FIRE with Real Estate: Using Rentals & Leverage to Build Income Faster

The following is a guest post from Brian Davis at Spark Rental. Brian is a landlord, personal finance writer, and the co-founder of Spark Rental. Swing by his site for all kinds of free stuff to help landlords including a rental property calculator, and video courses on building passive income from rentals. 

There’s also a free rental application and tenant screening service, and a range of other free rental investing tools. 

Even though I’m selling my rental property, I still think real estate is one of the best ways to build income streams. I need to find a better property.

Take it away, Brian!

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Retiring at 65 is so 20th Century.

I want to retire while I’m young and fit. Write novels. Work at a winery for fun. Be there for my (yet unborn) kids.

And travel. My wife and I visit around ten countries each year, which is possible because we live overseas, get free housing, and pay almost nothing in income taxes.

I’ll be the first to admit that I have not reached financial independence or retired early (FIRE) yet. But it’s a journey, not a jaunt. And like most long journeys, if you look at it as drudgery, then you probably won’t make it. The journey itself is just as important as the destination.

While most FIRE-mongers tout equities, I take a different approach. Here’s how real estate – and rental properties in particular – can help you reach financial independence within the next five to ten years, by throwing out the 4% Rule.

The Classic Model for Retirement

In the 20^th Century, people either worked until they died (which often happened; the life expectancy in 1936 was 58.5 years), or relied on pensions and Social Security.

And why not? With such short life expectancies, it was affordable for employers and Uncle Sam to pay for a few years of retirement.

That math abruptly changes when retirees start living for another 20, 30, 40 years after retiring.

The answer for employers was to transition from defined benefit plans like pensions to defined contribution plans like 401(k)s. Instead of saying, “We’ll pay you $1,500/month until you die,” they say: “We’ll match up to 3% of your paycheck in contributions to your retirement account.”

Notice how employees suddenly become responsible for their retirement planning. They have to manage their retirement plans and choose what to invest in – which spells trouble when most Americans can’t pass a basic financial literacy test.

The other big shift? For the first time, Americans had to start asking themselves, “How much do I need to retire?”

Which brings us to safe withdrawal rates, the 4% rule, and its corollary, the 25X rule.

The 4% Rule

In 1994, financial planner William P. Bengen reviewed 50 years of market data and found that retirees could safely withdraw up to 4% of their (initial) portfolio every year to live on, without running out of money in under 30 years. Thus the 4% Rule was born.

According to the 4% Rule, if you have a $1,000,000 nest egg, you can withdraw up to $40,000/year for living expenses.

Which means you can flip the rule around to determine how much you need to retire. If you want $40,000/year annual income in retirement, you can multiply your income figure by 25, to reach your target nest egg ($1,000,000 in this case).

Since then, economists and personal finance experts have hemmed and hawed and disagreed over whether the 4% rule still holds in today’s economy. My favorite analysis was done by Michael Kitces, CFP, who demonstrates that a withdrawal rate of 3.5% should leave your portfolio intact forever – at least based on historical returns.

Tomorrow’s returns may not reflect yesterday’s gains, given slowing population growth and maturing global markets.

But the question of whether 4% or 3% or 5% is the magic number for safe withdrawal rates doesn’t bother me. What bothers me is the very premise: you gradually sell off your assets, hoping that you don’t run out of them before you die.

The FIRE with Real Estate Model for Retirement

In the classic model, you save up a nest egg over a 40- or 50-year career. Then you gradually spend it down in retirement.

In the FIRE model, you build a portfolio of income-producing assets, designed to keep generating income indefinitely. What I like to call “forever income.”

Because when you retire in your 30s or 40s, you may well live for another 50, 60, 70 years.

Examples of forever income include dividends from equities, rents from real estate, and interest from private notes. For that matter, you can even sell off equities for income, if your withdrawal rate stays significantly lower than your portfolio’s growth rate. (But that means you should have other sources of income, so don’t need to sell anything during corrections and crashes.)

The goal with FIRE is to be able to live on the income from your investments, from here to eternity — a nest egg that keeps on growing, the gift that keeps on giving.

Don’t get me wrong. I love equities. They provide easy diversification and are highly liquid. But it’s rare for dividends to pay more than 2-, 3-, 4%, which is why I love rental properties for ongoing income.

Rental Income: Cash Purchase

Here’s how the math breaks down for rental income, compared to the 4% Rule for stocks and bonds.

But to run sample numbers, we need to make a few assumptions. First, we’re going to assume that you buy properties that rent for 1.5% of the purchase price (e.g., you buy a property for $100,000, that rents for $1,500/month).

Some investors only buy properties that rent for 2% of the purchase price. Others prefer properties that rent around 1% of the purchase price; for our purposes, we’re assuming 1.5%. (Yes, these deals exist, even if not in your expensive coastal market!)

