Thank you to Dividend Growth Investor for letting me share with you today. It's an honor!
Over the last 15 years, I've used real estate investing as a vehicle to achieve financial independence. Everyone has their own idea of life after financial independence, but in my case, it involves my family and travel to other countries.
Currently my wife, two young daughters, and I are living in Ecuador in South America for 14 months. We're having new experiences, my daughters are enrolled in local Spanish speaking schools, and we're all learning and growing together.
And relevant to this article, real estate income pays for it all!
In the rest of this article, I'll share lessons that have helped me get to this point using real estate. I can assure you my journey has been far from perfect, but I hope my successes and failures will help with your own journey.
Dividend Growth Investing vs Rental Properties
As I've read through the excellent content on this blog, I realized that dividend growth investing and my approach to rental property investing are similar. For example, they both prioritize income generation, purchasing assets at reasonable prices, and following deliberate, disciplined strategies over time.
The good news is that you don't have to decide between one investing strategy or the other. Dividend investing and rental properties are actually quite complimentary. Moving between the two strategies offers diversification that can give you a more solid financial foundation.
Many real estate investors only buy 1 or 2 properties. Some build bigger portfolios. And others just loan money to real estate investors using real estate as collateral. But whatever unique approach you choose, the fundamentals of investing and real estate are the same.
So, in the sections that follow I'll provide an overview of how to invest in real estate to produce dividend-like income. It's a big topic with MANY smaller niches, but I will do my best to give you a solid foundation that points you in the right direction to get started.
Different Vehicles, Same Goal
Whether you use the investment vehicles of stocks, rental properties, or both, the destination is the same. The goal is financial independence.I like this simple definition of financial independence from fellow blogger ESI Money:
Financial Independence = having wealth to cover expenses indefinitelyOnce your expenses are covered by your wealth, working a job for money is no longer necessary. A whole range of new life possibilities opens up. This is the point where you can focus only on what matters, whether it makes money or not.
But as a real estate investor, I like to take the financial independence definition above a step further. I like the conservative approach of not eating up any of the principal of my wealth. I'd prefer to simply live off of the income.
And that's one of the main benefits of real estate. The right rental properties produce income at a much higher rate than comparable amounts invested in other assets. If you have $500,000 dollars invested in real estate and the rental yield is 7%, you earn $35,000 or almost $3,000 per month without touching the principal.
To more examples of how the retirement real estate math works, you can read my article How Many Rental Properties Do You Need to Retire.
Now that we're clear on the destination, let's take a look at the core benefits of real estate investing.
The Benefits of Rental Property Investing
When I first began investing, I learned an acronym that showed the core benefits of investing in real estate. I have yet to find a better way to explain it.Remember that real estate investments are the I.D.E.A.L asset:
Income
As I mentioned above, real estate shines because it produces rental income. In my investing world, unleveraged returns of 5% - 10% on quality properties are the norm. And if you choose to use leverage with reasonable terms, it's sometimes possible to double or triple those numbers (with some added risk, of course).Depreciation
Our government requires rental owners to spread out the cost of an asset over multiple years (27.5 years for residential real estate). This produces something called a yearly depreciation expense that can “shelter” or protect your income from taxes and reduce your tax bill. My article The Incredible Tax Benefits of Real Estate Investing over at Mad Fientist explains the concept in more detail.Equity
When my tenants pay rent each month, I can use the money to pay my mortgage. This means they (not me) pay off my debt! This creates a regular equity builder that increases my net worth automatically over time.Appreciation
Historically, residential real estate has appreciated at approximately the same rate as inflation. Of course, this is not guaranteed. But if you purchase in the right locations with good fundamentals, this is a likely outcome over time. But real estate also gives you the opportunity to FORCE appreciation. Instead of waiting passively, you can often do something to the property (like repairs, upgrades, or changing zoning) to increase the value. And because real estate markets are more illiquid and local than stock markets, you can sometimes find bargains below the full value right when you make a purchase.Leverage
While I'm very cautious and respectful of the dangers of leverage, I also recognize that not all debt is equally risky. Real estate provides some of the least risky debt available. In fact, at the depth of the 2008-2009 recession, Warren Buffett said on CNBC he would buy "a couple hundred thousand houses" with 30-year mortgages if he could. Why would he say that? Because if an investment produces a 7% yield and your cost of funds are fixed at 4% for 30 years, it creates a nice profit spread (i.e. arbitrage) for many years to come. And with a 25% down payment, you could make money this way on 4 houses instead of 1!While these are the core benefits of real estate investing, just purchasing any old piece of property will not work. To purchase the right properties, you first need to have the right strategy.
