Afford Anything - Ask Paula: Should I Sell My Rental Property to Pay Off My Student Loans?

Episode Date: March 18, 2019

#183: Should a newlywed couple with two cash flowing rental properties sell one to pay off $92,000 of student loan debt? What percentage of your portfolio should you have in rental properties? What's the smartest way to approach rental property investing, particularly if you get anxiety thinking about tenant requests? How much should high interest rates impact your decision to buy a rental? I answer these four questions on today's episode, plus, I have a big announcement regarding the future of real estate Ask Paula episodes, so check it out. :)   For more information, visit the show notes at https://affordanything.com/episode183  Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every decision that you make is a trade off against something else. And that doesn't just apply to your money. It applies to your time, your focus, your energy, your attention. It applies to anything in your life that's a limited resource. And that leads to two questions. Number one, what matters most to you? Not what does society tell you ought to matter most, but what actually matters to you in your life?

And number two, how do you live your life accordingly? answering those two questions requires a lifetime of practice. And this podcast is here to help facilitate that. My name is Paula Pant. I'm the host of the Afford Anything podcast. And before we get into today's episode, I want to talk about something that's been bothering me for a while. I go to a lot of face-to-face events and meetups that are around the personal finance or financial independence community. And I go to these so that I can connect with people.

And that connection is what makes it worthwhile. But lately, I've realized that when I go to these, what often happens is that people want to talk to me about real estate. The thing is, I never think about real estate, like never, unless somebody is specifically asking me about it. Because real estate is actually a very, very, very small, almost insignificant part of who I am and what I've done. and my journey to financial independence. I don't really see myself as a real estate investor. I see myself as somebody who grew a business, as an entrepreneur who grew a business,

and who then invested the proceeds that she earned from that business into a wide variety of different assets and different vehicles, such as a Rothsola 401K and an IRS, and an HSA and some properties. I do feel that it's important to set the record straight because I never want anyone to think that I made my money through rental properties. I did not. I made my money by running a business,

and I used the proceeds from that business to make investments in a lot of different vehicles, rentals being one of many. I reached financial independence by figuring out how I could earn more. I reached financial independence through entrepreneurship and hustle. And by doing so, I grew the gap between what I earned and what I spent, and I invested that gap in a diversified way. And that is how I've built the wealth that I have. Now, with all of that being said, I'm going to announce a change to the format of,

this podcast. As you know, if you're a long-time listener, every other week I interview a guest and on the weeks in between, I answer questions that come from you, the community. Of the weeks in which I answer community-based questions, half of those episodes are with my buddy Joe Saul See-high, he's a former financial planner, and Joe and I answer general personal finance questions. The other half of the episodes are episodes that I host solo, in which, you know, I answer questions specifically about real estate investing. I had hoped that by structuring the podcast in such a way, such that three out of four episodes are not about real estate, I was communicating the idea that three quarters of what I do is not around real estate,

but I wanted to go all the way. So I've decided that the next Ask Paula Real Estate episode that we air, the episode that we're going to air on April 8th, 2019, that is going to be the last episode in which I specifically answer questions about real estate investing. After that episode, I'm not going to record any additional episodes that are specifically about real estate investing. If you do have questions about it, I will sprinkle those questions into other episodes that I do, but I don't want to dedicate material specifically just to that topic. In other words, the Ask Paula real estate episodes are coming to a close.

This is the second to last one. And episode 187, which we will air on April 8th, will be the last one. I would rather devote this time to exploring other topics. I would rather talk about entrepreneurship, side hustles, financial independence, growing the gap between spending and earning. But if you do have a question about real estate investing, I'll sprinkle one or two into the future Ask Paula episodes. Maybe Joe and I will tackle one together or on a solo episode. I'll answer one. But I'm just not going to dedicate whole episodes to it anymore. So why don't we take a little break right now to hear from our sponsors?

And when we come back, I'm going to answer questions about real estate investing. So stay tuned because that is what's coming up right now. As many of you know, I used to be a newspaper reporter, and recently I decided that I wanted to frame the very first article that I ever wrote on my first day as an intern at that paper. Day one of my internship, I wrote this article about hauntavirus, which is a disease that was spreading in the local community at the time. And I still have that article, but I've never framed it.

