Real Estate Income for Retiring: Pros vs. Cons
About the author: G. Brian Davis is a real estate investor who has owned dozens of investment properties over the last 15 years. He’s also the co-founder of SparkRental.com, an online resource which provides free landlord education and video series for anyone looking to build passive income from rentals.
Using real estate investment business for retirement income
gradually spend it down in retirement—and you hope you don’t run out of money before you kick the proverbial bucket.
The average person pumped most of their retirement savings into stocks and bonds each month, and as they got closer to retirement, they abandoned the higher returns of stocks in favor of the higher stability of bonds.
None of that ever sat well with me. What if I don’t want to wait 45 years before retiring, or don’t want to worry about running out of money in retirement and don’t want to settle for the low yields paid by bonds?
It turns out real estate investing can help. In an analysis of asset returns in developed countries over the last 150 years, economists found the rental properties aspect of real estate investing (vs. other niches like flipping houses for a living) actually combined the high returns of stocks with the low volatility of bonds. In other words, real estate investing for retirement offers the best of both worlds.
Keep the following pros and cons of rental properties for retirement in mind, and create your own personal plan, real estate investing business plan, or otherwise, to escape the rat race at any age.
Advantages of rental properties for retirement income
Real estate investing for retirement comes with a slew of upsides. Capitalize on them to build retirement income quickly and safely, whether you hope to retire young or catch up on your retirement savings later in adulthood.
Ongoing income
When you invest in paper assets for retirement income, you typically decide on a withdrawal rate—how much of your portfolio you feel comfortable selling off to live on each year. If you’ve ever heard of the "4% Rule," you’re familiar with the concept of withdrawal rates. It indicates that if you sell off 4% of your initial retirement portfolio each year, it should last you at least 30 years before running dry. Your net worth shrinks over time as you sell off stocks and bonds.
In contrast, rental income keeps coming month after month, year after year. You don’t have to sell rental properties to generate income; in fact, selling them is akin to slaughtering the golden goose.
Yes, stocks pay dividends, equities equivalent to rental income. But dividends make up a minority of typical stocks’ returns, with the bulk of the returns coming from price growth over time. That makes stocks a growth-oriented rather than income-oriented investment.
Returns adjust for inflation
That ongoing income doesn’t stay static over time, either. Property owners can raise the rent each year to keep pace with or even surpass inflation.
Meanwhile, your monthly mortgage payment stays the same, even as your rents grow and compound. That leaves a widening gap between your rent and your mortgage payment, a margin that disproportionately grows each year.
Imagine you buy a property that rents for $1,000, and you finance it with a $500 monthly mortgage payment. If you raise the rent by 3% after the first year, or $30, that gap between your mortgage and your rent (initially $500) goes up by 6%. Over time, that gap grows even faster.
Consider bonds by comparison. Bond investors have to subtract out inflation to calculate their "real" return. If a bond pays 4% interest for a year, but inflation grew at 2.5% that year, then your real return was only 1.5%. Hardly a return to write home about, especially for those trying to create retirement income to live on.
Rising equity and net worth over time
Because you don’t have to sell off any assets to generate rental income, your net worth rises over time instead of shrinking.
Landlords see their equity grow from both directions at once. Their rental properties usually appreciate over time, growing in value. At the same time, their tenants pay down their mortgage for them, so their debt shrinks even as the property value rises.
Eventually, their tenants pay off the mortgage entirely, leaving them with a free and clear rental property and even greater cash flow for retirement income. Rather than hoping you don’t run out of money before you die, you can leave behind a substantial inheritance for your children or charity of choice.
The power of leverage
As outlined above, taking out a mortgage helps disproportionately grow your cash flow as time goes by. But the advantages of leveraging other people’s money don’t end there.
To begin with, you don’t need to commit as much of your own cash. It takes a long time to save up $125,000 to buy a rental property in cash. And while a $25,000 down payment still isn’t trivial, it’s far more manageable than the alternative.
That also enables you to diversify your real estate investments more easily. Imagine you did have $125,000 in cash that you wanted to invest in rental properties for retirement income. You could invest all of it in one property by buying in cash – or you could invest $25,000 apiece in five different rental properties by financing the bulk of each purchase with a long-term rental mortgage.
Even better, leverage can sometimes increase your cash-on-cash returns: the return you earn on your own cash invested. For example, say you could earn a 7% return by buying that $125,000 rental property in cash. But by financing the rest and only putting $25,000 in each, you might earn 10% on each $25,000 down payment.
Predictability of returns
When you buy a stock or mutual fund, you don’t really know how it will perform. All you can do is research the company or fund manager and hope they perform well moving forward.
With real estate investing for retirement, you can predict your rental property returns with precision. You know your purchase price, you know the market rent through market research tools like Rentometer and Zillow, and you either know or can precisely forecast your expenses.
Diving deeper into the expenses, you know the property tax rate, you know your insurance costs, and you know the cost of property management fees (if you choose to hire a property manager). You can discover the neighborhood’s vacancy rate by speaking with other landlords and property managers who operate in the neighborhood. And you can estimate the long-term average of maintenance and repair costs.
