Passive Income > Net worth

Regular sustainable passive income > net worth when it comes to financial security and ultimately financial independence.

A basement pantry full of non-perishable items can be great in a natural disaster, but a garden in your back yard can provide sustainable nourishment for survival over years.

My first job out of college was as a high school boarding school teacher. I got paid $16,000 for 9 months.  I did however have an apartment provided to me for free.  This was a lot of money to me at that time. I wasn’t saving much, but I was living off the money, and I was happy.  My lifestyle was commensurate with my income, and I wasn’t worried about bankruptcy.  Many retirees in American need to live off of Social Security alone, and they manage to.

On the other hand, we’ve all heard stories of people who win the lottery. Unfortunately, many end up in bankruptcy. Because it’s not about how much money they have, but because the pile of cash is not an income stream. It, just like the pantry of non-perishables, is finite.

Converting Net Worth into Passive Income

The traditional model for planning for retirement is to use investment accounts such as 401k’s, 403b’s 457b’s, and IRA’s is to grow your net worth tax efficiently using these accounts during the ‘accumulation phase’ (your working years).  You build up a large nest egg upon ‘retirement’ that will sustain your lifestyle until you die, the ‘decumulation’ phase of the account.  These accounts are invested in primarily Stocks and Bonds.

Most people cite the “4% rule” from the Trinity Study that says that 4% (with inflation adjustment) is a Sustainable Withdrawal Rate (SWR) that will last 30 years (or at least it has, historically over nearly all 30-year periods in the past century).  More conservatively, a 3% withdrawal rate has historically lasted for perpetuity (not just 30 years). As such, many people conservatively recommend planning only a 3% annual withdrawal. There are many sources where you can read about the 4% rule (and 3% rule) and its pros and cons.

4% rule example
If your retirement accounts get up to  $3M, then you ‘retire.’
Assume inflation is 2% per year.
Year 1: $3M x 4% = $120,000 per year or $10,000 per month
Year 2 (2% inflation adjustment): $122,400 per year or $10,200 per month
Year 3 (2% inflation adjustment again): $124,848 per year or $10,404 per month
etc. until Year 30

3% rule example
same as above
Year 1: $3M x 3% = $90,000 per year or $7,500 per month
Year 2 (2% inflation adjustment): $91,800 r or $7,750 per month
Year 3 (2% inflation adjustment again): $93,636 per year or $7,803 per month
etc. for perpetuity

 

Using Real Estate for Passive Income

Rental Properties create passive income. They do this more efficiently than stocks/bonds. Hence, if your goal is early financial independence, this is the fast track to financial independence.

We own some single family rentals, but–even with property management–they do take more work than passively investing in an apartment complex with other people.  Multifamily apartment investing as a group is very easy and takes very little time/effort. Once you have a network of people with whom to invest. It’s a team sport.

Let’s take an example of getting yourself to financial independence with group apartment investing

1st apartment purchase

Let’s take a typical group apartment investment (aka a “syndicated” / “crowdfunded” investment) that I might invest in.  The people I invest with usually buy “value add” investments where there is a direct opportunity to “force appreciation” (e.g making upgrades or boosting rents up to market price, which increases the revenue and therefore value of the business/apartment). This increasse the resale value of the asset substantially in ~5 years.

However, for simplicity, let’s take a property that we just buy and own and enjoy the rental income from for 5 years, what investors call a “yield play” (where you’re just enjoying the “yield” of the asset e.g. the rental income).

In this example, 40 people each put in $25,000 to raise $1M (that’s short for 1 Million Dollars) to purchase an apartment complex worth $4M.

Every 3 months, for my $25,000 investment, I get a check for $500.

At the end of the year, this is a total of $2000.

The entire $2000 is tax free at this time because the rental property generates $0 in taxable income (due to depreciation and other deductions). Fantastic.

So this is a full $2000 return (I don’t have to pay any tax on it, at least not now) on a $25,000 investment.

$2000 / $25,000  x 100% = 8% return on invested cash (aka – “cash on cash return”)

This $2000 is analagous to a “dividend” that a stock pays out or the “interest” that a bond pays out.  I still have the same ownership of the property that I had before I got paid the $2000. I haven’t lost any of my original investment, the “principal.”

Let’s assume that the rent and profit of the apartment keep up with inflation, and in turn the quarterly rental payouts will also keep up with inflation. After 5 years, the property is sold, and you get all of your initial investment back ($25,000) and the increase of value of your share.

Since the property value kept up exactly with inflation, we’ll assume it gained 2% per year in value.

After 5 years, the 4M property is now worth $4M x 1.02 x 1.02 x 1.02 x 1.02 x 1.02 = $4.416 M.

Assume that in the 5 years, none of the mortgage principal was paid off because an interest-only mortgage was used (and the math is simpler)

So after paying the $3M mortgage, there is $1.416M left after the sale.

The investors originally put in $1M total ($25,000 x 40 investors). They get back their initial $25,000 each.
Then there is $416,000 in profit (from the appreciation) that is left to divide amongst investors.
$416,000 / 40 investors = $10,400 profit per investor at time of sale

Total initial investment: $25,000
Year 1 quarterly payouts: $500 x 4 = $2000
Year 2 quarterly payouts: $510 x 4 = $2040
Year 3 quarterly payouts: $520 x 4 = $2080
Year 4 quarterly payouts: $530 x 4 = $2120
Year 5 quarterly payouts: $540 x 4 =$2160
Year 5 return of original capital to investor after sale: $25,000
Year 5 distribution of profits of sale of investment: $10,400

But, you have to pay taxes on the capital gains (0%, 15%, 18.8%, 20%, 23.8% depending on AGI) and recaptured depreciation (25%).
For simplicity, we’ll take 25% tax on all the capital gains and your distributions, which would be
25% x ($2000 + $2040 + $2080 +$2120 + $2160 + $10400) = $5200

EXAMPLE: Original investment, quarterly cash flows, return of original capital, appreciation, and capital gains tax of a $25,000 investment in an apartment without any growth beyond inflation (~2%) for a high income earner at maximum tax brackets.

