It’s easy to understand why so many people dream of retiring with rental properties in their portfolios. The tenants pay the expenses and the retiree keeps the profits. Considering how many people have built generational wealth through real estate, it’s a worthy aspiration for anyone who dreams of financial security.
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But to realistically retire on rental income, one property probably won’t cut it unless the rent is incredibly high and your expenses are incredibly low. So the question becomes, how many rental properties do you need to retire early?
It’s a complicated question that doesn’t have a single answer. Each retiree’s financial situation is different, as is the profit an investor can expect to collect from any one rental property. Let’s give finding an answer our best shot, though.
Finding the Formula Is the Simple Part
Each person’s retirement expenses are unique, and each property will generate a different amount of rental income — but there’s a universal formula to identify the right number of properties for you. Simply divide the amount of monthly income you need by the cash flow each property generates.
For example, if you need $2,000 per month to get by in retirement, then you’d need four properties that generate $500 each.
That’s an easy calculation to make on paper, and one that ignores a whole lot of real-world wrinkles. In all cases, however, the formula starts the same way — determining how early you want to retire and how much you’ll need per month.
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According to T. Rowe Price, most people spend less when they retire, their tax obligations typically decrease and they can stop saving a portion of their income in a retirement account. Therefore, the firm suggests shooting for 75% of your current income to sustain you in retirement. If you earned $100,000 in your working years, plan to live off of $75,000 when you retire.
But early retirement compounds your financial considerations. For example, if you retire at 55:
You’ll have to pay for private health insurance for 10 years until you’re eligible for Medicare at 65.
You’ll have to wait seven years until you’re eligible for Social Security at 62.
You’ll have only five years to make catch-up contributions to your 401(k) or IRA after you turn 50, instead of 17 years had you waited until the full retirement age of 67.
You’ll also be more likely to be paying down a mortgage or funding a child’s college education if you retire early. Balancing the scale, however, you might have annuities, dividend stocks or other passive income that reduce the amount you’ll need your rental properties to generate.
How Much Profit Does a Rental Property Produce?
Before you make your calculations, avoid the common mistake of overestimating how much profit you’ll take from the rent you charge.
According to Morris Invest, you should estimate 40% of your rental income will go to expenses like insurance, property taxes, potential vacancies and property management. However, don’t assume you’ll pocket the other 60%.
The government taxes your profit separately from the property taxes you already paid, and unless you own the property outright, you still have to make a monthly mortgage payment. For example:
If you charge your tenant $2,000 a month, you’ll get $24,000 per year.
Accounting for expenses, you’ll subtract 40%, or $9,600, leaving you with $14,400 per year or $1,200 per month.
If your monthly mortgage is $500 per month, you’ll be left with a monthly profit of $700 — but keep in mind those are pre-tax dollars.
In the previous example, the retiree with a $100,000 salary who planned to live off of $75,000 would need $6,250 per month.
With this example as the baseline, the retiree would need nine rental properties to retire early. But in 12 years, after reaching full retirement age, the addition of Social Security and Medicare might allow the retiree to sell one of the nine properties, live off the income from the remaining eight, and invest the windfall from the sale. Hopefully, your property’s value will appreciate during those dozen years and you might pay off the mortgage of one or more.
Know the Property’s ROI Before You Invest
Investors who buy rental properties with unrealistic profit expectations are setting themselves up for failure in retirement. The trick is to distill the numbers down to your return on investment (ROI). ROI is the gain on your investment minus the cost of your investment. Only then can you predict how much money you’ll actually keep after all the expenses and taxes are paid.
It all starts with a cash flow statement. Here’s a basic example from Stessa, which is part of the Roofstock network, for a property with a $100,000 purchase price and a $25,000 down payment:
Projected gross rental income: $900
Vacancy loss: 5%, or $45
Effective gross income: $855
Repairs: 5%, or $45
Property management: 8%, or $72
Other expenses, including property tax, insurance and HOA: $180
Mortgage principal and interest: $320
Projected monthly pre-tax profit: $238
It’s important to note that this is a cash flow statement in its most basic form. It omits many risks and other considerations. Stessa and many industry experts suggest using a pro forma income statement, which uses hypothetical data and assumptions about future values to more accurately project your property’s likely performance.
If you’re planning to retire on rental income, however, the best investment you can make is the advice of a professional who specializes in real estate as a retirement plan.
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This article originally appeared on GOBankingRates.com: How Many Rental Properties Do You Need To Retire Early?
As a seasoned expert in real estate investment and retirement planning, I can confidently delve into the intricacies of the article, providing valuable insights and additional information to enhance your understanding of the subject.
The article rightly highlights the allure of retiring with rental properties, citing the potential for tenants to cover expenses while the retiree enjoys the profits. This strategy has indeed been a cornerstone for many individuals in building generational wealth through real estate. To retire early on rental income, however, the article correctly suggests that relying on just one property may not be sufficient.
The central question posed — how many rental properties are needed to retire early — is complex and varies based on individual circ*mstances. The article proposes a universal formula: dividing the required monthly income by the cash flow each property generates. This is a simplified approach but sets the foundation for a more in-depth analysis.
T. Rowe Price's recommendation to aim for 75% of one's current income during retirement is a practical guideline, considering reduced expenses and altered financial obligations. The article insightfully outlines the additional considerations for those opting for early retirement, such as private health insurance costs, delayed Social Security eligibility, and shorter windows for retirement account contributions.
Crucially, the article addresses the common mistake of overestimating rental property profits. It emphasizes the need to account for various expenses, including insurance, property taxes, potential vacancies, and property management. The example provided by Morris Invest illustrates how pre-tax profits can be significantly lower than anticipated, reinforcing the importance of realistic expectations.
The article introduces the concept of Return on Investment (ROI) as a crucial metric for evaluating rental property success. The basic cash flow statement from Stessa is a valuable starting point, projecting income and deducting various costs to estimate pre-tax profits. However, it wisely suggests using a pro forma income statement for a more comprehensive analysis, acknowledging the complexity of real-world scenarios.
In conclusion, the article serves as a helpful guide for individuals considering retirement through rental properties. It underscores the need for a nuanced approach, considering individual financial situations, property specifics, and a realistic assessment of expenses. For those serious about retiring on rental income, seeking advice from real estate professionals with expertise in retirement planning is strongly recommended.
