How Much Will You Need to Live on Your Investments? Use This Equation!

by | BiggerPockets.com

“How can I quit my job and live on my investment income streams?”

This is a massively more complex question than it first appears. At the most conservative level, the answer is “enough money to pay for everything you’ll need to buy for the rest of your life.” But, of course, the real answer depends on a lot of factors. Let’s make an equation.

  • Take the total amount of money you need to live a full life for a year. Let’s call that y for “a year’s worth of expenses.”
  • Take the total amount of money you need to spend to maintain every property in your portfolio for a year. Let’s call that m for “maintenance costs.”
  • Take the amount of money that you make in profit in a full year of property investment. Let’s call that i for “income.”
  • Subtract your age from 90. We’ll call that l for “anticipated lifespan.”
  • And we’ll call the total amount of money you need in the bank $ for obvious reasons.

So the amount of money you’ll need to make, in the abstract, is:

$ = l[i-(m+y)]

In other words, you need enough money ($) to cover the difference between your anticipated expenses (m+y) and your anticipated income (i) for every year for the rest of your life (l). So our answer has changed from “enough money to buy everything you need for the rest of your life” to “enough money to cover the difference between total expenses and total income for the rest of your life: $ = l[i-(m+y)].”

While this equation is great in the abstract, it ignores a critical part of real-world landlording: the existence of natural (and man-made) disasters.

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The Disaster Recovery Fund

In the real world, there are three categories of expense: operational expenses, capital expenses, and disaster recovery. OpEx consists of all of the predictable, repetitive expenses involved in keeping your rentals full and productive, including routine maintenance. CapEx consists of all of the predictable expenses involved in replacing/upgrading, renovating, and any large repair/replacement expenses the IRS requires you to depreciate. Both of these, because they’re predictable, can and should be accounted for in the m number above.

But disaster recovery expenses are unpredictable — and they can range from a few thousand to several hundred thousand dollars. Fortunately, a full suite of insurance covers most of these situations, shifting them to the m column (at a small but well-worth-it cost). Unfortunately, there are several situations that are rare-but-normal for landlords that insurance doesn’t cover — like “my tenant died, and no one found them for a week, and now we have a ton of expenses in addition to lost rent.”

In order to compensate for uninsured disaster expenses, we have to add a big chunk of change to the pool of money waiting in the bank and about 2.5% of that amount to your monthly expenses in order to keep your emergency fund flush for the next emergency. So how much do you need? Assume you need about $10,000 base, plus another $2,000 per house in your portfolio. This means we need to add a new number, h, to our equation.

The new equation, after a bit of simplifying, is:

= [10,000 + h(2,000)] + {l[i – (m + y + 250 + h50)]}

(Because it’s not obvious: the “250 + h50” is the 2.5% of [10,000 + h(2000)] you need to keep the emergency fund continuously re-stocking itself.)

But, of course, that’s not anywhere near the total answer either — because who the heck knows what’s going to happen to your expenses and your income as time goes by? We’d all like to believe that our income will go up and our expenses will go down, but anyone who has been a landlord for any length of time can tell you that real life is far more complex than that. On a related note, did you know that the number one cause of investor failure is a lack of proper attention paid to cash flow?

Accounting for Changes in Cash Flow

This model has a subtle flaw in it. If you’re currently in a position where your income exceeds your expenses, you can plug everything into our current equation and come out with a negative number! But it would be the height of silliness to believe that you can quit your job with no money in the bank.

Ultimately, the problem with this model is that, as a landlord, both expenses and income vary from month to month — sometimes wildly! And if your expenses exceed your income for a few months in a row, you can rapidly eat through what you thought was your “emergency fund” and end up submitting resumes again. So once again, we need to build another safeguard into our equation to prevent ourselves from becoming the victim of a sudden shift in cash flow.

In order to do that, we should assume that every year will bring us a couple of months of bad luck, where our expenses go up by 100 percent and our income drops to $0, and we should add a flat fund to cover the difference, along with an additional expense to recreate that flat fund every year. In other words, our flat fund needs to contain an additional 1/6m (to cover 2 months of monthly expenses), and an additional 1/6i (to cover 2 months of lost income). Also, our annual expenses need to go up by the same amount.

The new equation, after a bit more simplifying, is:

$ = [10,000 + h(2,000) + (1/6m) + (1/6i)] + {l[i – ((7/6m) + (7/6y) + 250 + h50)]}

This is looking mighty complex, but we’re finally getting to the realm of sanity in terms of being able to confidently quit your job and invest in real estate full-time.

