyzing returns. Unfortunately there is no silver bullet.

    1. The good investors don’t need those platforms, they got their own pipeline of institutional and private investor money. So, I stay away from the syndicated deals on crowd-sourcing platforms. I fear that only the crummy deals end up on the new and hyped new platforms.

      1. Hi ERN,

        Question for you regarding the capital required for accredited investors. Where is the best place to save this money during the interim say over the course of a year? Is it wise to place the money in one’s taxable account then liquidate once you want to pull a 50k or 100k, etc trigger. Or does one place this in a money market account? I realize there are pros/cons with each and was hoping for your take.

        Thank you!

  10. Any thoughts on using REITs instead of owning the property directly? Or more valid to compare using REITs vs funds, such as the pe funds you mentioned?

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