In the 20th century retirement model, workers saved up a nest egg over the course of their career, then gradually spent it down in retirement. Many received a pension from their former employer, and most received significant Social Security benefits to boot.
Those days are gone.
The number of defined-benefit pension plans dropped by 73% between 1986-2016, according to the Department of Labor's Employee Benefits Security Administration. Of the remaining private sector employers who offer pensions, 63% are looking to end them within the next five years, per Mercer's 2020 Defined Benefit Outlook report.
While Social Security remains solvent for now, that clock is ticking as well. Analysts calculate Social Security will be insolvent by 2035 without major overhauls, and forecast Medicare’s hospital insurance fund to be depleted by 2026. Already, Social Security benefits have seen a decline in real dollars, losing 33% of their buying power since 2000 according to the Senior Citizens League.
All of which means that Americans are increasingly on their own to plan and pay for their retirement. Yet the median American retirement savings is only around $50,000, per a 2019 Transamerica study, and even baby boomers remain woefully unprepared for retirement.
Fortunately, the 20th century retirement model isn’t your only option for retirement income. Here’s how how to invest in real estate for retirement to tilt the scales back in your favor.
Real Estate Retirement Lets You Diversify From Stocks
Historically, stocks have offered high average long-term returns, but the stock market is so volatile that it poses a risk to retirees. That risk has a specific name: sequence of returns risk, or the risk of a stock market crash early in your retirement that decimates your portfolio.
To mitigate this risk, financial planners traditionally urged people to increasingly shift their asset allocation from stocks to bonds as they got older. Bonds provided much lower volatility, but at the cost of returns.
Real estate offers a third option. Investors can benefit from high returns, without the volatility of the stock market. One study of 145 years of stock, bond, and real estate returns found that rental properties offered even higher returns than stocks over the long-term, but with far lower risk and volatility.
By diversifying their investments to include real estate, those approaching or in retirement can create an income floor and mitigate sequence of returns risk in their stock portfolio. And with higher returns, investors can invest less cash to reach the same retirement income.
Ongoing Income, No Loss of Assets
Ever heard of the 4% Rule? It proposes that retirees can sell off 4% of their portfolio in the first year of retirement, and keep withdrawing that amount each year thereafter (plus inflation), with a near-certain likelihood of their portfolio lasting at least 30 years.
In other words, you gradually sell off your portfolio, with the goal of dying before you run out of money.
I don’t like that plan. The very notion of "safe withdrawal rates" revolves around my net worth diminishing, and me hoping not to outlive my money.
I want my nest egg to keep growing indefinitely, to keep generating ongoing income. Which is what rental properties do.
The rents keep coming, month after month, year after year. You don’t have to sell off any assets to generate that income. In fact, your net worth rises over time, as the properties (hopefully) appreciate, and as your tenants pay off your mortgages. And when you do eventually pay off your rental property loans, your cash flow leaps upward.
When you don’t have to sell off any assets in your portfolio to generate income, you don’t have to worry about safe withdrawal rates. You can live to the ripe age of 120, with more income than ever, and plenty of inheritance to leave your children or charities.
Returns Adjust for Inflation
One of the problems with bonds is that inflation eats into their returns.
Imagine you buy a one-year bond paying 3%. At the end of the year, you get your original investment back, plus 3%. But if inflation ran at 2.5% that year, then your real return is only 0.5%.
But with rental properties, the rents constantly rise. In many markets, rents actually rise faster than inflation, and rents remain one of the primary drivers of inflation at large.
So instead of inflation diminishing your returns, many property owners actually come out ahead on inflation. If inflation rises by 2.5% this year, you can probably raise your rent by 3%, assuming demand remains strong in your market.
In fact, when you borrow a rental property loan, inflation works entirely in your favor. Your monthly mortgage payment stays fixed for the next 30 years, even as your rents rise each year. So the spread between your rental property loan payments and your rents widens faster with each passing year, as rent increases compound on one another.
Higher Retirement Income Yield Per Dollar Invested
When retirees follow the 4% Rule, they must save up 25 times their desired annual spending: 4% times 25 equals 100%.