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Our first question comes from Stephen, who's wondering if he should sell his rental property to repay his student debt. Hi, Paula. Devoted podcast listener of Afford Anything. The question up front, sell a rental house to pay off student debt or not. Our quick background, recently married,

we have two rentals. One was my wife's house she lived in previously. and the other we purchased as an investment property. We plan on building a retirement portfolio with rentals. My wife's house has appreciated greatly in the last few years. We owe roughly 157,000 and comps are selling at 220. We have 92,000 in student loans at 6.5% roughly. The rental house grows at 1,600 a month with PITI, vacancy maintenance and everything.

That's about 320 a month. So nothing over the moon, but definitely cash flowing. Now for the debt, I know it's a lot, but we just got back from Camp FI. and we have a solid three-year plan to crush the student loans using our regular W-2 incomes. We've been going back and forth about selling the house and dropping a lump sum on the debt versus sticking to our payoff plan and in three years having no debt and two rentals. I was really leaning toward selling the house until your recent podcast number 170 about when not to use the 1% rule, where if I hear you correctly, you're saying there's a lot

of intrinsic non-monetary value to a rental you know and own and know intimately. It was such a well-timed episode in our life because I was literally doing exactly that, comparing its gross rental income to what it would sell for now in the 1% rule. So should we sell the house, pay off roughly $45,000 to $50,000 after everything's closed and finalized, fees paid, or crush the debt over three years and keep the rentals going? One last note, if we sell now, we will not pay taxes as it was a primary residence for two of the last three years. I know you wisely usually don't give black and white answers, but would love your suggested thought process to approach this. Thanks.

Stephen, that's a great question. All right, let's take a look at this. Your wife's home could sell for $220,000 and you owe $167,000 on it, which leaves you with a difference of $53,000. However, if you pay 6% in closing costs and agent commissions, well, 6% of 220,000 is 13,200, which means that if you sell the home for 220 and pay 6% in closing costs and agent commissions, then at the end of the day, you would be left with $40,000 as a result of selling this home. So let's put that $40,000 in perspective. Now, you mentioned that this home nets about $320 per month after all expenses, including vacancies, repairs, and PITI mortgage. $40,000 divided by $320 is $125.

And what that means is that this house is going to produce. net cash flow of $40,000 in today's dollars, not including any inflation adjustments, this house is going to produce $40,000 in net cash flow after all expenses every 10 years. 125 months is a little over 10 years. And that cash flow is not the only source of wealth creation on the property. Every 10 years, you will have $40,000 plus the principal pay down. from the tenants that are covering the PITI mortgage, plus equity growth, which we will conservatively assume

will keep pace with inflation but nothing better, plus tax depreciation on the components of the home, which allow you to keep a big chunk of that wealth creation tax-free, or free isn't really the right word for it. Really, the taxes are offset by the depreciation, or at least much of the taxes are. And so the question that you want to ask yourself is, would you give up $40,000 that comes in the form of, let's say, tax-favored income?

Would you give up a stream of $40,000 every 10 years plus all of the principal paydown that's not counted within that 40,000 number? Would you give all of that up for the sake of getting a lump sum $40,000 payment once now? To rephrase that a little bit differently, would you give up an ongoing stream a 40 grand every decade in perpetuity plus equity growth for the sake of getting that lump sum payment one time right now. I think that's all I have to say. I think that answers the question. It sounds like this is an excellent property, a property that's performing very well. And I'm very, very happy that the previous episode that I did about when not to use the 1%

rule, I'm happy that that came at the right time. And that's a message that I should be communicating more because I want to emphasize that the 1% rule applies to buying a property, not to holding a property. And as I think I mentioned on that episode, real estate is very different from the stock investing world. In the world of stock investing or index fund investing, it's easy to say, if you wouldn't buy it right now, then don't hold it right now. But real estate, for a variety of reasons that I elaborated on in that previous episode, is unique. And so the cliche of if you wouldn't buy it now, don't hold it now, does not apply to the field of real estate and rental properties in particular. In fact, and I'll say this for the benefit of everybody who's listening, all of you, your ideal situation is that after you buy your rental properties, in the future, your rental properties as you hold them, will no longer meet the 1% rule based on their current value because ideally those properties would go up in value. You don't want to bank on that. You don't want to speculate on that. Don't make a speculative purchase. But in an ideal world, you buy a property, a duplex for $200,000.

