IMPORTANT NOTE: This is written with my sons JC and Timmy as the intended readers.
In the last post we discussed achieving Financial Independence and Retiring Early relying solely on savings invested in stocks. We compared how saving different percentages of income affects when you might expect to reach your FIRE date. The best outcome we modeled would allow you to retire in just under 14 years, but it would also require you to save 60% of your income. What we're going to talk about today is what happens if we buy a Property (or several) instead of just renting and investing in stocks.
So, JC, the thought process is, before we talked about you being able to save a certain amount of money. Based on the personal expenses you have right now you are able to save 30 percent of your income, which is $1,750 a month at the very beginning and that increases with inflation. But, what if instead of just investing all of that in the stock market, we decided to have you buy a single Property? What impact does that have on your ability to retire early?
What I'd like to do is go through the assumptions that we use for that particular Property and then show you the impact that has on your dates for retiring early. Basically, everything is set up the exact same as before. Inflation rate is 3%, the safe withdrawal rate is 3.25%, the target monthly income in retirement is still $4,083.33, and we're still investing any extra money in the stock market Account which is getting a fixed 8.97% return rate. Where it differs though is that in the previous Scenario your personal expenses included rent and totaled $2,627.33 but in this Scenario personal expenses are $1,527.33. That is because the mortgage payment for the house you are living in gets captured elsewhere and is not included in that amount. The mortgage payment will go away once you pay off the house in year 30 and then your monthly expenses will go down even further because you'll only have to pay Property taxes, insurance and any maintenance which will be way less than what rent would be 30 years in the future. Another advantage to buying a Property is that the principle and interest part of your mortgage payment is fixed whereas rents go up with inflation. This means a big percentage of your housing costs are no longer sensitive to inflation.
So let's go look at what buying a house looks like. I don't know the real estate market in Madison where you're living. However, I did look at some stuff online and what I have assumed is we can get a reasonably priced house at $300,000. You're not getting a discount and you're paying full retail price for this Property. I'm assuming you're able to get a 4.5% interest rate on your mortgage. Interest rates vary all the time, so by the time you're ready to do this in a few months, it may be higher than that. Interest rates have been rising a little bit but it's also possible interest rates could drop. The great thing about the Real Estate Financial Planner™ software is that if we need to change any of these assumptions and rerun these Scenarios, you can copy the Scenario into your planner by clicking on the link below and then modify it accordingly.
Copy the Scenario 1 Nomad 5% DP, 30% Saved Monthly into your Real Estate Financial Planner™.Copy Scenario into my Real Estate Financial Planner™ Software
B 1 Nomad 5% DP, 30% Saved Monthly with 2 Accounts, 1 Property, 2 Rules, 1 Goal
Or, read the detailed, computer-generated, narrated
We're also assuming you're getting a 30-year mortgage, which is a 360-month mortgage. That's the most common mortgage we see. A 15-year mortgage is another common one but, the payment is going to be much higher and we don't want to do that for you because we're trying to keep your expenses down in this Scenario. For down payment, I'm assuming you're going to do a 5% down owner occupant loan program which is conventional financing. And one of the things we're going to test is what's the impact if mom and I gift you this 5% down to be able to buy the house versus you paying for it yourself. In this case we're assuming you're paying for it yourself so you're going to wait until you save up enough to have this five percent down payment plus closing costs. If you're buying a $300,000 Property, a 5% down payment on that is $15,000 so the loan amount will be $285,000. Your monthly mortgage payment on that Property is going to be $1,444.05, and if I remember correctly, I think you told me your rent on your Property is about $1,100 a month.
This seems like it's much more expensive. It seems like it's $344.05 more expensive than what you're paying for rent, but there's a couple interesting things about that. Number one is your rent payment is not fixed. Next year it's probably going up. It's probably still going to be going up 15 years from now and it will be considerably more expensive than what you're paying right now. But your mortgage payment of $1,444 is locked in for the next 30 years. So even if it's more expensive today, it's probably still worthwhile for you to lock in your housing payment rather than take the risk of rents going up in the future five, 10, 15, 20, 30 years from now. And eventually this $1,444.05 goes away completely. That's what's magical about a 30 year mortgage payment – it goes to zero after 30 years and then you no longer have a rent payment at all forever.