 

So how much is the total return on the apartment investment over the 5 years?

Quarterly Payouts: ($500 x 4) + ($510 x 4) + ($520 x 4) +($530 x 4) + ($540 x 4) =$10,400
Profits at sale of property from appreciation: $10,400
Capital Gains tax : $5200
Total Return: $10,400 + $10,400 – $5200 = $15,600
*note, you initially invested $25,000 and got a return of that initial $25,000 investment after sale of the building, so I am excluding it from the calculations above

Total return on investment (ROI): $15,600 / $25,000 = 62.4% over a 5 year period
Average rate of return: 62.4% / 5 years = 12.5% per year
Internal rate of return (using excel XIRR function): 11.9% per year

 

 

 

2nd apartment purchase (years 6-10)

After you sold the first apartment, you got your original $25,000 returned to you and an extra $10,400 in profit from the appreciation of your share.  You, however, had to pay $5,200 in capital gains tax.

This leaves you with $25,000 + $10,400 – $5,200 tax = $30,200 to invest the next property.

For simplicity, let’s round this off to $30,000.
You now invest $30,000 for the next apartment syndication.
This is $5,000 more (or 17% more) than your original investment 5 years prior of $25,000.

Let’s assume the same returns with an 8% annual cash-on-cash return, increasing 2% annually for inflation.
With a 17% bigger investment, the quarterly payouts will be 17% more. So instead of $500 per quarter, it’s now $520 per quarter to start.
(Some numbers are rounded)

Year 5: Total initial investment: $30,000
Year 6 quarterly payouts: $600 x 4 = $2400
Year 7 quarterly payouts: $612 x 4 = $2450
Year 8 quarterly payouts: $624 x 4 = $2500
Year 9 quarterly payouts: $637 x 4 = $2550
Year 10 quarterly payouts: $649 x 4 =$2600

Year 10 return of original capital to investor after sale: $30,000
Year 10 distribution of profits of sale of investment: $12,500

 

So how much is the total return on the apartment investment over the next 5 years (Years 6-10)?

Quarterly Payouts =$12,500
Capital Gains from appreciation of property: $12,500
Capital Gains tax (assuming highest bracket): – $6,250
Total Return: $12,500 + $12,500 – $6,250 = $18,750

Total return on investment (ROI): $18,750 / $30,000 = 63% over a 5 year period
Average rate of return: 63% / 5 years = 12.5% per year
Internal rate of return (using excel XIRR function): 11.9% per year

(Note, the percentages here are the same as in years 1-5, but the dollar amounts are 17% higher)

In summary:

In year 1, invest $25,000 into a real estate investment that earns 8% cash-on-cash annual profits into a real estate asset, which by nature, will keep up with inflation.

You will then receive annual payouts of
Year 1: $2000
Year 2: $2040
Year 3: $2080
Year 4: $2120
Year 5: $2160 (then sell property)
Year 6: $2400
Year 7: $2450
Year 8: $2500
Year 9: $2550
Year 10: $2660

These payouts keep up with inflation (2% annually) and actually outpace inflation because every 5 years you buy the next asset.
In year 5, you earned $2160, but in year 6, it went up to $2400, that’s a $240/year bump, or an 11% increase, so that’s a 9% bump above inflation.

Sustainable Withdrawal Rate with real estate

Since the underlying asset keeps up with inflation or better, you can spend all the cash flow (e.g. dividends), which is equivalent to the cash-on-cash return of your asset.

If you’re getting 8% cash-on-cash returns, you have an 8% (tax free) sustainable withdrawal rate. You never deplete your “principal” and just enjoy the earnings.

Real estate perform like an inflation-adjusted annuity, but with higher growth and heritability. Annuities end after you (and possibly your spouse) die.  Real estate can provide a multi-generational legacy.

$10,000/month with Stocks/Bonds vs. Real Estate

Let’s pretend you want an income stream of $10,000 per month.
That’s a total of $10,000 per month x 12 months = $120,000 per year.

With stocks and bonds, and using the 4% rule, we go back to the example at the beginning.
Starting with a $3M nest egg, and taking 4% per year, you get $120,000 per year.
If you want to use the 3% rule, well, you actually need 1M extra, or $4M total. $4M x 3% = $120,000 per year.

(Note: with the stock/bond account, you need to account for taxes still, which actually drives your sustainable withdrawal rate lower)

So you need 3-4 Million Dollars in order to enjoy $10,000 per month sustainably over a long period of time.

Using real estate, the original $25,000 investment gets you $2,000 per year in total payouts from cash flow.

If you want $10,000 per month or $120,000 per year, then you need $120,000 / $2,000 = 60 of these investments.*

60 investments x $25,000 per investment = $1.5M in investments.

$1.5M << $3M or $4M.  And the payouts increase above and beyond inflation.

*this is all proportional. You could just invest $100,000 per investment and do 15 investments to get to $1.5M.

If you had $1.5M in rental properties

Using the above example for years 1-10, and continuing for 40 more years, spending the cash flow and, every 5 years, selling and buying a new asset at 25% down, earning 8% cash-on-cash returns each time, with asset growth of 2% (inflation), your annual income and net worth would grow as follows:

 

And in table format

The fast track:

If you can get to financial independence with half as much, you can get there twice as fast.

 

 

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