thousand dollars. You rent out each side for a thousand a month, so you're collecting grossing $2,000 per month on this $200,000 property. So at the time of purchase, the property meets the 1% rule. But ideally, as you're holding it, the value of that property goes up to $250,000 or $300,000. And the rent may increase a little bit, but the rental increase probably won't keep pace with the equity growth in the property. And from a cash flow perspective, that's actually worse for you because then you have to pay property taxes on the higher equity value, which is kind of a sucky feeling, but it's still net worth it because, hey, now you have this property which you bought in a way that was optimized for its cash flow and its cap rate.

You bought it in a way in which you were not reliant on market appreciation to make the deal worthwhile. and yet the property appreciated anyway. And due to that appreciation, it no longer meets the 1% rule. And you're happy with that because that has amplified your returns. Now you're making returns both in the form of a healthy cap rate relative to the price that you paid for it, as well as equity gains that exceeded what you had conservatively projected. So yes, in an ideal world, the property values rise enough that it no longer meets the 1% rule. while you're holding it, and you are totally cool with that, because that means that the total

return is even better than what you had initially projected. So, Stephen, I love your three-year plan to crush the loans with W-2 income. I think that's fantastic. If I were in your shoes, I would do that. You mentioned the student loans of a 6.5% interest rate. I don't know if you've tried refinancing or consolidating. If you've tried it and nothing's working out that way, or if the numbers don't make sense based on a three-year payback. That may or may not be a good option for you, but check into that to see whether or not refying would make sense in your situation. But regardless of whether you refi those loans or not, you're correct. I don't like to give black and white answers. I don't like to tell you what to do. I like to tell you how I think through the problem.

But I will say, don't slay the goose that lays the golden egg. So thank you, Stephen, for asking that question. Our next question comes from Gerardo. Hi, Paula. I'm Gerardo from Mexico and I want to start investing in real estate here in my country, but the interest rates here in my country are pretty high. They are between 10 to 12 percent annually. So my question is, given these interest rates on mortgages, is still a good investment in my country, or should I start seeking to another type of investment because they are too high for real estate to be a good investment? Thanks.

Gerardo, I'm going to challenge the premise of your question a little bit because what you are looking at and what you have expressed in your question is one and only one variable, that variable being the interest rate on mortgages. That is the single line item that you are focusing on. And when you find yourself focusing on only one singular line item in a vacuum, that's a sign that you're not zooming out and taking enough of a big picture holistic view of the situation. So I'm not specifically familiar with rental properties in Mexico. And I'm sure that rental properties in Mexico vary depending on what part of the country you're in.

But the broader question that you want to ask yourself is, what is the total return on this investment? And remember, assets grow value in two ways. There is the dividend or income stream that an asset pays out. And then there is the capital appreciation on that asset. Now, that's true of all assets, right? So a stock, like a share of Coca-Cola, will have capital appreciation, meaning the cost of that share of Coca-Cola will hopefully go up over time, and that share of Coca-Cola will also pay out a dividend or an income stream.

And so the total return on that share of Coca-Cola stock will be the capital appreciation plus the dividend. Rental properties operate in the same way. The total return on a rental property is the capital appreciation, meaning the growth of the value of that property over time, as well as the dividend or income stream that the property pays through the property's net operating income, which is the net rental income that you collect after paying operating expenses.

Now, the net operating income relative to the purchase price of a property is what's known as cap rate. So cap rate is a measure of the unleveraged dividend, the unleveraged income stream on a property. So let's say that you're looking at a property that has a 10% cap rate and also that property is located in an area that historically has seen long-term market appreciation at, we'll say, a 5% rate over the long term. You see that pattern over the course of many decades.

