By Brad Thomason, CPA
A big part of the work that my team and I have done over the last 15 years is based on a simple premise. The world of investment assets is made up of more than just stocks and bonds, and the first alternative that most people think to look at when they start their wider exploration, is real estate. Investing in real estate is not as easy as buying stocks and bonds from a broker. The whole purpose for this part of our practice has been to remove (or absorb) many of the most common hassles, to make it easier and in turn more accessible.
When considering asset selection decisions, portfolio size plays a big role in matters related to diversification and the particular investments chosen for inclusion. Using a single model-portfolio and making simple, ratio-based adjustments for commas and zeroes is not an informed way to do this in the real world, at least not in personal finance situations. What’s right for one investor may not be even remotely right for another. In general, I have a reflexive aversion to just about any of the one-size-fits-all ideas bouncing around out there.
But today we’re going to talk about something which actually could realistically be part of a wide range of portfolios, including some that would be smaller than what you would normally see for a real estate allocation.
The set up is a single rental house that you sweat-equity your way into, along with a mortgage from your bank (and maybe just a little bit of cash or short-term borrowing for building materials, appliances, etc; which you’ll pay back within the first year or two from the rental income).
Most banks, even big ones, will do this deal; at least for a single property or two. If you try to go multiple units, you may start running into some headwind. But as long as you have decent credit and can demonstrate ability to make payments even if the house isn’t rented, they’ll usually say yes.
I’ll mention one more preparatory remark before we get into the specifics: We want to analyze this particular move in a unique way. Instead of looking at the investment performance itself, we want to look at how its presence affects the rate at which the other parts of your portfolio have to supply income after you retire.
Unless you have several million dollars and are already into your seventies, the odds are good that at some point you are going to have to start spending down your investment capital, even if right now your portfolio could generate enough each year to meet the income need. That’s just what happens as inflation does its thing over the years.
We refer to this situation – spending the annual return and dipping into the principal, as well - as a depletion model. Any time a depletion model is in play, the rate of depletion matters a lot for planning purposes; and disrupting that rate of depletion becomes very important. Enter our rental house.
I will now attempt to summarize the impact of taking this step within the broader context of a standard retirement income projection. That said, it’s a lot easier to understand if you can see all the numbers. It would create a mess to try to put all of that into a blog post, but we’ll be happy to send you the spreadsheet if you want to look at the details. Just pop us a note through the Contact tab and we’ll email it to you.
In the hypothetical we created, we gave a 65 year old $1,000,000; set the rate of return at 6%; set the initial, annual withdrawal at $60,000 (increasing by 2.5% each year for inflation); and sat back to see what would happen. Answer: twenty years later the balance was down to about $520K; and came to the point of full depletion near the end of year 26.
Then we made a single adjustment. For the second run of the numbers we added $2,500 a year. That was the net that was left from the rent payments on a $100,000 rental house (i.e. after paying for all of the operating expenses, and servicing the debt). That’s it. That’s the only difference. Just $2,500 a year.
Which probably doesn’t sound like a lot of money.
But it makes a bigger difference than you would think.
At the twenty year mark, instead of having $520K left in the portfolio, there was $610K. That’s right: 20 years of receiving $2,500 (i.e. a total of $50,000) made a $90K difference to the portfolio. Compounding returns are pretty cool, aren’t they? Plus, our retiree had also built up $57K worth of equity in the house. And that’s assuming zero appreciation from the day it was bought. Nor any increase to the rental rate.
Looking on down the track, this ultimately pushed the point of depletion out a couple more years (keep in mind that initial income of $60K a year climbs up to about $115K a year after that many years of inflation…), or age 93.
I think the implications here are pretty obvious, so I’ll point out that one scenario clearly looks better than the other, and leave the commentary right there. You will probably want to explore some variations on this theme (HINT: you don’t have to stop at one house…).
I like this exercise for several reasons. First, it highlights the importance of understanding the depletion dynamics, and how to disrupt them to postpone their ultimate effect. This concept also highlights the use of your full balance sheet: it not only utilizes assets as they are classically understood, but also pulls in credit worthiness and ability to inject labor to create capital. Both of which are important resources, with nearly endless applications. Finally, it demonstrates that surface-level analysis often fails to show what more complicated studies make clear: who would think $2,500 a year could have such a big impact down the stretch?
To finish where I started, this sort of play has applicability across a wide range of portfolio sizes. Even if you think you are going to have enough, this is a nice way to get some cushion. On the other end of the spectrum, this could be a powerful means to closing any shortfall gaps you may be expecting. People sometimes try to do that by amping up risk in pursuit of higher returns, often to disastrous effect. This is a more sober approach, and one that probably has better odds of actually working.
Herbert Hoover promised a chicken in every pot. I don’t know much about chickens, or whether he delivered on that promise. But I can recommend a nice 3/2 in an established neighborhood, if you’re interested.
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