Case Study: How to Replace a $70,000 Job Income Using Rentals (for the Math-Averse!)
The first step to properly answer an important question is to challenge its premise. In this case, the premise is that since you’re currently earning $70,000 per year in your job, you would need to replace that entire amount if you needed to maintain the same standard of living in retirement. But is that really true?
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Take a look at how your current income is utilized. The majority of your current income goes to covering living expenses like mortgage, food, utilities, debt payments, etc. But some of it usually goes to fund retirement investment accounts. Some of it may go to fund education accounts for your children. Lastly, if you’re living below your means, some of it would go to savings. When you retire, the passive income you will rely upon must cover your living expenses. But you will not need to keep saving for retirement, and your children will probably be out of college so you won’t need to fund any education accounts.
I get why most long-term investors pick their current job income as the target for their retirement income. By our very nature, we don’t like change — especially when it comes to our finances and especially when we view our current position as comfortable. So, to set a goal of simply changing the source of the income (from active to passive) but not its quantity makes sense. However, I see many investors who postpone their retirement indefinitely because they can’t reach a certain level of income, which, upon closer inspection, isn’t necessary for them to retire in the first place.
Perform an Audit
My advice to you is to do a quick audit of your personal income and expense statement to figure out exactly what your necessary living expenses are for the lifestyle you want to lead in retirement. That amount is the minimum required for your retirement. Then, if you’d like to cushion that amount to allow for fun, discretionary items like travel, extra spending money, etc., that’s perfectly fine.
Having questioned that premise to death, now let’s assume that $70,000 is the right income amount you need to create through your real estate portfolio.
How many rentals will it take for you to reach that goal?
The answer will depend on two main things: the investing model to follow and the type of investment property you target.
Real Estate Investing Models
There are countless permutations of real estate investing strategies that you can follow in pursuit of your goal. But if we zoom out and take a look at the big picture, there are two primary investing models or schools of thought. Neither of them is wrong or right in and of itself. You have to figure out which one is a better fit for your investing style and aversion to risk.
First, let’s go over some fundamentals. Income (or cash flow) is the yield on capital. Think of it as a dividend on your money invested. If you had enough capital lying around, you could create whatever income stream you wanted by simply purchasing the required amount of real estate. For example, let’s say you had a cool million dollars in your glove compartment doing nothing. You could purchase $1M worth of real estate that yields 7% per year and create an income stream of $70,000 per year without breaking a sweat.
Of course, the problem is most of us don’t have a cool million dollars just lying around, so the fundamental problem we need to solve is how do we acquire enough real estate using the capital we do have to achieve our goal.
Now, the amount of real estate you need to own will depend on the long-term real estate investing model you follow.
The Perpetual Leverage Model
The first real estate investing model was popularized by Robert Kiyosaki and his bestselling book Rich Dad Poor Dad. The idea itself far pre-dates Mr. Kiyosaki, but his successful book certainly popularized the model. Let’s call that school of thought the “perpetual leverage” model. The idea is simple and it focuses squarely on cash flow.
Suppose you purchase an investment property for $100k, putting down $20k of your capital and borrowing $80k for 30 years at 5%. After the purchase, you turn around and lease the property for $1,000 per month, and your operating expenses are $400 per month, leaving you will $600 per month to service the debt and make a profit. The mortgage payment is $430 per month, so your positive cash flow is $170 per month.
The perpetual leverage model assumes that the property will remain leveraged for the entire term of the loan (hence the name "perpetual") and you will make mortgage payments according to the schedule the lender set when they made the loan. In essence, the property is a leveraged ATM machine that throws off $170 each month.
So back to your goal: You want to replace $70,000 a year in job income with passive real estate income. That means your real estate portfolio must produce $5,833 per month in income. If we assume that each property you own will produce a leveraged cash flow of $170 per month, you would need to own 34-35 such properties to achieve your goal under the perpetual leverage model ($5,833/$170).
The Smart Leverage Model
The second long-term real estate investing model is the “smart leverage” model. It recognizes the fact that leverage is necessary to bridge the gap between the capital we have and the real estate we must acquire to achieve our income goals. But it simply uses leverage as a tool in the acquisition of a larger asset value, not a support column to hold the weight of your entire portfolio. The basic idea is that an investment property produces the maximum amount of nominal cash flow with the minimum amount of risk and management when the investment property is free and clear. Second, under this model, cash flow is very important, but its timing is more important.
In the end, we’re all after cash flow. The crucial question is, when will you need this cash flow? Every investor I have spoken to over the last decade has told me they’re after creating cash flow. When I ask the question of when they need the cash flow, a puzzled look comes over their face and they ask me to clarify what I mean. My point becomes crystal clear when I ask them if they’re planning to use current cash flow to pay that month’s light bill or buy groceries. What most real estate investors are really after is cash flow at retirement.
If that’s true for you, doesn’t it make more sense to use current cash flow (which you don’t need to cover current expenses) to grow your asset value through paying off the mortgages that encumber them? In other words, under this model, we will NOT pay off the mortgages according to the schedule your bank set. Which brings up an interesting question: When the bank set that schedule, do you think they did it because it was good for them or because it was good for you? I rest my case.
Back to the case study. That same investment property that produced $170 per month in leveraged cash flow would produce $600 per month in cash flow if it were free and clear ($1,000 rent less $400 operating costs). Therefore, you could achieve the same $5,833 per month in income by owning 9-10 free and clear properties (instead of 34-35).
Putting aside the question of how you could reach the point where you own 10 free and clear properties for a moment, which investor would you rather be? Would you prefer owning and managing 35 properties all the while carrying a multi-million dollar mortgage balance or would you rather own 10 free and clear properties if both methods produced the same passive income? Lastly, do you think one method leads to an inherently riskier portfolio, and how does that factor affect your decision?
The answers to these questions will indicate which model works best for you and your investing style.
The second factor that determines how many properties you need to acquire is the type of investment property that is available. In the case study above, we used a $100,000 single family property (because it’s a nice round number that makes it easier to calculate). But in your specific situation, the numbers will likely be very different, as will the types of available property at your disposal. As an example, in your market, there might be an available supply of small multifamily properties (2-4 units) that fit your property criteria. The numbers on these properties would vary quite a bit from the simplistic example I provided above.
But the principle remains unchanged.
- First, determine which model you want to pursue.
- Then, get clear on the basic numbers of an “average” investment property in your target market (price, rent, operating expenses, net operating income, debt service, and cash flow).
- Depending on the model, you can divide either the monthly cash flow (perpetual leverage) or monthly net operating income (smart leverage) into the monthly passive income goal to determine the number of properties you need to acquire.
[Editor’s Note: We are republishing this article to help out our newer readers.]
Which model do you (or would you) use to determine what you need to replace your income? Where are you in this process?
Let’s talk in the comments section below!