Rental Income and Retirement Planning

11/3/2016 – A lot of my clients are buying real estate properties and renting them out as a strategy to help them with cash flow during retirement. So, I thought I would share what this strategy could look like.

The rental property question comes up more often than not. A lot of my clients envision themselves managing a small portfolio of rental properties while going into retirement. I suppose this goal crops up simply because we live in Southern California. Whatever the reason, investing in real estate is not for the faint of heart nor is it for those that are impatient. It usually takes years before cash flow turns positive on these investments. Nonetheless, I believe investing in real estate has its benefits, especially for those planning for strong cash flow during retirement. Keep in mind that I am not a real estate guru. I am not a local market expert, nor do I know if a specific home is going to increase in value or not. Nonetheless, I am a financial professional and I can quickly tell if a property (or a set of properties) is a good investment, given a few simple assumptions.

Before I begin, I wish to make it clear that I do not make any money if any of my clients invest in real estate. Bull Oak Capital is an Registered Investment Advisory firm. We do not participate in private/public REITS, partnerships, dealmaking, referral kickbacks, etc. I simply provide advice to my clients from a financial planning perspective. If renting out a property makes sense for a client, then I will recommend it. If it doesn’t, then I won’t.

Furthermore, I do not condone house flipping, speculative purchases, or any other type of short-term R.E. investing. I am also not condoning over-leveraging yourself. As with any other type of investment, leverage increases your risk and the potential to cause financial distress. The type of real estate planning I provide for my clients is a more conservative approach. I always plan for 20% down payments on all properties and the plan always includes a plan to pay off that debt in a reasonable amount of time. The goal is to become cashflow positive sooner rather than later, not to sell the home for a profit (though this is certainly a possibility).

Building out a real estate portfolio not only takes a time, but it also takes quite a bit of money. This is usually an option for those that have a large cash surplus at the end of the month after expenses are paid.

The Lure of Rental Income

Aside from the prospect of housing values increasing, the lure of real estate investing is the steady stream of income. In San Diego, the average apartment rental rate within the city is $2,123 per month. That number in itself is enough for those interested to begin planning. A side topic is whether or not the housing market is in a bubble. I do not know, but I suspect it is, along with most other asset classes. Nonetheless, I am intentionally ignoring current market conditions as I only hope to outline the economics behind rental properties. I am also intentionally ignoring what would happen if you were to sell a property for a gain. There are a number of tax consequences that should be considered, but that is a topic for another day.

One of the biggest headwinds to a successful retirement is inflation. If you were to retire at the age of 60 and to pass at the age of 90, that is 30 years of retirement. Let’s say that you had $1MM at retirement and you decided to keep your money in the bank, earning 0% interest. And let’s also assume that you did not touch it during those years (perhaps you were living off of another asset/income stream). What would happen to that $1MM during those years if inflation was 3% on average?

Purchase Power and Inflation

The same can also be true if one were to accept a fixed annuity during retirement. A fixed annuity does not change it’s monthly/quarterly/annual benefit. That means that the true value of that benefit diminishes over time if inflation is anything above zero.

This concept is simple, but it’s important to truly understand it. This is one of the primary reasons why we invest our funds at all; to beat inflation. Whether you are investing in stocks, or bonds, or anything else, the idea is to at least keep above the inflation rate (real return).

The Economics of Renting Out Properties

Let’s build out a model to see how this can play out. Assume that we have a 35 year-old client that is looking to buy properties and hopes to rent them out. The goal is for the client to become cash flow positive before retirement. The client would like to purchase a new property every 3 years before retiring (age 55). Here are the assumptions behind these projections:

re-assumptions

These assumptions are a bit conservative, making the positive FCF that much higher. That’s okay. It’s always better to build in conservatism in a model rather than to make overly optimistic assumptions.

Property Purchase Schedule

property purchase schedule1

As you can see, under this scenario, the client would be able to purchase 6 properties before retiring. The next step is to see what this cash flow would look like.

real-estate-cash-flow

I know this sheet is a bit daunting to look at, but focus on the last column, Net Income. This is the big takeaway from all of this. Of course, during those years when the client is putting down 20% on each property the cash flow is negative. But, over time as rental rates are increasing and as mortgages are being paid off, the free cash flow begins to grow.

The large numbers can be a bit deceiving as we are looking at cash flows that are far into the future. To help with this, here are the same numbers, but it todays 2016$ dollars (present value). These numbers help give you a better idea of what a real estate portfolio can generate in income.

pv-of-cash-flow

Managing Properties Is Not For Everybody

While owning a real estate portfolio can be advantageous, it also comes with its own risks and drawbacks. The most obvious ones are the ancillary costs:

  • Property taxes
  • Property Insurance
  • Property management company (if you choose to work with one)
  • Maintenance expenses
  • Etc.

Investing in real property also means that you are purchasing an illiquid asset. If you need to sell a property for whatever reason, it will likely take some time. Furthermore, the transaction costs are going to be astronomical. On average, you should expect ~6% for each buy/sell (3% for each selling agent).

The other obvious drawback is the headache of managing a property. Most of my clients work with property management companies to help separate themselves from this issue, but that costs money (usually 8-10% of gross rental receipts) and most management companies tend to slack off over time. I cannot overstate the importance of using a good property manager and leasing your home to good renters.

There is also concentration risk to consider. Most of the time, investors will accumulate a R.E. portfolio within a concentrated area (e.g. San Diego County). For example, if the local San Diego market were to tank (e.g. there is a recession, Qualcomm decides to leave the area, there is an earthquake, etc.), your entire portfolio will likely go down with the market.

That being said, I believe the pros outweigh the cons, if done correctly. Try to build a good team of professionals (financial advisor, real estate agent, mortgage broker, CPA, etc.) to work with you if you’ve never ventured into this field before. And of course, please take the long-term view if you do decide to pull the trigger!

 

Ryan Hughes
Bull Oak Capital
Bull Oak Newsletter
11/3/2016


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While the information presented herein is believed to be accurate, Bull Oak Capital LLC (Bull Oak) makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors appearing in the document. Bull Oak is under no obligation to notify you of any errors discovered later or of any subsequent changes in opinions. Nothing herein should be construed as a recommendation to buy or sell any of these securities. It should not be assumed that any of the securities, transactions, or holdings discussed will prove to be profitable in the future or that investment recommendations or decisions Bull Oak makes in the future will be profitable or will equal the investment performance of the securities discussed herein. Bull Oak or its employees may have an economic interest in securities mentioned herein.