Next is the closing cost percentage. We're assuming that you're paying one percent of the purchase price in closing costs which in this case would be about $3,000. So, between down payment and closing costs, you'll need about $18,000. We're assuming the Property you buy is all ready to go and doesn't need any work, so the rent ready costs are zero. We're going to assume that you're not able to get the seller to contribute to your closing cost. It's possible we could end up negotiating some seller concessions, maybe a couple thousand dollars, but in this particular case, we're assuming it's zero. Land value, if we're going to actually rent this out later we'll use this for calculating depreciation. For now, you don't need to worry about it because you're not going to be renting out this particular Property. It would come into play if you get roommates and later, we will cover how having roommates could get this $1,444 below what you're currently paying in rent. Imagine for a second, I'll kind of preview one of the other scenarios we'll run in a few days, that you have a roommate that pays you $500 or $600 a month. Subtract that from the $1,444 and you reduce it to less than a thousand dollars, which is less than what your rent it. If you got two roommates, let's say you buy a four-bedroom house and you get two roommates and each of them pays you $500 or $600 a month, which I think is about a typical roommate type fee, then you could actually get this down to considerably less. You could pay less than $500 a month for your share of the house. If you get three roommates and they pay you $500 a month, you essentially could be living there for free. And this is going to be one of the tools we use in order to help you retire early. If we can get your housing cost down to zero (usually a pretty big percentage of living expenses) it will give you rocket boosters on your ability to achieve financial independence, retire early. For now, though, we're assuming you don't have any roommates and that you're just going to buy a Property and we'll see what impact this has on your ability to retire early.
Back to land value. When you do rent out a property you'll be able to depreciate the cost of the building, not the cost of the land. So, take the total purchase price and we'll calculate what percentage of this is the value of the land. In this case, we're assuming it's 15% or about $45,000. We subtract that from the purchase price and we get $255,000 to use as the value of the building itself. Residential Properties can be depreciated for 27.5 years, so divide the value of the house by 27.5 and that will give you the amount you get to reduce your taxes by each year which turns out to be $9,272.73. So if you earn $70,000 in income per year, the $9,272.73 gets subtracted from your income so that you're only paying taxes on $60.727.27. You will want to talk to your CPA or your tax advisor as this is not exactly how it works but it provides a general idea of how having a rental Property helps you get more money back on your tax return.
We've talked a little bit about depreciation. Now we'll go to Accounts. We'll take the money for the down payment from your stock market Account which is also where we'd deposit any income you get from this Property. In this case it's none since you're living in it, but for future scenarios with rentals you will deposit your income in there. Your expenses like your mortgage payment, taxes and insurance will all come out of that stock market Account as well. For the Property value, you're buying it for $300,000 and we assume that over time the Property value is going to increase. If you look at historical data over a very long period of time, 100 years or so, real estate values have gone up at about the pace of inflation. Inflation tends to go up about three percent each year and so has the Case-Shiller Index for real estate values. Now, it is very possible that you may buy a Property and the very next year a pretty significant decline occurs. It's to be expected, not something for you to stress out over. We're going to talk about buying a Property every year or every other year or a couple a year, whatever plan we're talking about, and you're going to end up buying Properties when markets are down, you're going to end up buying Properties when markets are up. With the Real Estate Financial Planner™ software we can model having variable rates of appreciation. So we can model a 10 percent down year, a five percent up year, a six percent up year, a one percent up year. We can go ahead and run lots of Monte Carlo simulations and we will do that in a future post. For now, we're doing a very simplified example using a fixed appreciation rate.
Next, we could delay the start of rent if you were going to buy a Property and fix it up before you rented it out. In this case, you're not doing that since you're going to live in this Property. For the Properties that you're buying that you are going to rent out, you're going to be able to do it immediately and you won't have a delay so leave this as zero. For the monthly rent, I've assumed that this is the monthly rent you need to get for breakeven cash flow if you had put 20 percent down. So, here's the assumption I made about the Madison market. You can go buy a $300,000 Property such that if you did put 20 percent down, which you're not doing in this case, if you were able to get $1,750.90 in rent, you'd be at breakeven cash flow. In this case, you're not renting it out, but if you were able to rent it out in the future scenarios where we're going to have you buy more than one of these, you will rent them out and that rent would be breakeven. Now, since you're only putting five percent down, you're actually going to have negative cash flow. And the way that I like to think about this is instead of you coming up with 20% of $300,000, which would be about $60,000, you're only going to have to come up with $15,000. Any negative cash flow you have is sort of like making payments toward that $45,000 that you didn't put in the down payment. As rents go up each year, the amount of negative cash flow goes down and eventually goes away so after a few years you don't even have negative cash flow. In the overwhelming majority of cases, you never get to the point where the total negative cash flow you have on your Property ever equals the difference, that extra $45,000 that you don't put down. Therefore, we're willing to pay a little bit of a negative cash flow on a Property that we're renting out because we only put 5% down. Or think of it this way. You're willing to set aside $1750 per month to invest in the stock market. So instead of putting the entire $1750 into savings we're going to take some of it and use it to pay negative cash flow. Monthly payments on the down payment you didn't put up is another way of looking at that.