Our next assumption is that your non-mortgage expenses will total around half of the rent. That’s a generous assumption, as landlords can routinely do better by implementing best practices in property management.

So, your $100,000 property that rents for $1,500/month will net you $750/month, after insurance, property taxes, vacancies, repairs, maintenance, property management fees, etc. That comes to $9,000/year in income: a 9% return. (You can play with the numbers using our free rental property calculator.)

Fair disclosure: it takes a bit of work to find good deals on rental properties. It’s not like buying an index fund with the click of a button.

At these numbers, it takes around $450,000 worth of rental properties to generate $40,000 in annual passive income. If that sounds like a lot of money, consider that it would have taken a million dollars – $1,000,000 – to generate $40,000 using the 4% Rule.

And you would have had to sell off your assets to achieve it. Not so with rental income.

Rental Income: Financed Purchase

What if you use leverage to buy rental properties? Borrow other people’s money to build your portfolio?

The math changes once again.

We’ll need to add a few other assumptions here. Let’s assume a 20% down payment on the loans, and a 6% interest rate for 30-year mortgages.

A $100,000 rental property thus requires a $20,000 down payment, and a quick crunch with the rental property calculator reveals that would leave you with a $479.64 monthly mortgage payment. So instead of netting $750/month on it, you’ll net around $270/month, or $3,240/year.

Working backward here, if every $20,000 you invest nets you $3,240/year, you’re now looking at an impressive 16.2% cash-on-cash return.

Does the risk also rise along with the returns? Sure. You’ve taken on a debt obligation to accelerate your investments. But there are ways to mitigate that risk, such as setting aside half the rent in a savings account to cover those expenses that we’ve already budgeted for above.

So to generate $40,000 in annual rental income in this example, you’d need to put down around $246,900 in cash. 

That’s less than a quarter of the $1,000,000 nest egg you would have had to save up following the 4% Rule.

Using Even Less Cash with the BRRRR Strategy

One of the perks of real estate is that you have some control over its value. You can “force equity” by improving and renovating properties.

And when you change the value of a property, you change the financeable amount you can borrow.

Enter: the BRRRR strategy. It stands for buy, renovate, rent, refinance, and repeat. The idea is that after completing the renovations, you pull your original cash back out when you refinance.

Say you buy a property for $100,000, and put $50,000 of renovations into it, raising its value to $200,000. For your initial purchase-rehab loan, you make a 20% down payment of $20,000 and borrow the remaining $130,000. Upon completion, you refinance for $160,000 (80% of the new value), which reimburses your $20,000 down payment plus an extra $10,000 in carrying costs.

Now you own a $200,000 income-producing asset with no money out of pocket. Following the same assumptions we used above, that property generates $3,000 in gross monthly rents, which drops to $1,500 after non-mortgage expenses, minus a $959.28 mortgage payment. That leaves $540.72 in net monthly income, with none of your cash invested.

Instead of needing $1,000,000 to generate $40,000 a year in income, all you need is enough money for a single down payment and carrying costs for the renovation period. You can reinvest the same money over, and over, and over again.

Pros, Cons, Caveats

There are a million ways to complicate the conversation above.

Here are a few common ones:

• “What about interest compounding, Brian?”
• “I can’t buy rental properties in my area that rent for 1.5% of the purchase price!”
• “But I can invest in equities in a tax-deferred account!”
• “What about closing costs?”

To which I would reply:

• “Returns are returns – you can compound rental income returns by reinvesting your cash flow.”
• “Then invest outside your home market.”
• “You can buy real estate in tax-deferred accounts, and even if you don’t, it comes with plenty of juicy tax benefits.”
• I ignored closing costs for the sake of simplicity in the examples above, but you can often cover them with a seller concession.

Which is not to say rental investing is without its risks and downsides. It requires some education and skill to do profitably. Each investment requires a significant amount of cash (unlike equities, which you can invest in with $100 if you like).

It also takes work to find good deals and to manage the properties (if you don’t hire a property manager).

But real estate boasts some unique advantages, too. Rents adjust for inflation automatically, unlike returns on bonds or equities. (In fact, rents are one of the most significant drivers of inflation.)

Real estate almost always appreciates over the long term. So even as your tenants pay down your mortgage for you, your underlying assets grow in value.  

Perhaps best of all, the returns are predictable. You know the purchase price. You know the rent you can charge. And while you may not know precisely when the next repair bill will come, you know how much repair costs will average in the long term.

Join me on the journey to reach FIRE. Consider using real estate as the vehicle.

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Thanks to Brian Davis for giving us some insight into achieving FIRE with real estate. Brain Davis is a landlord, writer, and the co-founder of Spark Rental. 

Photo via DepositPhotos used under license