The Right Real Estate Strategy
I was a starting linebacker on the Clemson University football team during my time in college (Go Tigers!). I learned a lot through that experience, but one of the most important lessons was about strategy. Namely, if your team doesn't have a good one, you'll lose no matter how hard you work or how much talent you have.Real estate investing works the same way. Just because you've lived in real estate doesn't mean you know how to win the game. You've got to build a bigger picture winning strategy, and you've got to customize that strategy for your situation and your unique set of strengths, weaknesses, and preferences.
What are some strategies that work within real estate investing? I'll list a few of the more popular ones below.
The Strategy of Turning Your Home Into an Investment
I have been on a crusade lately to show people the most sensible, profitable way to live in a home. Of course, some people value other factors in their choice of home besides profitability (like comfort, convenience, status, pride). But even those people should know the true cost of choosing those factors.Our society spends a LOT of our financial resources on personal housing. A U.S. Bureau of Labor Statistics report for 2015 shows that 19.2% of the average U.S. household’s expenses were dedicated to shelter. Canadian households’ average shelter expenses were even higher at 28.9% of household expenses. And many high-priced locations get worse than that.
That's 20% or more of your total expenses with zero or subpar return on investment! As I showed in the Ultimate Housing Battle: Dream House vs House Hacking, the choice of starting your life with a beautiful dream house instead of other, smarter choices could cause you miss out on between $420,000 to $760,000 of net worth over time!
My preference, especially for people in their 20s or 30s, is to use one of three strategies that turn your home into an investment. I provided links to articles about each in case you want to study them in more depth.
- House Hacking - This is a strategy that turns your home into an income producer. For example, you can buy a duplex, rent out the second unit, and live in the first unit. You could also Airbnb or other sources to rent a basement apartment, a garage apartment, or a spare bedroom of a house. Using this strategy, you can cover some or even all of your mortgage payment. And when you move out, you now have a long-term rental.
- Live-In Flips - This strategy means you move into a house that has fix-up potential so that you can increase the value over time. In the U.S. and many other countries, the tax laws reward you with tax-free profit if you follow the basic rules (like living in the home for at least 2 years). A blogger and friend of mine named Carl at 1500days.com has used this strategy to build a large portion of his $1,800,000+ net worth.
- Live-In-Then Rent - This just means you buy a house as a residence that you can later convert to a profitable rental. These are usually simpler houses in up-and-coming areas. My wife and I did this and now receive an income of more than $400/month (plus equity growth) from our former residence.
Buy-and-Hold Rental Strategy
Buying rental properties is a tried and true way of building income streams and wealth. But like my football analogy, choosing the right strategy will make you much more likely to win the game.Two of my favorite strategies within buy and hold rentals include:
- The All Cash Plan
- The Debt Snowball Plan
The All Cash Plan
The All Cash Plan is for those who don't want to play the real estate debt game. If you already have enough capital or just don't want to grow with leverage, this plan could make sense.The plan basically works like this:
- Save or allocate enough cash to buy one income property
- Save 100% of the rental income plus extra savings from a job
- Buy another income property
- Repeat until your target goal for income and/or equity is met
The next plan is a similar variation of this plan, but it uses debt as leverage.
The Debt Snowball Plan
The Debt Snowball Plan concentrates excess cash flow from rental properties and other sources to pay off mortgages more quickly. Like a rolling snowball, the rate of debt payoff accelerates over time as more properties are paid off.The plan basically works like this:
- Save cash for down payments
- Purchase several income properties using conservative, low-interest loans.
- Save 100% of the real estate income plus extra savings from a job.
- Use all savings to apply towards one of the loans each month until one loan is paid early.
- Use all savings + new free & clear income to apply towards another loan until paid early.
