My path toward financial independence is at odds with the majority of the financial independence/retire early (FIRE) movement. Many FIRE advocates stress investing their savings in the stock market – specifically index funds like VTSAX. Save until you have 25 times your annual spend stashed away, then withdraw 4% of the dividends annually. There are finer points like rebalancing your portfolio, but that’s it in a nutshell. It’s easy, effective, and once achieved, takes very little time from your day, leaving you with the opportunity to retire early and enjoy life. But this crowd typically would not use real estate to achieve financial independence.
Why?
Because it’s too much work. Considered too volatile. It’s subject to big capital expenses that can kill your cash flow. And there are some real horror stories around problem tenants.
So…why the hell did I choose real estate to achieve financial independence?
Overall, I appreciate the direct control over my assets and cash flow. And even though it’s not as passive as stock market investing, the time I take monthly to manage my existing properties and analyze future investment properties is negligible compared to my old corporate job. On a “bad” week, I spend about 16 hours on my properties. On a “good” week – and these are the vast majority – I spend only one to two hours on my properties. This is thanks to a good education in real estate investment and property management.
I cannot stress the education enough. This and hands-on experience have helped me streamline all aspects of residential multifamily ownership. And once it’s streamlined, it’s a pretty painless process.
And as for those painful 16-hour-a-week instances, they make for some great stories. And learning experiences.
Below are some reasons why I leaned into real estate to achieve financial independence.
Comfort With Real Estate as an Asset
The biggest reason I went with real estate is my comfort level with the asset.
I remembered my dad’s lack of success with the stock market. And without a degree in business or finance, I just didn’t feel comfortable with the stock market as a whole. My instinct is to want to fully understand what I’m investing in. And after reading off a list of companies included in a particular index fund, I just didn’t think I understood them well enough to feel good about investing in them.
Real estate, on the other hand, seemed really straightforward. I immediately felt comfortable talking about real estate. Which gave me the confidence and desire to continue my education in the investment analytics and property management space.
One thing that helped was honing in on a very specific type of real estate: multifamily residential real estate.
I identify with multifamily residential real estate. I’ve lived in several apartments in my lifetime and experienced firsthand what I did and did not appreciate as a tenant.
Although I initially had no experience with multifamily properties, I did have experience with a couple of single family residences, so I understood the overall process.
And as I got more involved with property management and the investment analytics aspect of owning multifamily residential properties, I further focused my scope. I prefer C class properties that provide homes to the working class, young couples, single parents, fixed income residents, etc. This type of housing is needed in both bear and bull markets, and probably makes up the majority of residential multifamily properties available in the world. My investment style emerged as one that identifies with value-add properties – properties with under-market rents that have not been renovated in 20-30 years. I wanted the opportunity to fully renovate units, bring rents up to market, and greatly improve the property asset. My property management style emerged as being very digitally focused. I enforced tougher rental criteria. Withstanding longer vacancies, in exchange for quality tenants who would appreciate a renovated and well-maintained home offered to them at a fair price.
The Joys of Unrealized Capital Gains
As I mentioned, my ideal multifamily property is one with under-market rents that hasn’t been renovated for decades. The people I buy properties from have either owned them for decades and just not kept up market rents and market finishes. Or, they have had the property for only a couple of years, but neglected maintenance and their residents, putting as little money into it as possible so they can flip it for a profit.
The latter is more common than I’d like to admit. Bad for residents. Good for me.
Over the course of six to twelve months, I work with residents, renovating individual units by upgrading appliances, addressing maintenance issues, and improving shared spaces and the exterior. After making these significant upgrades, as leases are up for renewal, I offer them a new lease at market rent – which is usually 20-25% higher than their current rent.
When I first did this, I was really nervous about it. Even felt bad about raising rents on good residents. I was afraid my good residents would leave.
Nothing could have been further from the truth.
Unless you are grossly over-raising rents, residents will see that your new rate is in line with everything else available out there. Sure, they can find something cheaper, but it won’t be as nice as where they are now. That’s the sweet spot. And even better, because I have already shown them I will quickly address maintenance issues and work to improve their home, they value me as their property manager and landlord.
