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

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“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.

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!

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!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.