- Repeat until all loans are paid off.
Below is a detailed diagram of how this plan could work. Once again, dividend investors will find this plan familiar because it reinvests earnings to build equity. The power of the approach is a steady reinvestment of income into debt acceleration.
By doing both of these rental plans, you can start with a relatively small amount of capital, grow to a larger net worth over a 10-15 year period, and end up with low risk, rental income producing properties in the end.
The Strategy of Becoming a Real Estate Lender
If owning rental properties does not appeal to you or does not work in your location, you could also consider lending money to other investors. With this strategy, you could receive interest (often between 6 -12%) without the risk and the hassles of ownership.But I mention this strategy last because there is a big caveat. Whenever you loan money, you should prepare for and assume that you'll own the property. Because if things go badly with your borrower, you WILL own it through a foreclosure.
So, as a lender, you still have to think like an owner. You need to evaluate the title, the location, and the numbers just as if you were going to own it. And you should loan much less than the current value of the property (usually 70% or less). This way you build a margin of safety to help cushion uncertain problems in the future.
This strategy is particularly good for self-directed 401k or IRA accounts. Interest is taxed at ordinary income rates, so a sheltered account can receive tax-free interest and continue to grow and compound their money.
I usually prefer to loan directly to individuals, but there is also a growing number of crowdfunding real estate websites that allow you to spread smaller amounts like $5-10,000 over several different loans. I have not yet vetted or used any of these companies personally, but you can research for yourself at sites like PatchofLand, RealtyShares, and Ground Floor (the only one I've seen who allows non-accredited investors).
Hassle and Illiquidity - The Challenges of Real Estate
So far I've focused on the benefits of real estate investing. But we're all adults here, and you know that nothing is 100% rainbows and roses. Like any strategy, real estate investing has its pitfalls and challenges.Most importantly, real estate is more of a hands-on sport than investing in stocks or bonds. It's best to think of real estate as a hybrid between business and investment. This is simultaneously one of its greatest strengths and challenges.
Unlike stocks, you as the entrepreneur/investor can directly influence your investment performance with your ideas, hard work, choice of team members, and screening of tenants or borrowers. But on the downside, you must invest some of your time and energy to make that happen.
Fortunately, I have found most of the hands on work is up front. I'm currently in Ecuador for 14 months, and I spend about 3-4 hours per week from a distance on a large portfolio of properties back in South Carolina. With help from a small team at home and by using well-tested systems, most of the rental operations run smoothly without me.
If you only own 1-2 properties, it's MUCH easier and more passive than my situation. And by hiring a management company, you can completely eliminate the need to deal with maintenance calls, screening tenants, or leasing properties.
Real estate also has the bad reputation of being illiquid. The costs of selling a property are enormous in comparison to stocks (real estate sales costs are 5-7% of sale price in my experience). And unlike stocks, you can't press a button to sell quickly.
As for the sales costs, these cost assumptions should always be built into your analysis and expectation up front. For that reason, it's really a non-issue because the deal will either meet your objectives including those costs or it won't. And I have personally found the returns to be well worth the investment even after those sales costs.
And I have actually found the slow-selling nature of real estate to be a hidden advantage. It's a sort of forced discipline because you're less likely to make the stupid mistake of selling emotionally at the bottom of a market.
Warren Buffett once said, after all, "When I buy a stock, I don't care whether they close the stock market tomorrow or for a couple of years." It's the same with real estate. The point of owning real estate or a stock is the earnings growth they produce over the years. By being more difficult to sell, real estate forces you to become serious about the investment before you buy it in the first place.
Is Real Estate Right For You?
I hope you can see now why individual properties are a big part of my own financial independence strategy. The income, diversification, and control that real estate provides make it a worthwhile part of a portfolio.
But there is no one right way to do things. You've heard my way, but you can take what you learn and apply it to your own investment portfolio. Different investing strategies are just like tools in a toolbox. They all have their appropriate uses for certain people, situations, and times.
Ultimately, you are the builder of your own financial house. You choose the tools. You build the foundation. And hopefully, you will get to enjoy many years of freedom that result from your hard work now.
I wish you best of luck in your future investing and financial independence journies!
