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The Surprisingly Simple Math To Retiring On Real Estate

real estate calculatorWhen I graduated from high school, one of the first things my dad did was take me to a Dave Ramsey seminar.

Being an 18-year-old “man” with my entire adult life ahead of me, I wasn’t crazy about the idea of spending an entire Saturday listening to someone yell at me about getting out of debt and saving for retirement. Nevertheless – my dad seemed to think it was important, so I went along.

At the end of the day, my mind was blown – I walked away from that seminar with a radically different outlook on my financial future. It was one of those rare, life-changing experiences where all the information instantly resonated with me – simply because I knew it was true.

One of the biggest “aha moments” I took away from that day was an illustration about the power of compound interest. I tore the page out of my program (over a decade ago now) and I still have it:

Dave Ramsey IRA Spreadsheet

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The real significance of this illustration is that it shows the power of starting early. When a person starts saving for retirement at a young age – their end result will FAR EXCEED a person who starts later in life – even though the person who started later will have invested far more principal over the long haul.

The paradox of the situation is that most 18 year olds couldn’t care less about saving for retirement – it’s one of the last things on the mind of a young person (especially when they don’t have such an obvious illustration showing them what to do). I was extremely lucky because when I first saw this illustration, I was 18 years old AND I decided to implement it (and I’ve been maxing out my Roth IRA almost every year since then).

Some people try to downplay this illustration with the argument that a 12% ROI over the course of 40+ years is totally unrealistic - but even with a less-optimistic assumption about your average return on investment, the undeniable power of compound interest remains the same.

Real Estate as a Retirement Vehicle

Most of the retirement calculators on the internet assume that your money is getting plugged into a mutual fund (or some other investment product that you don’t have to think about). While it’s certainly nice to invest in something this easy – there is also the potential for far higher returns if you’re willing to deal with a slightly more complex investment like real estate (and the ups and downs that come with it).

So what would an investment calculator look like if we applied it to real estate instead of the stock market?

How soon can you retire?

It all boils down to three simple things:

  1. How much money you need to live on.
  2. How much you’re willing/able to invest.
  3. The ROI you’re able to get on each new property.

If you don’t already know the answer to #1, check out Tim Ferriss’ monthly expense calculator to get a better idea.

So let’s try and apply this to real estate! Suppose an investor has a goal of retiring and living off the income generated from their rental properties. In order to do this, we need to make a few assumptions:

Assumptions:

  • On average, your goal is to earn a 15% cash-on-cash return on all the properties you buy during your active investing years (and if you’re buying the right properties, a 15% ROI should be feasible).
    • As explained in this post, a property’s ROI is calculated as the property’s gross income minus any/all expenses, vacancy, property management costs, mortgage principal, interest, taxes, insurance costs, etc.
  • You will be financing all of your properties with 30 year mortgages at an interest rate of 5%.
  • After 25 years of investing $5,000 annually, you will STOP all new investment and instead, you will start siphoning off half of your 15% returns to cover your living expenses.
  • The other half of your 15% ROI will continue to be reinvested into your portfolio. As such, your real estate investments will continue growing without any new principal investment from you (so in theory –  your income will continue to grow and will support you indefinitely).

Here’s how this model would look:

7-1-2014 10-54-48 PM

Here’s how each column is calculated:

  • Timeline: This is showing the number of years that you are actively investing in your real estate portfolio (i.e. – if you were 18 years old in Year 1, you would be 78 years old in Year 60).
  • Principal Investment: This is the amount of new principal (outside money, directly from your pocket) you are investing into your rental property portfolio each year.
  • Annual Profit: This is the annual net income you are earning from your real estate investments by the end of each year (the example above assumes you are earning a 10% annual return on your total investment to date).
  • Withdraw for Living Expenses: This is the amount you are pulling from your Annual Profit to cover your living expenses (or to spend wildly on whatever your heart desires).
  • Total Investment: This accounts for your annual Principal Investment PLUS the sum of your prior year’s annual profit minus living expenses (i.e. – your total investment/reinvestment into new rental properties each year).

