In my previous two posts FI Portfolio – I: Effort Free Option with Index Funds, and FI Portfolio – II: Eat Your Cake with Dividend Income Strategy , I talked about two different portfolios to get enough passive income to achieve Financial Independence. With the first option, we invest money mainly in index funds of mixed stocks and bonds, and get income by following the 4% withdrawal rule; and with the second option, we invest money in dividend growth stocks, and get enough dividend to cover all living expenses.
They are both very good options, but require one common condition: your portfolio value needs to be big enough, most likely at least one million in order to get an annual income of $40k. For a lot of people, it is perhaps too big a number to reach even after years of work. Here comes the third option: invest in rental properties. Rental properties can significantly shorten your time to achieve financial independence , thus I call this portfolio a “short-cut”.
Benefits of Rental Properties
Let’s look at some numbers. Assume a rental property has $200 per month cash flow with an initial investment of $25,000 ( initial purchasing costs and 25% down payment on mortgage), 100k will buy you 4 rental properties that give you $9600 (($200×4)x12) in passive income. So the rate of return in terms of cash flow is 9.6% ( 9600/100k). On the contrary, 100k invested in index funds will only generate $4000 a year with a 4% withdrawal rate ( 100k*4%).
Different from a stock, which you don’t have any control of its price and dividend payout, your rental properties are controlled by you thus you can improve the rate of return in various ways. For example, you can figure out ways to get a mortgage with less than 25% down payment, or buy a rental property at a very good price, or manage the properties well to increase cash flow.
Not only do rental properties bring you much more cash flow for the same amount of investment, they have other great advantages. First, in addition to cash flow, you gain more and more equity on the house due to monthly mortgage payment and house value appreciation. At the end of your mortgage term, you will not only own the property straight up, but also have a much higher cash flow after getting rid of mortgage payment.
Second, you get great tax benefits on rental properties, which is one of the main reasons that a lot of rich people invest in real estates. You can deduct all the expenses related to rentals, mortgage interest, property depreciation, etc. You might get $10k cash flow from your rentals, which is your real income, but when you file taxes, it is possible your “taxable income” is only 2k. Even if you sell a rental property for a big profit, as long as buy another rental as an “exchange”, you don’t pay any tax on the profit. I am not going to get into the details, but trust me, you will be amazed how tax rules favor landlords once you become one!
Third, you can borrow against your rental properties if needed. As your house value goes up and gains enough equity, you can either refinance or get an equity line of credit to take a big chunk of money out. You can invest the money to buy more rental properties, or in stocks, to generate more money. However, be careful of leverage. It is a double-edged sword and needs to be used wisely.
Last, compared to stocks, rental properties are much more predictable. You can estimate the value of a property quite accurately either by using an expert, or even just doing your own research. Cash flow can be estimated by factoring various costs associated with a rental with historical data of similar properties. There is a reason why rental property investors are called “Mom and Pop landlords” because it is a skill that can be mastered by average people, yet stocks are too “difficult” for most people.
Drawbacks of Rental Properties
Although rental properties provide much more cash flow compared with stock investment, they do have their own issues. First, it is more time consuming to get a rental property that gives you a good rate of return. For stocks, at least you can buy index funds and let time do its magic, but for rental properties, you need to do your own research and make sure you know what you are doing.
Second, owning a rental property will never be as effort free as owning an index fund. Even if you hire a management company, you still need to keep an eye on the property and make decisions when things come up. You need to deal with property managers, insurance companies, tenants, homeowner associations, and maybe attorneys if unfortunately you get sued.
Third, selling a rental property takes time. In an emergency situation, you can count on selling stocks to get the cash you need fast, but never from a rental property.
A Mixed Portfolio with Rental Properties
I like stocks for its simplicity and easy to liquidation, yet I like rental properties for its high cash flow, leverage, and tax benefits. Both of them serve essential roles in a portfolio. We can choose to invest half a million either in index funds like Portfolio-I, or dividend stocks like Portfolio-II, which provides about 20k passive income a year, and then invest 200k on rental properties, which can provide you another 20k passive income. In this way, you would only need 700k to achieve financial independence, instead of more than 1 million. Think about how long it is going to take you to go from 700k to 1 million, that’s how much faster you can achieve Financial Independence.
You might ask, but even 700k is too big a number to achieve. If you like real estate, it is possible you can start from zero and still reach your goal. For example, you can buy a house that needs work with a good price as your primary house, thus only 3% to 5% down-payment is needed. You work on improving the house by yourself to increase the value of the house. Once the house value goes up, you can refinance to get the extra equity out, using the money to buy your second house. And repeat the same thing. Sooner or later, you will get enough cash flow to support your life, instead of working in a cube and let others to decide how to live.
If you are interested with real estate investing, I highly recommend BiggerPockets, Everything you need to know about real estate investing, you can find there ( This is not an exaggeration! Seriously, everything you need). If you are a beginner, definitely read Ultimate Beginner’s Guide to Real Estate Investing first, and then thank me later, 🙂