Well, then you can reasonably project a total return, a total unleveraged return of 15%. That's the 10% cap rate plus the 3%. 5% capital appreciation projection. Then the question is, would you borrow money at 8% or 10% in order to buy an asset that is likely to give you a 15% return? Well, yeah, the spread is pretty solid there. But on the other hand, if you're looking at properties where you're looking at what you project to be 3% equity growth and the property has a 5% or 6% cap rate, well, then you're projecting a total return of 8% or 9%. And then, of course, the answer would be no.

So looking at the mortgage interest rate alone doesn't really tell you anything because the question is, what is the spread, what is the arbitrage between the price that you are paying to access this money and the expected return that you could get on this asset if you were to buy this asset in cash? Now notice that what I did not just describe was I did not describe the cash-on-cash return formula. And I did that intentionally. And I know I'm going to get some angry emails from real estate investors who say, you know, you don't pay enough attention to the cash-on-cash-return formula. Yeah.

True. I don't. That is a very, very specific part of my philosophy. Because before I make any type of buying decision, I want to first know what type of return would this property produce, what type of return would this asset create if, if you're not. I bought it free and clear because first and foremost I want to evaluate the asset itself absent of any financing. So if I'm looking at an asset and I know that if I bought this thing in cash free and clear that this asset would under a conservative set of projections produce a 15% return, then I'm going to ask myself, am I willing to borrow money at 10% to buy this thing that conservatively will bring back 15%. Yes, I will. Right? So I'm not asking what's my cash on cash return. I'm asking how well is this asset itself going to do? And based on that number, how much am I willing to pay to get the money that would allow me to buy this asset? Thank you so much for asking that question. We'll return to the show in just a moment. Hey, do you remember starting a small business? Yeah, it was rough. There's late nights, there's early mornings, there's all-nighters, it's stressful.

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so you have the tools that you need when you need them. Join the 24 million people who have used FreshBooks by trying it for free for 30 days, no catch, and no credit card required. Go to FreshBooks.com slash Paula. And when they ask, How did you hear about us? Type in, afford anything. Again, that's fresh books, F-R-E-S-H, Books.com slash Paula, P-A-A-U-L-A. Do you run a business? If so, as you know, small business owners wear a lot of different hats.

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Hi, Paula. My name is Anujan. I'm 19 years old, and I just have a few questions about real estate. So small brief about me. Ever since I was, I think, like 16, I was managing my parents' rental properties. It only had two, but it was kind of a big deal when I was young, right? And I kind of learned a lot. But what I've seen was my parents were really that prepared, right? And they were immigrants.

They've just seen other people doing this, so they just jumped on the bandwagon. But I want to be a smart investor. I want to go into this in the future. Before I'm 30, I want to have at least, like, one rental property. And I want to know what is a smart way of approaching it, right? I heard stuff like doing under corporation, et cetera, et cetera. And also, number two, I don't know if this is smart,

but I hear it a lot. I hear that you could subsidize your retirement with rental properties. But I know, like, rental properties are somewhat stressful. Like, I get anxiety, which is not good when I get emails from my parents' tennis and stuff. So, like, maybe when you're older, you get super stressed out. But I'm wondering, like, is that a feasible or possible solution, right? So, yeah, I look forward to hearing back from you. And thank you so much.

Anuchin, first of all, I'm super happy that you're 19 years old and you're thinking about retirement. That is awesome. Anything that you do now at the age of 19 or 20 or 21, your future self is going to thank you. So save as much as you can now, invest as much as you can now. I think that is really amazing that at 19 you're thinking about, all right, how am I going to manage my money in retirement? What investments do I want to have in my portfolio at retirement? Those are the questions that you're asking already. Now, speaking of asking the right questions, I want to take a look at the two questions that