You'll see that when we start adding Properties, even with the very conservative assumptions we're using, you're going to be better off with real estate than you will be with the stock market. We'll go over those numbers in detail, but that's how I look at it. Part of that $1750 you had set aside for investing will be to help cover the slightly negative cash flow upfront but then that goes away over time and the cash flow becomes very significant with a better rate of return than the stock market. We use the same appreciation rate for rent that we had on the Property values. There will be years when rents go up faster than Property values and some years rents will not keep pace with increases in Property values or even years when rents go down. That's normal, but over long periods of time they tend to track. If Property values become really, really expensive and it is really, really cheap to rent more people will want to rent which will increase demand for rentals and allow landlords to increase the rent that they're charging. Then, if renting gets really expensive and Property values are cheaper people will buy instead of spending all that money on rent so they tend to stay relatively even.
Property taxes are calculated based on a percentage of the value of the Property. In this case we've assumed it's 0.75% which comes out to be $2,250/year or $187.50/month. Similarly, we assume Property insurance is 0.50% which is $1,500/year or $125/month. So as the Property value goes up with appreciation, the dollar amounts for taxes and insurance will increase as well. For HOA we are leaving it blank because we are assuming there's no HOA fee but if we did have one we could input an appreciation rate for the annual HOA in here as well. Monthly Utilities and other Monthly Expenses will be left blank and are really more for when we're dealing with multifamily Properties so we'll skip those for now. For maintenance we calculate that we'll spend 10% of the monthly rent on maintenance and repairs once we start renting it out. We'd calculate Property management as a percentage of monthly rent as well but even when you rent this Property out we're assuming you'll manage the Property yourself and will not be paying a Property management fee.
Now let's go through the calculations for determining expenses, income, etc. To determine the Operating Expenses we'll add together the expenses and as you can see below the result is $482.34/month.
Property Taxes + Property Insurance + HOA + Utilities + Other Expense 1 + Other Expense 2 + Maintenance + Property Management = Operating Expenses
$187.50 + $125 + $0 + $0 + $0 + $0 + $169.84 = $482.34/month
Next, we'll calculate Net Operating Income by subtracting Operating Expenses from Operating Income (Monthly Gross Potential Income or Rent – Vacancy Dollar) to get $1216.04/month.
Gross Operating Income - Operating Expenses = Net Operating Income
$1698.37 - $482.34 = $1216.04/month
To get the Capitalization Rate we take the Net Operating Income divided by the Purchase Price of the house to get 4.86%. We'll cover how to use the Capitalization Rate for deal analysis in another post.
Net Operating Income/Purchase Price = Capitalization Rate
$1216.04/$300,000 = 4.86%
Monthly Cash Flow is calculated by subtracting the Mortgage Payment from the Net Operating Income which gives us -$228.01/month in cash flow.
Net Operating Income - Mortgage Payment = Monthly Cash Flow
$1216.04 - $1444.05 = -$228.01/month
However, if we take depreciation into account we can estimate how much extra cash flow from depreciation you will see, which in this case would be $192.87/month.
$9,272.73 × 24.96% tax rate ÷ 12 months = $192.87/month cash flow from depreciation
If we add the cash flow from depreciation back in the amount of negative cash flow becomes -$35.14/month.
We are setting aside money for capital expenses. We know at some point the roof will need to be replaced or we'll need to get a new water heater or furnace so we're setting aside $200 a month for all those kinds of capital improvements to your Property. Now, in reality, you may actually store this in your stock market Account but with the way I'm modeling it, you're setting aside $200 a month. And, we're saying that that goes up by three percent a year as well. Then hit “Save” and we'll run the Scenario.
So, when we add in that Property, what does it look like compared to you renting and just saving 30 percent? We'll compare Net Worth on the Chart below and you can see at month 600 (50 years), in the Scenario where you're saving 30% your Net Worth is $25.5 million and when you buy a single 5% down payment Nomad™ Property it's $21.3 million. You do end up with about $4,000,000 more Net Worth just investing 100% in stocks. I just wanted to show you this real quick but what we're really interested in is how quickly you can get to retirement which we'll look at next.
When we open the table for how long it takes to reach our retirement Goal if we only invest in stocks we can retire in 346 months and when we buy a Property it takes 402 months to retire. So it still looks like just investing all our savings in stocks is the better option and you may be wondering why would we even go through the hassle of buying a home then?