About 25% of my residents have left in response to a rent increase. They are residents who are looking for the cheapest place they can find, not quality for a good value. It’s the latter type of resident that I’m catering to.
So, what does this do to my capital gains?
Wonderful things!
Unlike single family properties – which are valued mostly by their neighborhoods and finishes, multifamily properties are valued mostly by their income. When you invest in your multifamily by renovating and improving, you’re also transforming a community to a higher standard. And a higher standard charges a higher premium.
By owning property in a community that warrants higher rents, you are increasing your net operating income and, therefore, the value of your property. If done correctly, the amount of “forced appreciation” is more than what you invested.
At its most basic, a capital gain is the profit you make after a sale.
If you purchase a multifamily property for $300,000 with a net operating income (NOI) of $3,000 monthly, invest $50,000 and increase the NOI to $4,500 monthly, you now have an unrealized capital gain. Using the back-of-the-napkin 1% rule, the property you purchased for $300,000 is now arguably worth $450,000 after your $50,000 investment. This is how you want to invest. Be ready to invest money into your property – but plan to make more than your initial investment when you sell it.
Someone Else Pays Down Your Principle Mortgage
Unless you are buying with cash, you will likely take out a loan to acquire your multifamily property. Unlike a single family personal residence, your tenants will pay your mortgage for you.
So, when you go to sell that property you’ve held for several years, your loan amount will have a nice dent in it thanks to your residents. And that is profit you get to pocket.
It’s as simple as that.
Appreciation Over Time is Pretty Reliable
Forced appreciation happens when you renovate a place and/or increase a property’s income and, in response, its value increases.
Appreciation is something that is never counted on, but always welcomed. Most real estate investors expect a 3% annual appreciation. This just means that the value of your property should go up without you having to change a thing about it. This can be due to increased demand or inflation. Regardless, except for a few outlier locations, most properties do appreciate over time, adding to your return on investment and net worth.
Cash is King! Cash Flow..
The dividend of real estate…cash flow! Cash flow is what’s left of your gross monthly rents after you’ve paid your mortgage, any utilities, repairs, and maintenance. Cash flow is your profit.
Most banks will not give you a loan unless you can show cash flow on a property, as this is a sign of property health.
Why do I prefer cash flow over, say, index fund dividends?
Control.
I feel like I have a lot more control over the cash flow my property produces than I have over the dividends my index funds will pay out.
Operating expenses can be reviewed and addressed. Some utilities can be negotiated. I can try to find more affordable vendors for things like lawn maintenance and pest control. Implementing quarterly or semi-annual inspections with my handyman can help me identify small issues so I can repair them before they become bigger, costlier issues. Property taxes can be reviewed and protested with local officials.
Gross income can be addressed by tracking market rents, providing a quality home that warrants higher rents, and increasing rents to keep up with market rates. Identifying other sources of income – like providing on-site storage or laundry facilities for a monthly fee – can also help increase income and cash flow.
Sweet Tax Advantages
Books have been written about this one, so I won’t go into too much detail. I couldn’t if I wanted to. My CPA handles most of this for me
What I do understand…being a “real estate professional” has serious tax advantages. Depreciation allows you to apply significant writes-offs. And Section 1031 exchanges – an IRS provision that allows you to forego capital gains taxes by rolling those profits into another, eligible property – can have a great impact on your tax savings annually.
Shop and ask around for accountants who work with real estate investors and professionals. They will help you understand what to track and how to invest to minimize your tax situation. My CPA (along with my lawyer) helped me set up LLCs to ensure minimal personal liability…advised me how to track and pay business expenses and how to pay myself a salary in a way that minimizes my tax burden.
I’ve learned a lot about real estate investment along the way and I’m enjoying the journey. So, although real estate investment isn’t the typical path for FIRE advocates, it’s definitely the right path for me.
“Two roads diverged in a wood, and I— I took the one less traveled by, And that has made all the difference.”
— The Road Not Taken by Robert Frost