you asked. And again, I want to zoom out and ask why you are asking these questions. So the very first thing that you've said, you've said, what's a good way to go about this? I heard that doing it under a corporation might be a good way. Let's unpack that statement because essentially what you asked within that was, how do I best protect my assets? Hold your horses because before you leap to protecting your assets, the first thing that you need to figure out is how do I wisely select an asset? And it makes me a little bit nervous that you and so many other people, this is not just, to you. I've heard this time and time again. So many people, when they get interested in rental

properties, their very first question is, should I create a corporation? Should I create an LLC? Should I do that? Like, their mind immediately jumps to how do I protect my asset, and they don't spend enough time asking, how do I properly analyze a property? How do I develop the critical thinking and the judgment to be able to separate a good deal from a mediocre one? How do I know whether or not a property is worth buying? Doing it under a corporation so that you can protect your assets, what assets do you have to protect? I don't want to make any assumptions,

but I'm going to make the assumption that you don't have at 19. You don't have a lot of assets yet. So why is the first question that you're leading with a question about how do I protect my non-existent assets? Let's make a more concrete example. You mentioned that you want to buy a price. property by the time that you're 30. Let's just assume for the sake of example that you decide to house hack into a duplex. So you take out, because it's a house hack, you can qualify for a mortgage

as a primary resident. So you take out an FHA loan with 3.5% down on a $200,000 property. With that down payment of 3.5% on a $200,000 property, that means that you have $7,000 of equity in this property. Assuming that you don't have other. significant assets, your question is, how do I protect $7,000? Well, I'll tell you, the fact that that is the only equity that you have in the property itself inherently is probably going to protect you because if a tenant slips and falls and goes to a lawyer and says, I want to sue my landlord. And the attorney realizes that the landlord has a total net worth of about $7,000,

I don't know if they're going to take that case. I mean, some people would, but if you've got a total net worth of $7,000, nobody's going to sue you because the retainer is going to cost that much. I keep hearing people ask the wrong question, and I'm just going to be blunt. Like, that's really the wrong question. If you want to buy your first rental property within the next 11 years, you're 19 now, you want to buy it by the time you're 30, then the question to, to ask is how do I learn how to find properties? How do I make a decision as to whether I want that property to be local or out of state? What are the pros and cons of each? How do I balance my other financial priorities of my 20s, such as getting an education, renting a place of your own? How do

I balance all of that with also saving for a down payment? Those are the questions that are most relevant to your situation. Should I create a corporation is not something that you need to worry about until you have something to protect. Now, to question number two, you mentioned that you get anxiety from dealing with your parents' tenants. And so you're wondering if being a landlord would be a good role in retirement because you wouldn't want your retirement to be colored by the anxiety that you feel when dealing with tenants. So a couple of things that I'll say here. First of all, you have no idea. how you will feel, let's say that you retire at the age of 30 or 40. You have no idea how you'll

feel in 20 years. The things that bring you anxiety now may or may not continue to bring you anxiety 10 or 20 years into the future. Oftentimes with practice, things become easier. And so the more practiced you are at dealing with tenants, the easier that that becomes. The skills, the skills set improves. So that's one thing that I would say. The second thing that I would say is if you don't like dealing with tenants, hire a property manager and have them deal with tenants. You can't outsource your judgment, but you can certainly outsource the work. And if you buy the right property, if you buy a property after running a spreadsheet that makes the assumption that all of the work will be outsourced to somebody else, if you run a property analysis in which the math, the

is identity agnostic, then any property that you buy will have space within the budget such that you could get a property manager at any time that you wanted to. And so again, this leads back to asking the correct questions. And the correct question is not how do I protect my property. The question is, how do I know what to buy so that I ultimately own something one day that is worth protecting? And so to answer that question, go to our previous rental property episodes and listen to any episode in which I talk about how to analyze a deal. Because if you want to buy your first rental property within the next 11 years, the three things on your mind need to be learning how to analyze a deal, learning how to find a deal, and learning how to save up for slash finance the deal. Those are the first three steps.

