When most people invest for retirement, they fixate on stocks versus bonds. That leaves them wondering how much of their portfolio they have to shift to low-yield but stable bonds, to avoid the volatility of stocks.
Few of them consider buying real estate to generate income in retirement.
As you plan out how to fund your retirement, consider the following pros and cons of rental income.
Advantages of Rental Properties in Retirement
Rentals come with some enormous benefits for retirees, that the average investors overlooks.
1. Ongoing Income
The problem with a traditional retirement portfolio of stocks is that retirees gradually sell them off, following the principle of “safe withdrawal rates.” If you’ve ever heard of the 4% rule, that’s the classic withdrawal rate: you sell off 4% of your portfolio each year in retirement, which historically would have left your nest egg intact for at least 30 years.
With rental properties, you don’t have to sell off any assets to generate income. They keep generating income forever. In fact, they help your net worth actually rise over time, as they appreciate in value. That not only removes the risk of running out of money before you die, but it also leaves behind an inheritance for your children or other heirs.
2. Hedge Against Inflation
Just as property values rise over time, so do rents. They typically rise at least as fast as inflation, and often surpass it, making them a primary driver of inflation.
So not only do you not have to sell your properties to generate income, that income rises over time. Contrast that against bonds — if a bond pays 4% in interest, but inflation runs at 2.5%, that means you earned a real return of only 1.5%.
Your rental income adjusts automatically for inflation, protecting you against it.
And if you finance your properties, your cash flow rises even faster over time.
3. You Can Leverage Other People’s Money
When you buy a stock or bond for the long term, you buy with 100% of your own cash.
When you buy a rental property, you can finance 80% of the cost with other people’s money. If you get creative with it, you can finance 100%.
So, someone else covers the overwhelming majority of the cost of your asset. An asset that generates ongoing income for you, and appreciates in value over time.
And when you take out a rental property mortgage, your cash flow rises faster than the actual rent increase each year. That’s because your mortgage payment stays the same every month for the next 30 years, but the rent rises, so the difference between the two increases at a faster rate than the total rent does.
As a quick example, if your property rents for $1,000 and your mortgage payment is $500, and you raise the rent $40 after the first year, the rent rose 4%. But your cash flow rose from $500 to $540: an 8% increase.
4. Predictability of Returns
When you buy a stock, you hope for the best. But you can predict the cash flow on a rental property with precision.
You know the market rent, and you either know or can accurately forecast all expenses. Those expenses include the rental property mortgage payment, the property’s vacancy rate, repairs and maintenance, property taxes, insurance, and property management fees.
Learn how to calculate cash flow accurately and you’ll never make a bad investment again.
5. Tax Advantages
All those expenses that come with rental properties? You can deduct all of them from your taxable income.
But real estate tax advantages don’t end there. You can also deduct the cost of the building itself, along with all capital improvements, through depreciation. And you have several ways to reduce, avoid, or defer capital gains taxes when and if you ever want to sell. Or you can simply leave the property to your children, so the cost basis resets and they don’t pay any capital gains on it either.
The more you diversify your investments, the better you protect against the risk of one investment collapsing.
While bonds offer diversification from stocks, they also offer weak returns in the 21st Century environment of perpetually low interest rates. They can keep your money safe, but the safest bonds barely keep pace with inflation. More on bonds here.
Rental properties offer another way to diversify your portfolio from stocks, but without the low returns of bonds. The correlation between real estate and stocks has historically stayed low, so they offer true protection against the other falling.
Real estate complements stocks well, as they come with opposite advantages and disadvantages.
Disadvantages of Rental Properties
No investment ticks every box. If one did, every investor on the planet would flock to it, and it would no longer offer competitive returns.
Keep these cons in mind as you consider rental properties for retirement income.
1. High Cost of Entry
At the time of this writing, the median home price in the US is around $375,000. Even if you borrow 80% of that, it still leaves you with a down payment of $75,000.
Granted, you can invest in less expensive rental properties. But you can still expect to shell out tens of thousands of dollars between the down payment, closing costs, and possibly repairs when you buy a house.
In contrast, you can invest in a stock ETF for $50.
2. Knowledge & Skill Required
It takes no knowledge or skill to buy ETFs that simply track stock indexes like the S&P 500.
But finding good deals on real estate, managing contractors, screening tenants, enforcing your lease agreement? That all takes knowledge and skill.
If you invest without learning the fundamentals, such as how to calculate rental cash flow, you can easily find yourself losing money on your property rather than earning it each year.
That knowledge and still required to buy rentals takes work to develop. You have to invest the time to learn the skills you need.
But the labor doesn’t end there. It takes work to find good deals on rental properties. After you find a good deal, secure a rental property mortgage for it, make any necessary repairs, advertise it for rent, screen applicants, and sign a lease, you still have ongoing labor to manage the property. You can outsource that labor to a property manager, but then you have to manage the manager.
Labor that you don’t have when you simply buy an ETF.
4. Lack of Liquidity
You can buy and sell stocks instantaneously, for free. Which is precisely why stocks are so volatile in price.
Real estate prices are far more stable because it takes so much time and money to buy and sell it. It typically takes months to sell a house even if you stage it, and thousands of dollars in real estate agent commissions and other closing costs.
In other words, real estate is notoriously illiquid. It costs time and money to buy, and even more so to sell.
Rental properties make excellent income-producing assets for retirement — if you’re willing to put in the work.
Work to learn the fundamentals of real estate investing, work to find good deals, work to manage rental units.
If you have a genuine interest in real estate, and are prepared to treat investing in it as a side hustle, you can earn strong returns with plenty of protections in retirement. But if you’re only looking to diversify your portfolio to include real estate, consider investing in real estate crowdfunding instead.
Article submitted by Tara Scott, Communications & Relationships Guru