Hey guys, Mike Frontera here, back with another Retirement Theory video. So, you’ve got some money set aside and you’re trying to figure out the better move for your retirement: invest it in your portfolio or buy yourself a rental property? It’s a tough question, but thankfully, I’m here to help you through it. Each has its own strengths and weaknesses, and ultimately, it’s got to be the decision that’s best for you. I’m going to walk you through the six main attributes to consider when making this decision. Let’s do a boxing theme—hopefully, I can find myself a good graphic to use!
Round One: Cost of Entry. This is always an important piece to keep in mind, and one that I commonly see underestimated on the rental real estate side. This round is a huge win for the investment portfolio because the barrier for entry is almost zero. You can open an investment account and start investing for less than $50. If you want to add $10 a month to your investment, have at it. A rental property, on the other hand, typically needs a big down payment. Most lenders like to see at least 20% to 25% down, plus another 2% to 5% in closing costs. You have your escrow, prepaids, and inspections—and all this stuff is just to get you a key to the door. Depending on the property, especially if it’s one you want to make a good return on, it’ll probably need some freshening up—repairs, paint, flooring, or appliances. Hopefully not the "biggies" like a roof or an HVAC system. Either way, you need to be prepared with at least another $10,000 to $30,000 to get it ready to rent. Once that's done, you’ll still want money left over for mortgage payments and upkeep. All in all, for a basic property, you’re easily looking at $25,000 to $50,000 set aside after your down payment. Again, this is an easy win for the investment portfolio. While rental properties are great wealth builders, they tend to be better for people who already have some wealth to build upon.
Round Two: Leverage. As I just said, rental properties can be great wealth builders. They have an enormous advantage over investment portfolios in that they routinely use leverage to multiply their returns. The average nominal returns on a residential real estate property aren't super impressive—the Case-Shiller Home Price Index has averaged a little more than 4% a year over the past hundred years. But with only 25% down to control 100% of an asset, that 4% return jumps up to 16%, and that’s before we even look at any rental income.
Let’s take a moment and go through a hypothetical example with our pals Jerry and Ginny. They’ve got a fistful of cash and want to get it to work. They put $200,000 down on an $800,000 fourplex. For the moment, let’s assume the property is perfectly turnkey and ready to rent. We’ll keep it simple and forget the closing costs. To highlight the conceptual advantage of leverage: on an $800,000 purchase with $200,000 down, they take out a mortgage of $600,000 at 6%. That's a 30-year fixed mortgage with a monthly payment of $3,597, or $43,165 annually. For rental income, let’s say they have gross rents of $1,400 per unit, which is $5,600 a month or $67,200 annually. After holding back an 8% vacancy reserve, they get an effective gross income of $61,824 for the year. After operating expenses—property taxes, insurance, and a maintenance budget—totaling $16,560, their net operating income is $45,264. After the mortgage payments, they are left with a modest annual cash flow of $2,099.
To summarize the four components of returns: you have the cash flow of $2,099; the assumed appreciation of 4% ($32,000), which is a 16% return on your $200,000 investment; and the mortgage principal pay-down of roughly $7,200. This leaves a total return on the $200,000 of $41,299, which is just over 20%. That is not bad for an asset with lower volatility than most portfolios. However, leverage cuts both ways. If the market goes cold and prices drop 10%, that’s a 40% hit to your equity. But real estate's illiquidity can actually protect investors from their own worst behaviors. There is no ticker symbol on your house; you don’t see the value dropping in real time in your Fidelity account. You can’t make a panicked call to "sell everything" at the worst possible time. This round is a major win for rental real estate.
Round Three: Concentration Risk. You are probably well aware of diversification—not putting all your eggs in one basket. Diversification uncouples your financial future from any single point of failure. In an investment portfolio, you own tiny pieces of thousands of companies. If one goes belly up, you probably don't even notice. On the opposite end, a rental property is a super-concentrated bet on a specific building in a specific neighborhood. What if the big employer in town relocates? What if a highway gets rerouted or a hurricane devastates the town? When it happens to your place, it happens 100% to you. For that reason, Round Three goes right back to the investment portfolio.
Round Four: Work and Hassle. I hear all the time that people love rental real estate for the "passive income." I agree it provides healthy income, but I disagree that it is passive. Imagine it’s January and your tenant in Unit 3 calls at 11 p.m. because the heat is out. You are legally required to fix it within 24 hours, which means calling emergency services at premium rates. Then mid-March comes and a tenant isn't paying rent. You eventually have to start the eviction process, still covering the mortgage while the non-paying tenant is still there. When they finally leave, you find holes in the walls and destroyed carpets. Meanwhile, your portfolio just sits there quietly. You can check your balance while having coffee. Ownership is a much easier experience.
Round Five: Liquidity. This one is short and sweet. An investment portfolio is a no-brainer for liquidity. Most publicly traded investments can be sold and settled by the next day. If you have medical bills or a family emergency, the money is right there. With real estate, your money is tied up. Getting to that equity means selling the property (not quick) or borrowing against it (not cheap). Round Five goes to the portfolio.
Round Six: Taxes. Real estate is coming in strong here. The government loves property owners. First, there’s the depreciation deduction. Even if the building is appreciating, the IRS lets you write off its value over 27.5 years. For Jerry and Ginny, that’s over $23,000 in deductions, putting $5,500 back in their pockets annually. Then there’s the 1031 exchange, allowing you to defer capital gains indefinitely by rolling equity into a new property. If you leave the property to your heirs, they get a step-up in basis and may never pay a dime in taxes on that accumulated depreciation. You can even have a cash-flow-positive property while taking a "loss" on paper. This round goes firmly to rental real estate.
The Decision. We have four rounds for the investment portfolio and two rounds for rental real estate. But those two rounds were biggies! The truth is, both have pros and cons. Most people start with a portfolio and consider rental real estate as their wealth builds and they can handle the lack of liquidity. But if you have the liquidity and the intestinal fortitude to deal with the hassles and unique risks of being a landlord, it is very hard to argue with the wealth-building potential of real estate.
If you have questions for me, come visit me at RetirementTheory.com or send me an email at Mike@RetirementTheory.com. Once again, thanks for joining me. We’ll see you next time.