If you go to my website, affordanything.com slash podcast, you will see a list of all of our previous episodes. So go through those and tune in to any of the episodes in which we talk about those three topics, how to amelize a deal, how to find a deal, and how to save up for a down payment slash get financing for the deal. Thank you so much for asking that question. And again, I'm very, very happy and very encouraging of you buying a property. frankly, I think that you can do it sooner than 11 years. I mean, I don't know what other competing priorities that you have if there are certain other big ticket items that you would want or need to pay for prior to when you could start aggressively saving for the down payment on a rental property. But I do think that there's a good chance that you'll be able to buy your rental property, your first rental property, before you're 30. I think you could do it depending on your other financial priorities. And I don't know what. what that whole picture is, but there's a chance that you might be able to buy your first rental property before you're 25. So I'm really glad that you're thinking ahead and learn as much as you

can about those three topics that I just named, analyzing a deal, finding a deal, and paying for the deal. Thank you so much, Anujan, for calling in and asking that question. Our final question comes from Mike. Hey, Paula, Mike here. I'm a long-time listener and want to say thanks for all you do to support real estate investors. My question is about how you choose what percentage of your portfolio you have in rental properties. On the recent show with Larry Swedro, you shared that 3%, or I should say Larry shared that 3% is the new 4% rule. Based on this new 3% rule, do you think it would be better to plan to move more of my traditional retirement funds to rental properties when I'm 59 and a half to have them generate better cash flow using your 1% rule. I'm thinking that having

one million in rental properties generating 100,000 in pre-expenses is much better than the 30,000 with the 3% rule that Larry shared. Currently, I have two rental properties that are now both cash flow positive each month. I hope to have their mortgages paid off in six to seven years. I'm 53 now with traditional retirement accounts with balances around 675,000 currently between my wife and myself. My goal was to buy a rental property each year for the next 15, but I haven't been able to do that. Let me know what you think. Thanks again, Mike. Mike, that's a great question. And yes, when Larry Swedro said that 3% is the new 4%, that was terrifying.

For the sake of everybody else who's listening, who didn't hear, that episode, that is a reference to the safe withdrawal rate from a portfolio of investments. So right now, the common thinking based on the Trinity study, which is a big study that was done on the rate at which a retiree could draw down from their retirement portfolio, right now the common thinking is that a person could safely withdraw 4% in year one of retirement and 4% adjusted for inflation every subsequent year. So in other words, if you have a portfolio of a million dollars, then you can withdraw 4%, which is $40,000 in year one of your retirement, and you can withdraw 40,000 adjusted for inflation every following year. That is known as the 4% rule,

and a lot of people within the financial independence community use that rule when they're running projections on their planned retirement. So this guy, Larry Swedro, who's not just some guy, he is one of the most respected thinkers and writers in the world. of retirement planning, he came on the show several episodes ago, and he stated very unequivocally that 3% is the new 4% going forward. And what that means at a practical level is that that same $1 million would produce $30,000 per year in year one and 30,000 adjusted for inflation every subsequent year. And if I'm not saying that I agree with it or disagree with it, I'm simply stating that Larry Swedro is a very well-respected figure in the world of retirement planning,

and that is what he thinks. And if that is the case, then wow, that's going to rock some boats. So, Mike, to your question, if portfolio drawdowns are going to be less than what many of us had anticipated or hoped for, does it or does it not then make sense to allocate a larger percentage of your portfolio into rental properties? To answer this, let's zoom out and look at how both sets of assets earn their money. Let's assume, for the sake of illustration, that you or that a person has $1 million in index funds and $1 million of free and clear rental properties. Let's also assume, for the sake of illustration, that both of these buckets, the index fund bucket and the rental property bucket, have the same total total.

return, which is a total return in this example of 9%. On the surface, these may seem like very similar investments. Bucket A has a total return of 9%, bucket B has a total return of 9%, and their risk profiles between bucket A and bucket B are not too widely dissimilar. For the sake of illustration, let's start with that set of assumptions. And based on that, let's look at how these returns are biased because in doing so, we can see how rental property returns are more heavily biased towards an income stream. So first, let's take a look at that bucket a, which is a million dollars in index funds, making a total return of 9%. Now, of that total return, around 2 to 3% of that will be in the form of dividends.

broadly speaking, and the other 6 to 7% of those returns will come in the form of appreciation or capital gains. Or I should say specifically in this hypothetical index fund portfolio that has a decent equities allocation, most of the returns are coming from gains and only a little bit of the returns are coming from a dividend. And what that means is that you do need to harness some of the principle, you do need to sell off some of the stocks in order to be able to live on that. With a million dollars worth of investments, you probably can't live on the dividends alone because the dividends are going to be a very small chunk of the overall return. So you do have to start drawing down on that principle a little bit.

