When you buy a rental property, it starts generating income for you immediately
Dubai: Investing in real estate allows you to develop an additional income source to help cover costs as an early retiree. But can it be the only reliable source of post-retirement income?
How it has worked out so far is that most often people save up a nest egg over the course of a 40-50 year career, and then spend it in retirement, all the while hoping they wouldn’t run out money.
However, surveys conducted worldwide repeatedly indicate how this practise raises questions about safe withdrawal rates of your retirement funds and how much you need to save for retirement.
As you approach retirement, you are also forced to move money into lower-risk, lower-return investments to mitigate or limit any unexpected uncertainty on your money.
How rental properties can help you retire early
“Financial independence is the ability to retire, to live on investment income alone. You reach it by building passive income from your investments,” explained Abu Dhabi-based Aditya Munjuluru, 54, Indian expat (?) who has a diversified into a number of investments in real estate, stocks and bonds.
“As you build passive income and work toward your own financial independence and retirement, don’t write off rental properties. They come with some impressive advantages for post-work income,” added Munjuluru, who is preparing to retire and move back home to India this year.
4 perks of investing in real estate for the purpose of retiring early
1. Ongoing Income
When you buy a rental property, it starts generating income for you immediately, and property values aren’t alone in rising over time.
“Because in the traditional nest egg model, you build up a portfolio of paper assets like stocks and bonds — then gradually sell them off to generate money for you to live on each month. Which means your net worth shrinks over time, and you risk running out of money,” Srivatsav added.
“With their ongoing passive income, rental properties don’t come with that risk. Quite the opposite: real estate usually appreciates over time, pushing your net worth higher rather than lower.”
2. Rents rise, countering inflation
Not only do rents rise to keep pace with inflation, rents are a primary driver of it. That means you don’t have to worry about inflation sapping your returns as time goes by, as you do with bonds.
Imagine you buy a bond paying 5 per cent annual interest. If inflation runs at 2 per cent, then your net return is only 3 per cent (5 minus 2).
In most cases, your rental cash flow and cash-on-cash returns rise over time — especially if you use leverage (borrowed capital or take money on loan).
EXAMPLE: HOW TAKING RENTAL INCOME DIMINISHES A HOME LOAN’S COST OVER TIME
When you take out a property loan, your principal (borrowed amount) and interest payment is fixed. So as time goes by, and you start to earn a rental income, your loan cost stays the same.
Consider this example. You buy a rental property for Dh100,000, and borrow Dh80,000 of it at 5 per cent interest for a 30 year term. That puts your principal and interest payment at Dh429.46.
The property rents for Dh1,500, and your total average monthly expenses come to Dh1,100, leaving you with Dh400 in monthly cash flow.
That comes to a cash-on-cash return of 24 per cent: Dh4,800 net annual rental income over your Dh20,000 down payment, equates to 24 per cent.
Five years later, the rent rose to Dh1,950. But your monthly mortgage payment remains Dh429.46. Instead of earning Dh400 in monthly cash flow, you now earn Dh700 or Dh800, even as other expenses do rise along with rents.
3. Predictability of returns
When you buy stocks, you target an average of historical returns. But when buying a rental property, if you calculate the cash flow right, you know precisely what return it will earn you.
You know the purchase price, you know the market rent, and you either know or can accurately forecast all your expenses.
For instance, you know the cost of rental property insurance, the cost of property management. You know the vacancy rate in the neighbourhood. You can forecast the average annual maintenance and repair costs accurately.
4. Diversification of asset classes
If all your money is tied up in stocks, what happens when the stock market crashes? Real estate values and rents have low correlation with the stock market and they’re also far more stable.
“Rental real estate can be a good source of retirement income as the relative inefficiency of the real estate market can produce bargains that offer strong returns,” Andrew Bailey, an independent real estate consultant residing in the UK.
With a portion of your investment income generated from rents, that diversification into another asset class reduces your risk and exposure to one asset.
Although you could buy REITs, real estate investment trusts which are simply assets that trade on stock markets, they correlate more closely to stock prices than brick-and-mortar real estate does.
Key downsides of rental properties
Rental properties come with their fair share of risks and downsides, like any investment. To begin with, they come with an extremely high cost of entry.
Even if you take out a rental property loan, you still have to come up with a down payment. That alone usually costs you tens of thousands of dirhams, which does not include the closing costs.
(Closing costs occur when the title of a property is transferred from the seller to a buyer.) With rental property loans you can borrow the down payment, but if you do, additional debt eats into your returns.
“If you need to borrow to buy a rental property, do so before you retire. However, choosing a good location is more important than finding the cheapest property,” Bailey added.
Once you buy a rental property, it requires some ongoing labour. Rental income isn’t completely passive — even if you hire a property manager, you still need to manage them.
A key downside most investors overlook is that real estate is an inherently illiquid asset. It takes money to buy or sell, unlike stocks. You can buy or sell shares in a fund instantly, with no commission.
Real estate can also take months to sell, and requires you to pay money in realtor commissions as well. So before investing in real estate, make sure you understand all the risks.
If you’re planning on relying on your investments to support you for many years, you definitely don’t want to have all of your eggs in one basket.
This is because if one income source doesn’t work out, you could find yourself in dire straits and struggling to get back into the workforce or live on less.
The more sources of income you have, the greater the chances that you’ll have plenty of money to live comfortably.
However, you’ll need to evaluate what types of real estate investments you’re comfortable with and know how much of your retirement funds should be invested in the real estate sector.
Regardless, it can be agreed upon that putting some of their funds into gaining exposure to real estate is a smart move that maximises the chances early retirement will become a reality.
If you’re hoping to retire early, you’ll need to make such investments to have the funds you need, apart from the other assets you invest in.
To put it simply, investing in real estate is one option you should seriously consider to help enable an early departure from the workforce.
Article originally published with GulfNews