The challenge with creating a retirement calculator for real estate is that (as you probably know) it’s not always feasible to buy rental properties in exact chunks of $10K each year (or however much you feel like investing each year). Mutual funds DO allow for this kind of simplicity, but rental properties have many more factors and variables involved, like:

In order to create this kind of calculator, you really have to oversimplify things a bit – but even so, it doesn’t necessarily mean the calculations are unrealistic. For example – if you can’t consistently find a deal each year that requires exactly $5K of new money – perhaps you can find one deal every other year that requires $10K? Perhaps you can find one every three years that requires a $15K injection? The chart above certainly oversimplifies things, but it still points you in a reasonably accurate direction.

The Added Benefits of Rental Properties

When I’m looking to retire on real estate, I am focused almost entirely on the cash flow of each property (because this is precisely what is going to pay my bills – now and in the future) but even so, there is FAR more to the story of rental properties than focusing solely on cash flow.

A few particularly relevant factors come to mind that should undoubtedly make rental properties a more compelling investment than other conventional retirement vehicles (on paper, anyway). The following factors are pretty commonly known among real estate investors – but I think they’re still worth reiterating (because these benefits are rather specific to real estate).

1. Real Estate Offers Significant Tax Advantages.

Thanks to “phantom expenses” like depreciation and interest (assuming you’re making loan payments on each property), you are practically guaranteed to pay less taxes on the passive income you generate from rental properties. This is a HUGE motivator for many real estate investors.

2. Real Estate Almost Always Appreciates in Value.

I say this with 3 basic assumptions in mind:

  • You bought your property at the right price (i.e. – one that allows for at least a 15% annual cash on cash return).
  • You didn’t acquire it during an obvious bubble in the market.
  • You’re planning to hold each of your properties for a period of at least 20+ years.

In most cases, even if you’re unable to check all 3 of these boxes, your portfolio of rental properties is still very likely to increase in value over the course of a few decades (and in most cases, it will increase significantly).

3. The Majority of Your Portfolio will be paid for by OPM (Other People’s Money).

Probably the most beautiful aspect of rental properties is that in most cases, the investor (aka – YOU) only needs to pay for a small portion of the total value of each property.

Conservatively speaking – most conventional lenders will require an investor to cover at least 20% of the purchase price for a single family home and 25% of the purchase price for a multi-unit apartment building or commercial property.

Assuming you did your homework upfront and bought a property that actually makes a profit after all expenses are paid, 100% of your outstanding loan amount should effectively be paid off by your tenants. It’s as easy as 1-2-3:

  1. Your tenants pay you their rent.
  2. The rent payments end up in your bank account.
  3. Your lender deducts a portion of these monthly payments from this pool of rent revenue - leaving a the remainder for you to:
    1. Pay your property manager.
    2. Make improvements to the property.
    3. Pay yourself (in the above example, this would come out to at least 15% of the money you originally invested – hence the 15% ROI).

If your properties are profitable (which is crucial, btw), there should be more than enough to pay everybody (including yourself) each month.

There is no other retirement vehicle on earth that boasts all 3 of these benefits (and each of these benefits are a big deal in their own right).

Let’s take a look at the same illustration above – only this time, we’re going to add in the collective liquidation value of your real estate portfolio (this shows the entire cash value that you could theoretically pull out of your properties if you decided to sell everything at any given year in the timeline). Again, here are our assumptions:

  • There has been NO appreciation on any property since your date of purchase (this is a very conservative assumption, btw)
  • Your lender required you to inject 25% into each property (another overly conservative assumption – since many properties will require less of a down payment)
  • On average, you will be able to obtain 30 year mortgage financing on all your properties with an interest rate of 5%
  • We will be deducting the collective mortgage balances on all of your properties in each given year (so you can see both the gross value and the net value of your entire real estate portfolio during each year).