Say you found a prospective rental property for $100,000 that rents for $1,200. Here’s how the expenses might look:
Vacancy Rate: 4%
Repairs and Maintenance: 12% of the rent
Property Management Fees: 10% of the rent (including for the occasional rental application screening fee)
Property Taxes: 1.5% of the property value ($1,500/year initially, or around 10% of the rent)
Property Insurance: 1% of the property value ($1,000/year initially, or around 7% of the rent)
Accounting and Legal: 2% of the rent
In this case, your non-mortgage expenses come to around 45% of the rent or $540 per month. You could expect to earn around $660 per month in cash flow if you didn’t take out a mortgage.
Keep in mind you have to calculate long-term averages for expenses–you won’t have repair costs every month, but over time, they add up to significant expenses.
Control over returns and risk mitigation
Similarly, when you buy a stock, you have no control over its returns. Short of being a major shareholder, you can’t influence the company’s management decisions. All you can do is buy or sell the stock.
You do have control over your returns when you invest in rental properties. You can renovate the property to force equity and boost asking rents. When you have a vacancy, you can screen all rental applications to place only the most reliable renters. Through proactive property management, you can discover property issues quickly. You can even buy rent default insurance to protect against the unlikely risk of your tenant defaulting.
That control over your returns and ability to mitigate risks offers an unparalleled advantage to real estate investing for retirement income.
Tax advantages
Most investors look to tax-sheltered retirement accounts for tax benefits. And while they work well, they also come with plenty of restrictions, such as a minimum age for taking withdrawals and a cap on how much you can invest each year.
Real estate retirement income comes with no such restrictions but plenty of its own tax advantages. You can deduct for nearly any conceivable expenses associated with your rental properties: insurance, property taxes, property management fees, rental application screening costs, real estate marketing costs, and even mortgage interest. Many closing costs are deductible, and most others can depreciate.
You can even deduct the cost to buy the property itself to depreciate it over time.
All those tax deductions mean many investors show a paper loss when reporting rental income for tax purposes, even when they earn real estate retirement income.
Downsides to real estate investing for retirement income
If real estate retirement income is so fantastic, why isn’t everyone out buying rental properties for retirement income?
Real estate investing for retirement does come with some cons. Before committing your life savings, make sure you understand the downsides, as well as the advantages of rental properties for retirement.
Knowledge and skill required
There’s a substantial barrier to entry in real estate investing in the form of knowledge and skill.
Anyone can buy stock index funds that mimic major indexes, like the S&P 500, and earn historically average stock returns. It doesn’t require any skill. You simply "invest in the market." But to buy rental properties, you have to understand how to calculate rental cash flow, how to find good deals, how to finance properties, how to screen rental applications, how to manage tenants, how to file for eviction, and a hundred other micro-skills.
Far too many novice investors gloss over these skills and dive into real estate investing for retirement income. Then they lose their shirt on that first property and vow to never buy another rental property again.
If you want all the advantages provided by rental properties for retirement, you need to first invest the time to learn how to do it. And then, you need to invest the labor and work to actually execute your investments.
Labor required
Similarly, it takes less than a minute to buy an index fund with a click of the mouse on your brokerage website. It takes significant labor to find good deals on rental properties, to close on them, and to manage them.
Think of it more as a side hustle than a passive investment because it takes work. And while you can outsource the ongoing property management, rent collection, and rental application screening, it’s much harder to outsource the deals initially.
High minimum cash investment
Returning to the stock example, you can invest in an index fund with $100. Anyone can start at any time with whatever extra money they happen to have on hand.
But it takes thousands of dollars to invest in rental properties for retirement income, even if you finance your properties. At 20-30% required for a down payment, you could be looking at $50,000 for the down payment alone.
The cash required adds another barrier to entry that prevents many people from investing. It also creates a challenge for diversification, having to pump $20-50,000 into a single investment. In contrast, that $100 you invested in an index fund exposes you to hundreds or even thousands of companies.
Lack of liquidity
Stocks are extremely liquid: You can buy or sell them instantaneously to convert your investments back to cash.
Real estate, on the other hand, is infamously illiquid. It often takes months to sell a property, between marketing it for sale with a real estate agent and waiting for the buyer to settle once under contract. Buying also takes time, at least a few weeks, for lenders and title companies to complete their due diligence.
Real estate transactions cost not just time but also money. Think thousands of dollars in closing costs on both the buying and selling sides of the transaction.
Once bought, rental properties for retirement income remain a long-term investment not easily be sold.
Final thoughts
Real estate investing for retirement income brings a host of advantages, but rental properties shouldn’t be your only source of retirement income.
In my personal portfolio, I invest in rental properties for income today that will only grow over time. I invest in stocks for diversification, liquidity, and long-term growth. By building rental income now, I can let my stock investments grow and compound for many more decades, with little temptation to tap into them. I get closer to financial independence with each rental property I add, and at a certain point, working becomes optional when I can cover my living expenses with passive income alone.
Consider rental properties for retirement income, but only if you’re willing to put in the work both to learn investing and to find good deals.