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!
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:
- You sell half of your properties over time and use the proceeds to fund the additional consumption.
- 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:
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.
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!
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!).
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!
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.
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.
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:
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:
- 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
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%!
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.
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):
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