7-1-2014 10-54-48 PMa

It’s a lot of numbers – I know…   but there’s an important point here.

Do you see that grey column on the right? When you isolate any particular year in the timeline – this is the “liquidation value” you feasibly have at your disposal. There are of course, a few caveats to keep in mind:

  • Liquidation Speed: Real Estate is NOT a “liquid asset”. In other words, you should never assume that you can instantly convert a property into cash (whereas, you CAN do this with publicly traded stocks and mutual funds). So, while these numbers for “Net Real Estate Equity” may look impressive, keep in mind that the speed at which you can convert each property to cash will depend greatly on the real estate market if/when you try to sell.
  • Market Value: A property’s value (or lack thereof) is seriously contingent on the market in which you try to sell it. There will be times when a property is worth MORE than it was when you bought it, and there will be times when a property is worth LESS than it was when you bought it. With this in mind, the chart above assumes that each property’s value has neither appreciated nor depreciated since your original date of purchase.

Conclusion?

A few things come to mind as I look at these charts:

  • For the average investor, building a huge source of passive income from rental properties is usually not going to be a “fast” process.
  • In order to reach “ultra-rich” status, you need to start sooner rather than later.
  • Cutting your ROI on each property in half (from 15% to 7.5%) will have a significant negative impact on your end result.
  • Changing the interest rate and/or term of each mortgage has a surprisingly minimal effect on the rate at which real estate equity grows.
  • The amount you withdraw for living expenses (and the time you can wait before you start doing this) can greatly fuel or diminish the growth of your cash flow and real estate equity.

Want to speed up the process? You’ll will have to at least one of the following things:

  • Throw a significantly larger sum of cash into your real estate portfolio each year (especially in the earlier years).
  • Buy properties with a significantly higher ROI (note: you’ll also have to find a sustainable source of these deals that you can pull from year after year)
  • Find a lender who will allow for an injection of 20% or less (rather than the 25% assumption shown above)
  • Find a lender who will charge an unusually low interest rate (this will be difficult, since most lenders are tied to whatever prime rate is at the time)
  • Wait as long as possible before you:
    • Start withdrawing money to spend on yourself and/or stop investing new dollars into your portfolio (though – once you’ve consistently invested for 10 – 15 years, this starts becoming a smaller and smaller issue).

Calculate Your Road to Retirement

The excel spreadsheet I used above is a bit more complicated than the typical retirement calculator you’ll find on the internet – mainly because it factors in several assumptions that most retirement calculators don’t need to account for:

  • Your required injection for each property
  • Your average interest rate for each mortgage
  • The amortization schedule for each mortgage
  • Your assumed ROI for each property
  • The length of time until you retire
  • The amount you’ll consistently invest each year
  • The amount you’ll withdraw for living expenses – and the amount that will be re-invested
  • The Gross Value, Mortgage Balances AND Net Equity for your entire portfolio in any given year

In the real world – the numbers will rarely (if ever) work out this simply. Nevertheless, this kind of calculator can be quite helpful in giving you a clearer idea for what inputs will be required in order to achieve your desired result. At the very least, it should give you a ballpark idea for what you can reasonably expect to see at the end of your career if you follow your projections until the day you retire.

Want to get your hands on my spreadsheet? Just leave a comment below and I’ll send it to you as soon as I can!

 

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{ 18 comments… add one }

  • Greg July 3, 2014, 3:36 pm

    Great article. I wished someone had taken me to the seminar when i was young. I am in the Arthur category, but i am aware that with real estate I can catch up in the game. Great Calculator for the rentals to see how they would cash flow in the future as you build equity. I like the visual there.
    Great post as usual!

    • Seth Williams July 6, 2014, 4:22 pm

      Thanks Greg – I appreciate that. Best of luck as you’re building up your own real estate portfolio!