But Wait! Before you stop reading this post and decide you'll just invest in stocks let me point out a few things.
- This is without roommates. If we added in a couple of roommates each paying $500/month this would drastically change our numbers. We will cover this more in another post but just remember that.
- We haven't even touched on Nomad™ yet since we've only covered buying one Property so far.
First, what is the Nomad™ model (which we'll refer to simply as Nomad™ moving forward)? Nomad™ has you buy a Property and live there for a year. Then after you've lived there for a year, you convert the Property (the one in which you were just living) into a rental and you buy a new Property to live in. You live in it for a year and then if you want to continue on, you convert that into a rental and you buy another one. Basically, you serially buy one Property after another but for complete information about Nomad™ you can check out these resources below.
- Nomad 101
- Your Second Nomad Property
- Your Third Nomad Property
- Buying New Construction as Investments and Nomads
- How to Do Nomad Without Moving
So, let's say we go buy the Property that you're living in, and then a year later we buy another Property. We move out of the first one, we convert it to a rental and now you have one rental Property and one Property that you live in. What does that look like?
There's no change to the Scenario in which you save 30% and invest in stocks. It still takes 346 months to be able to retire which is still better than either of the Scenarios in which you buy a Property whether it's one (402 months) or two (367 months). However, the difference is much less when we buy 2 Properties. This is because we had a rental Property and we're able to collect rental income. This rental income is positive cash flow you'd get on that Property and it contributes towards your ability to hit your retirement numbers. The cash flow counts towards the income you'd get in retirement, just like your safe withdrawal rate from the stock market Account. So here's Total True Cash Flow and we only have cash flow on the one where we convert a Property into a rental. If we zoom in, we can see that we have zero cash flow for the first 25 months. That's how long it takes you to get to the point where you're able to save up enough to buy your second Property. When you start renting out the previous Nomad™ Property you have negative cash flow at first. You're at negative $147 a month with this Property because you only put five percent down on this Property. But you can see rents over time are increasing such that you have a little bit of negative cash flow and then rents kind of bump up and you have a little bit less negative cash flow.
Zoom out again and we can see that at month 79 the cash flow turns positive and from this point on the Property is a money producing asset. Even if we take the maximum amount of negative cash flow (-$155) and add it up over the 54 months it took before cash flow turned positive it's only about $8,370. So instead of paying $45,000 more in down payment all at once to have break even cash flow, you paid $8,370 over time (less than since the negative cash flow wasn't $155 the entire time). Which would you rather pay?
Let's look at equity. You're building up equity in your Properties so the amount of money you have is not just your stock market balance anymore. You also have equity in your Properties. So, the one where you're saving 30 percent, you have zero equity. When you buy one Property the amount of equity you have goes up over time. When you buy two Properties, you now have two assets growing in parallel. When you're paying off the loans, a certain amount of the payment each month goes towards principle, which pays down the loan, and a certain amount goes towards interest. And you can see that as how much you owe is going down, how much the Property is worth is going up and the difference between what it's worth and what you owe is your equity.
What about total saved? Remember before we talked about the idea that when you have a mortgage on a Property, after 30 years you no longer have that mortgage payment? Well, this Chart shows how that impacts the amount you're able to save each month. So when we're renting we start with $1750 per month and it looks like it's going up but that's just inflation. So if we adjust for inflation it becomes a flat line. But when you buy your first Property you're able to save only $913 a month. Over time the amount you're able to save increases and when you get to month 367 you pay off the Property and the amount you save really bumps up. Before, when you still had a mortgage on it, you're only able to save $1745 but once it's paid off you're able to save $2339 per month. So not only are you able to save a lot more but you no longer have that housing expense since the house is paid off and the only thing you have to pay are the taxes and insurance. The other interesting thing to point out about this curve is your cost of living is actually going down. Your mortgage payment is fixed, but it's being fixed in inflated dollars. So a dollar in month 250 is worth a lot less than a dollar was back in month 1 and since the mortgage payment is fixed the value of that dollar is less. That's why it's curved and going up.
If we look at number of Properties owned we can see the total number of houses we buy in each Scenario and when we buy them. In the saving 30% we don't own any Property so that line stays at zero. If we look at the blue line it shows the 1 Nomad™ Property Scenario where we buy a Property in month 7. For the 2 Nomad™ Properties Scenario we can see that the timing for when we buy the first Property is the same as the previous Scenario. However, in that one we purchase a second Nomad™ Property which happens in month 26. This shows us it takes 19 months to be able to save up the down payment to purchase the next Property.