Almost. There’s one further wrinkle: As a property investor, you are going to want to be able to expand your portfolio — as in, you are going to want to be able to buy more properties. Fortunately, we don’t have to actually dig that deep right now: This equation deliberately doesn’t take into account a wide variety of non-income assets (equity, investments, inheritance, and other windfalls). Those assets can be used to further develop your property portfolio, and with just a little bit of risk-taking, the flat fund you’ve set aside can help. It wouldn’t be investing if there weren’t risk, after all!

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An Example

Let’s say I’m 37 and I own 7 investment homes. I’ve adapted to scraping by on $23,000/year, having put all of the extra money into buying those homes. I typically bring in an average of $9,000/year per home, but I spend $2000/year per home on maintenance, property management, and other related expenses.

How much do I need in the bank to quit my job?

$ = 10,000 + (7*2,000) + (1/6*14,000) + (1/6*63,000)] + 53{63,000 – [(7/6*14,000) + (7/6*63,000) + 250 +(7*50)]

$ = 10,000 + 14,000 + 234 + 10500 + {53[63,000 – (1634 + 7350 + 250 + 350)]}

$ = 34,734 + 53(63,000 – 9584)

$ = 34,734 + 53*53,416

$ = 34,734 + 2,831,048

$ = 2,865,782

Yep. I need nearly $3 million to retire and live entirely on the projected income from your houses.

Yes, this is a LOT of money! But because of the way the math works out, the number gets smaller quickly the more houses you have in your portfolio (and the higher the average net income per house). If you have 20 houses, you can drop it into the high-six-figure mark. If you have 40, you can probably quit your job with what you have right now.

The lesson here is simple: If your goal is to safely live on your investment income, you need a significant portfolio — or a huge safety cushion in the bank. Either way works. What doesn’t work is dropping your day job and trying to live on $200k in savings with only a handful of houses bringing in money.

Run your own numbers through the equation…

Then, if you’re comfortable sharing, let us know what you got!

About Author

Drew Sygit

Drew is the manager of Royal Rose Property Management, a fairly high-tech solution for Detroit Metro area property owners & investors.

27 Comments

  1. Curt Smith

    One thing one looses when you quit is the ability to buy more rentals with bank mortgages. True there are portfolio lenders like visiolending dot com who lend not on W2 but you need 30% down plus reserves plus rehab cash. A lot of cash in other words.

    You can take up wholesaling to make more cash or switch to marketing to expired listings for lease option or subject to deals that are low cash needing.

    Your buying more deals and expanding your passive income stops when you quit with a very tight budget.

    You’re so young why quit? Find a job you like and keep working and keep adding to your rentals.

    • David Krulac

      We never lost ability to get mortgages after leaving the W-2 world behind, in fact got about 40 mortgages, residential, commercial and portfolio and never put down more than 20% sometimes less. Some of the portfolio mortgages were from local credit unions that kept the mortgage in house and did not sell to Fannie and Freddie. We’ve bought and sold over 900 properties and the oss of W-2 income had no effect on the ability to get institution mortgages. We’ve gotten mortgages as low as 2.87% fixed and many others in the 4% range all fixed.

      • Drew Sygit

        @DAVID KRULAC: thanks for sharing your personal successful experience!

        You bring up a great point about also establishing connections with small local bankers and credit unions that may do lending like this. We had some here in the Detroit area that were doing so before the real estate crash, but they really haven’t started doing so again yet. I know it’s being done in other states though that have recovered faster than Metro Detroit.

    • Drew Sygit

      @CURT SMITH: Great points Curt! Another option is start farming NOW for private lenders (friends, family & other investors) so you can keep buying after you quit your day job. Trumpet your successes so they associate you with success and will lend you funds from their retirement funds (via self-directed IRA’s)!

  2. I very much appreciate the time and effort taken to write and post this article, but I am concerned that it misses the mark. If I understand correctly, the author has concluded that the hypothetical investor needs about $2.87 million put away to retire for an income stream of $23,000/year. There has been a large amount of information collected and articles written over the past few years concerning the amount of money a person needs to “retire”. In simple terms, a common approach is to say that you will need to withdraw no more than 4% a year from savings to make a go of it. In this article, the author arrives at the equivalent of a 0.8% withdrawal rate. I would very much encourage those of us looking at giving up the day job to visit one of the big investment houses that offer retirement calculators (Monte Carlo simulation anyone?). A great website for insight into early retirement funding is CanIRetireYet.com. There is a very comprehensive review of retirement calculators there. The guy that runs the website is very straightforward and objective in his postings. Good luck to all in getting to that elusive life of living off of our investment income.