  • Alex July 4, 2014, 8:57 pm

    Hey Seth,

    Just read the article and watched the video. Awesome job man and thanks for the info! I’m 33 now and really need to incorporate real estate into my retirement plan. I think I’m going to start with the land investing then possibly branch out later. I look forward to messing around with this spreadsheet. Thanks again!

    Alex

    • Seth Williams July 6, 2014, 4:21 pm

      Hey Alex, absolutely! I’ll email that spreadsheet over to you right now. Thanks!

  • Christina McCaffrey July 5, 2014, 12:32 am

    Very well writtem article! I’m a full time Realtor and an investor and I’m very interested in reading more. Can you also send me the excel worksheet?

    Thanks…Christina

    • Seth Williams July 6, 2014, 4:19 pm

      Hi Christina – absolutely, I’ll email it to you right now. Thanks for checking out the article!

  • Stuart July 6, 2014, 7:21 pm

    Love the article. I wish someone had told me about rentals early on. Now I advise everyone to keep their homes when they move as rentals – a couple have done this and are so grateful for the advice. I want to retire on rental income within 7 years

    Thanks for emailing the spreadsheet over!

    Stuart

    • Seth Williams July 7, 2014, 12:14 pm

      No problem Stuart – thanks for your comment. Check your inbox for the spreadsheet!

  • Tim Bloedow July 9, 2014, 12:47 pm

    Many thanks for this. Question. Your video answers one question – that the $5,000 invested is annually. That being the case, in your chart, why does your last column (Total Investment) not read: $5,750, $11, 613, $17,604, etc., instead of $5,750, $6,613, $7,604? Thanks.

    • Seth Williams July 9, 2014, 1:24 pm

      Hi Tim – that is a GREAT question. The “Total Investment” column only reflects the dollars invested in that year (not over the entire course of the entire investing career).

      Your question raises a good point though. I had thought about adding another column laying out the total career investment, but thought it would muddy up the waters and make the chart more confusing. Do you think it’d be helpful if I added another column showing the total investment as you’re describing it?

      • Tim July 11, 2014, 6:58 pm

        Perhaps, or just clarify the column that’s there. You’ve already done a lot of work for us with what’s here. Many thanks.

  • Victor July 14, 2014, 9:04 am

    I recall being told this advise when I was in high school. I wish I would have listened. Now I pass this advice down to others. As for me, my wife and I kept our first home as a rental. We are moving into land investing next. Thanks for the post and creating this blog.

    -Victor

  • Eve July 17, 2014, 10:50 am

    Financial planning is the best gift the parents can give to their children, unfortunately most of them don’t get it, you are very lucky!
    Do you favor residential real estate vs. commercial real estate? I like Commercial retail real estate for the ease of the management with good cash flow with the right deal, of course it cost more. What are the cons. you see investing in commercial retail real estate?

    • Seth Williams July 17, 2014, 5:31 pm

      Hi Eve, certainly – I don’t own any commercial real estate right now, but I’d love to as my portfolio gets bigger.

      The only real “con” I could see is that commercial buildings are generally more difficult to get occupied – for a number of reasons (especially when the market is bad)… not to mention, the numbers are usually a lot bigger all the way around – so if your building becomes vacant, you’d better be able to handle a vacancy for several months if need be.

      On the same coin, when you do get tenants, they’re usually long term ones (and again – the numbers are a lot bigger, which means you stand to make a lot more money than with a residential property).

      Great question – thanks for asking!

  • Joseph Atkin July 19, 2014, 2:35 pm

    Great post, Seth. Just read it and watched the video. I’m getting closer to starting in land investing, in addition to buying my first rental property. Can you please send the spreadsheet? Thanks!

    joe

    • Seth Williams July 20, 2014, 2:55 pm

      Hi Joe,

      Absolutely – I’ll send it over to you right now. Thanks for the comment!

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