Now let's compare personal expenses including real estate. This Chart shows you how much your personal expenses are when you include the cost of real estate. When we rent and save 30% your personal expenses continue to increase with inflation from the start of the Scenario to the end. With the single Nomad™ Property Scenario our expenses increase with inflation and peak at $6466.56 in month 366 just before the mortgage is paid off and then the expenses drop down to $5020.44. When we buy the second Nomad™ Property in month 26 our expenses increase slightly and when both Properties are paid off the expenses drop from $6768.19 to $5252.79.
Next let's talk about total Account balances. In the Scenario where you're saving the stock market balance just keeps going up and up and up. It never really stops. When you buy a Property, you save up and then eventually you have enough for the down payment for the Property. So there's a little dip around month 6 when you buy the Property but then you continue saving and you continue to invest in stocks and the Account balance just grows from there. When you have a second Property, it dips again. So you save up, buy the first Property and your savings dips, save up again to buy the second Property and then your savings dips again but from there you save and the Account balance goes up.
Let's get back to our Goal of early retirement. I've now shown you what it looks like if you buy a Property to live in and what that impact has on your retire date. I've shown you what happens when you buy a Property to live in, live there for a year and then you convert that one to a rental and you buy another Property. Let's look at what happens with being able to retire early if we go and we add one more Nomad™ Property.
When we add in a 3rd Property it's 351 months to reach retirement. Before, with 2 Properties it was 367 so it's getting closer to being the equivalent of how you do in the 30 percent savings Scenario.
There's one other thing I want to point out about this. If you look at the different lines above the target goal it will show you what percentage of the monthly target income you want in retirement that you have achieved. Looking at the yellow line when we have three rentals, you can see that you end up having a higher standard of living in retirement because you're earning more money than you need to live in retirement. So you could technically bump up your standard of living.
If we add in a 4th Nomad™ Property we actually beat the Scenario where we're just saving and investing in stocks. You reach your Goal at 331 months which is better than 346 months it takes with 100% invested in stocks. You also end up with a much higher standard of living the longer it goes out, which is one of the key factors we want to do, right? You want to become more and more relaxed and more and more financially independent. Again, this is assuming no roommates, no gift from your parents, saving 30 percent. If you go and you do Nomad™ four times to get three rentals, one owner occupant Property, it ends up being better.
We're going to jump ahead and add Nomad™ Scenarios 5 through 11 to this Chart to see what impact it has on when we are able to achieve retirement.
So when we look at the Goal Chart comparing the length of time it takes to achieve retirement we can see that the best outcome from doing the Nomad™ model with the assumptions we're following is 289 months or 24 years 1 month. One thing I do want to point out is there's a point where buying more Nomad™ Properties doesn't help you reach your FIRE date any faster. Buying your ninth, 10th, and 11th Nomad™ Property all get you to retirement in the same amount of time so you may want to stop at nine. Your income in retirement will continue to go up as you buy more Nomad™ Properties but the benefit of buying these extra Properties doesn't happen until much later into your retirement so it may not be worth doing.
If we compare the Total True Cash Flow for all of these Scenarios we can see the difference in what you're making when you stabilize and pay off the Properties. So when you own 11 Nomad™ Properties, it's like making $10,000 a month in inflation adjusted dollars after all expenses including taxes, insurance, maintenance, capital expenses. Even if you stop at 9 Nomad™ Properties you'll still have $8230 in passive income from your rental Properties which is nearly twice what we decided we'd need for retirement. With just investing in stocks we don't have any cash flow since we don't own any rental Properties.
Let's look at Total Equity now. If you buy 11 Nomad™ Properties you'll have $3.3 million dollars in equity. If you stop at 8 you'd have $2.4 million dollars in equity. In the Scenario where you keep renting and investing in stocks you don't have any equity because you don't own any Properties.
If we pull up Total Account Balances you can see the Scenario with 11 Nomad™ Properties has $6.5 million dollars in the Account. The Scenario with 8 Nomad™ Properties has $6.3 million dollars and the Scenario where we just save results in $5.8 million inflation adjusted dollars in your Accounts.
Finally, let's check out your Total Net Worth. We'll zoom into month 600 again and you can see when you do 11 Properties your net worth is $9.8 million dollars. Versus if you only save 30 percent, it's $5.8 million in today's dollars. So the difference is definitely significant. Even if you only buy 3 Nomad™ Properties your net worth ends up being better than just the 30 percent into savings Scenario as you can see in this Chart below.
That about sums up what it looks like when we decide to purchase some Nomad™ Properties versus just saving 30% of your income and investing in the stock market. In the next post we'll change some of the assumptions and explore how to further optimize our Financial Independence, Retire Early Goal.