So, if you want $40,000 in retirement income from your paper assets, you need to save up $1,000,000.
Rental properties obey different laws. Imagine you invest $80,000 to buy a rental property that rents for $1,000 per month. Assuming you lose half of that to non-mortgage expenses such as vacancy rate, repairs, property management fees, insurance, property taxes, and so on, that leaves you $500/month in net income. Annually, that comes to $6,000, for a yield of 7.5% ($6,000 divided by $80,000 yields a 7.5% return).
To produce $40,000 in net income, you would need six or seven of those properties (technically 6.67 of them). That would cost you $533,333 in cash – around half of the amount you’d need if you followed the 4% Rule.
Which says nothing of leveraging rental property loans to earn even higher cash-on-cash returns.
Leverage Can Yield Even More Per Dollar Invested
Rather than buy cash, say you put down 20% and took out a rental property loan to cover the rest of that $80,000 purchase price. You put down $16,000, and borrow the other $64,000 at 5% interest for 30 years.
That adds a monthly payment of $343.57 for principal and interest, reducing your net monthly cash flow to $156.43. Annually, that comes to $1,877, on your $16,000 cash investment, or an 11.73% yield.
How many of those properties would it take to generate $40,000 in annual income? Around 21 rental properties, 21.31 to be exact. And at a $16,000 cash investment apiece, that would cost you $340,941 in down payments.
Roughly a third of the amount of cash you’d need according to the 4% Rule.
Keep in mind these examples merely illustrate a point; every rental property comes with a different yield, and different borrowers can access mortgages at different interest rates. But these yields and loan terms are realistic for experienced investors.
Rental investors have far more control over their investments’ performance than stock or bond investors.
When you buy a stock or bond, you hope for the best based on historical risk and performance. You have exactly two options: keep the asset or sell it.
But landlords can mitigate the most common risks posed by rental properties. By buying in stable, high-demand neighborhoods, they mitigate the risk of vacancies. By thoroughly screening tenants, with a detailed rental application, tenant screening reports, and verifying income and housing history, they mitigate the risk of rent defaults and tenant-caused property damage. In fact, a person’s rental application and housing history can help landlords exclusively rent to long-term tenants, mitigating the risks and costs of turnovers.
Landlords can also mitigate risks with insurance. Comprehensive landlord insurance policies cover not just property damage but also liability. And nowadays, landlords can even buy rent default insurance, that kicks in if the tenant stops paying the rent and needs to be evicted.
Rental property owners can deduct all incurred expenses, and some paper expenses, all while still taking the standard deduction. These property expenses get deducted on a separate schedule in your tax return.
From maintenance costs to bookkeeping, travel expenses to property management software, rental applications and screening reports to lease agreements, landlords can deduct it all. They can also deduct mortgage interest on rental property loans – again without having to itemize personal deductions.
Property owners can even deduct for depreciation, a paper expense, to reduce their tax bill even further.
With all these tax benefits inherent in real estate, investors don’t need to rely on tax-sheltered accounts such as IRAs or 401(k)s. They can use those tax-sheltered accounts to score tax breaks on their paper assets such as stocks, while still getting great tax breaks on their real estate.
A sound retirement portfolio doesn’t count on just one source of income. Not Social Security, not a pension, not your paper assets, and not rental properties.
The trick is to create multiple, diversified sources of income for retirement. That should unquestionably include stocks but shouldn’t stop there.
I personally plan to reach financial independence in my early 40s. Here’s how my income will likely look:
- Rental Income: 30%
- Dividends from Stocks: 15%
- Private REITs: 10%
- Private Notes: 5%
- Post-Independence Fun Work: 40%
Actually, my post-independence fun work will generate a lot more income than that, but I plan to just keep investing it to generate ever more passive income.
Don’t put all your nest eggs in one basket. Invest for stocks for diversification and liquidity, real estate for ongoing income, and whatever else you like based on your own personal needs, but the more diverse it is, the easier you’ll ride out economic storms when they inevitably strike.
How does real estate fit into your retirement strategy? When do you aim to retire or reach financial independence?