  3. KEVIN SAPP

    As a recently retired, early, I’ll have to agree with Jason and Michael. There are tons of blogs now that are dedicated to early retirement, simulations and calculators that, allow for growth of the investment in the calculation. My favorite is firecalc. Financially Independant Retire Early (FIRE).

    Even an annuity (not recommended) would give ya 5% these days, 5% of 3M would be 150K a year.

    I see many folks discuss retiring early and being successful, once ya dig in, many have pensions and some type of medical benefit plan. Folks, trying to live on 23K a year AND pay for medical insurance for two people, uhhh not happening in the US. I live in NC, 54 years old and cheapest ACA/Obamacare is $1450 a month for the family of 3 in a high deductible ($7250) plan. Last year it was $911 So please consider medical insurance in your personal equations.

    Kevin

  4. Chris Field

    Oh and secondly if your doing it right you can live on your rental income very well with a “small” income.

    I live a very lavish life on less than 36k a year which includes lots of trips all over the world and a not cheap boat kept in a not cheap slip.

    How? My rentals pay for my housing, truck, phone etc.

    If your doing it right you don’t need much to live.

  5. Daniel Peterson

    You’re on the right track with this equation, but you made large mistakes in your calculations. you left off a zero when you did these calculations: [(7/6*14,000) + (7/6*63,000)]. they should be [(7/6*14,000) + (7/6*23,000)] >>>16333 and 26833, not 1634 and 7350. This brings your answer to $=2,356,000. Fortunately this is not the only mistake you made. In the very first step of making this equation, you said “$=L[i-(m+y)]” but this equation should really be “$=L[(m+y)-i]”. The way you have it, you need to have money saved in the bank for all of your excess income, which is completely backwards.

    Making this correction, your equation will likely tell you that you need a negative amount in savings to retire, but the expenses-income portion of your eqaution should not be included if its negative. Therefore, all you would need to safely retire would be an adequate, emergency fund.

    In other words, if your income covers all of the expenses, you do not need millions in the bank, jut enought to cover all emergencies.

  6. John Rives

    Drew,

    This is my first time to comment on an article. However this is sooo misleading that I had to reply. I really hope that you will correct the math errors in the article, as not to mis-lead others. I often recommend this website to new investors, most of which are looking to use real estate to retire early. If this article is not corrected, then the site loses credibility.

    I noted your comment above, mentioning there are different viewpoints on the calculation, and fully agree. However I used your calculations, your numbers, and just simply corrected the math. I used excel (for ease and to ensure no typos), and would be happy to email you the spreadsheet.

    In short, if this 37 year old has 63K (9K per 7 homes) in income, with only 14K (2K per 7 Homes) in maintenance and 23K in annual living expenses, then it doesn’t take complex math to tell you that this person is in good financial shape (His Income is almost double of his expenses). This 37 year old will run at an annual surplus of $19,233.33 (if properly calculated using your formula, and built-in operational contingencies). This person is free to retire today, once he properly funds his Emergency Fund

    I agree with your calculation in Part 1 of the equation, for Emergency Fund [10,000 + h(2,000) + (1/6m) + (1/6i)]. However if you correct the math errors the number it is actually $36,833.33

    Again, I appreciate your article, and in general think the formulas and reasoning behind the formulas all makes sense. However to suggest the 37 year old that has 7 good cash flowing homes, and frugally lives on 23K a year needs to save an additional 2.8 million is absurd. There is a HUGE difference between saving that kind of money, and being free to retire almost immediately. If you corrected the formula and the math it would clearly show this.

    If the formula / math is corrected, I think this article will be beneficial to show investors how feasible it can be to become financially independent using real estate. Not the lesson you have currently suggested “If your goal is to safely live on your investment income, you need a significant portfolio — or a huge safety cushion in the bank”

    I hope you do not take offense to this comment, I am simply hoping that others will not be mis-lead.

  7. Michael Ketchen

    I have a question regarding what would appear to me to help expedite the process as well….as you pay down the principal you also gain the ability to refi and take on “debt” again tax free..how do you adjust for this?

    • Drew Sygit

      @MICHAEL KETCHEN: yes you can do this, it’s even mentioned by several “experts” charging for their advice. You just have to be careful managing your debt and cashflow so you don’t lose the properties.

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