Real estate investment (not flipping) is the common mans easiest path to financial freedom. By financial freedom I mean a revenue stream which you (and perhaps your children) will not out live, is inflation friendly and tax advantaged.
Accumulate and Draw-Down vs. Revenue Stream
I am frequently asked by new investors, "Why real estate is better than dividend stocks, CDs, annuities, etc. for achieving financial freedom?" I will explain the difference using an (overly simplified) example where financial freedom is defined as a long term revenue stream of $5,000/Mo.
Accumulate and Draw-Down
Achieving financial freedom through traditional investments consists of accumulating a large quantity of funds and then drawing-down these funds over a fixed period of time. The amount you need to accumulate is totally dependent on how long you need the funds. If you plan on living another 30 years (I will assume zero inflation and zero working capital growth which I will explain later) the math is simple:
30 Years x $5,000/Month x 12 Months/Year = $1,800,000
So, if you accumulate $1,800,000 you can draw down $5,000/Mo. for 30 years with the understanding that at the end you will have zero funds. "What about capital appreciation?" Appreciation and inflation need to be considered together.
Official inflation during 2014 is about 1.7% (source). However, remember that the “official” inflation numbers do not include energy or food. Personally, I use energy and eat so the inflation I experience at the gas station and the grocery store is much higher than the “official” number. Depending on whose numbers you use, actual inflation is currently between 5% and 10% per year(source 1, source 2, source 3, source 4). For simplicity, let's assume that from now on inflation will be 5%. What this means is that you will need 5% more money each year just to have the same buying power as the previous year. Based on 5%, the amount you need to accumulate before draw-down increases from $1,800,000 to $2,000,000. Is 5% a reasonable guess as to future actual inflation? Not necessarily. During the 1980s the “official” inflation was over 14% (source). At 14% inflation the amount you need to accumulate before draw-down would be $6,500,000!
"But what about asset growth and assets that can handle inflation?" There is a tradeoff between the level of risk and gain. Conservative investments like CDs are currently paying about 1% thus with even the official inflation you are losing about 0.7%/yr in buying power. "What about a portfolio of stocks that can handle inflation?" While it is certainly possible to maintain such a portfolio even the big mutual funds have a hard time achieving it. But, suppose your investments could track inflation there are still two problems: 1) Every month that you draw-down funds you are reducing your working capital and thus potential gains. 2) In order to maintain the right portfolio mix you are going to have to frequently buy and sell stocks. Every time you sell stocks all profits are subject to capital gains tax which further decreases your working capital.
In summary, I do not believe that the average person can achieve a life-long revenue stream using the traditional accumulate and draw-down approach because:
- It is unlikely that the common man can accumulate the necessary millions.
- Accumulation and draw-down is a finite proposition; the income is only for a fixed number of years and what happens if you outlive your investments?
- Even moderate inflation can easily wipe out any fixed amount of accumulated funds over time.
According to The College Investor over 90% of the worlds millionaires created their wealth by investing in real estate. Why did they choose real estate? Revenue streams! I will start my explanation by estimating the amount of money necessary to create a life-long revenue stream of $5,000/Mo. Suppose you could purchase a property for $100,000 and rent it for $900/Mo. (This is very realistic in a lot of markets throughout the US and in some markets the returns can be higher. ) The monthly PITI (PITI stands for monthly principle, Interest, taxes and insurance) would be about $550/Mo (20% down, 30 year, 4.5%, 1% tax, 400/Yr insurance). (Warning, over simplification coming!) If I assume the property is always rented, the numbers work out to be: $900/Mo rent - $550/Mo PITI which results in a revenue stream of $350 per month. If I obtained 15 such properties I will have a revenue stream of $5,250/Mo.which never ends. And, the total capital I needed to establish such a revenue stream is 15x$20,000 = $300,000 compared to $1,800,000 in the accumulate and draw-down approach!
Here are some additional advantages of investment real estate:
- Cumulative: In the above example, each revenue stream will cost you $20,000. The positive cash flow from each revenue stream helps you buy additional revenue streams. Note that there are many financing alternatives to standard 20% down investor loans which include loans from smaller banks, seller financing and even government programs for first time home buyers, etc.
- Inflation: If you are using the accumulate and draw-down method, inflation is your enemy. With real estate, inflation is your friend. This is true because rents tend to track inflation but debt service is constant. Further, when inflation occurs interest rates increase thereby limiting people’s ability to purchase homes increasing demand for rental properties.
- Tax savings: With the accumulate and draw-down approach the IRS will love you (not good) because everything is visible and easy to tax. With real estate there are lots of expense deductions (Like coming to Las Vegas to check on your properties!). Another advantage of real estate is depreciation. (source). The IRS mandates that you depreciate the typical investment property over 27.5 years. (This is a phantom deduction because in the long run most real estate prices increase.) For our example property, deprecation will be about $2,900/year/property which offsets rental income. Many people have a positive cash flow from their real estate but still have tax losses.
- Leverage: While debt is bad leverage is good. Using common investor loans you can (in the example above) gain the income of a $100,000 property with only $20,000. There is no such leverage with other financial instruments.
- 1031 Exchange: Remember that every time you sell a stock you pay capital gains on profits. With investment real estate IRS rule 1031 (source) enables you to sell (“exchange”) one type of property for another and, if handled correctly, is not a taxable event. So, if the best investment today is single family homes in Anchorage and the situation changes such that condo medical offices in Houston are now a better deal, you can sell the single family homes and buy the medical condos with no tax due if you adhere to the 1031 rules.
- Forgiving: As long as you buy investment real estate in a good area, all but the worst mistakes will be corrected over time through appreciation, inflation and rent increases. (We strongly recommend only investing in areas with growing population and low crime.)
- Requires little time: Once you buy good investment real estate it requires little personal time if you use a good property manager. If you choose to manage your own properties, be sure to watch for a forthcoming article titled, “How to Fail in Real Estate”.
The accumulate and draw-down method has serious problems including outliving your investments, taxes and inflation just to name a few. You never outlive real estate revenue streams and they are tax advantaged and inflation friendly. To me, there is no comparison when it comes to financial freedom, real estate is the clear winner.