And that's where the question of the safe withdrawal rate comes in. is it 3%? Is it 4%? At what rate can you draw down on that principle? So if in your index fund portfolio, you're getting 2% in dividends, then if you draw down at a 3% rate, all right, you're drawing down your dividends plus an additional 1% of your portfolio. Now, of course, this is a highly oversimplified hypothetical, but I'm stating it for the sake of illustrating a concept, right? So that's what's going on in bucket A with your index funds. Now, in bucket B, which has the same value and the same total return, $1 million of rental properties held free and clear, the way that that return is expressed does not require you to draw down on the principle

because the way that that return is expressed is biased towards cash flow. So if you have $1 million of rental properties at the 1% rule, then your rental properties are generating $10,000 per month, which is $120,000 per year. And using the 50% rule, which states that 50% of gross rent goes towards operating expenses, then you're grossing $120,000 a year. 50% of that, which is $60,000 goes towards operating expenses, and the remaining $60,000 is yours to keep.

That remaining $60,000 is what's considered the net operating income, which is the operating income net after you pay for operating expenses. And because you hold these properties free and clear, your net operating income is also your cash flow. So you have $60,000 in cash flow. But that's not your total return. Your total return is that $60,000 per year, which is essentially a 6% dividend or a 6% income stream on that $1 million portfolio of rentals, Plus, if we conservatively assume that the rental properties keep pace with inflation but nothing more, and the rate of inflation is 3%, then the total return in that portfolio is 9%. So you can see how in portfolios A and B, we have $1 million worth of assets, both of which are producing 9% returns.

but due to the nature of rental properties, the majority of the returns that you're getting from the rental property is expressed in the form of a dividend or expressed in the form of an income stream. Of that 9% return that's coming from the rental property bucket, 6% of that 60,000 a year is the dividend or the income stream and the other 3% is the equity growth. And so at a conceptual level, this is where, why I very much believe, in my opinion, that rental properties are, particularly when they're held

free and clear, are a fantastic tool for funding a retirement. The setup of the returns lends itself well to cash flow. Now, that being said, that cash flow is going to be volatile. The numbers that I'm using in this example are long-term aggregate averages, so there will be volatility. there will be variance. There will be times when a water heater breaks and a roof leaks and and and and and, and if you look at cash outlays, remember, there is a difference between required cash outlay versus long-term aggregate return. So it might be that in any one given year, you may need to outlay a significant amount of cash in order to deal with long-term capital expenses, right? If you replace a roof on a property, that's a major cash outlay in the year in which you make that expense. That doesn't mean that your returns have been hampered. That doesn't mean that your cash flow at a conceptual level is any weaker. It means that you have – that roof is going to last for 25 years, so it means that you have paid

upfront for not only this year, but also for the next 24 years of service that that roof is going to give you. So rental properties are a fantastic way to fund a retirement, assuming that you have strong enough cash reserves that that volatility, that variance, those cash outlays do not cause a short-term stressful situation. And that's basically another way of saying if you are going to retire on rental income, you want to extra, extra beef up that emergency fund because you're not going to be able to use W-2 income or any other active source of income to provide a cash infusion into the business at a time when multiple major CAP-X expenses hit simultaneously. Now, in terms of asset allocation, which is how the question began, that was the first thing

that you asked about, what percentage of your portfolio would you put in index funds versus rental properties? I mean, it's such a judgment call, right? Because, sure, the returns on a rental property are more biased towards income. That is true, but it is also equally true that your index funds will never need a cash infusion. We'll go back to that roof example. If you have to spend $6,000 on a roof and that roof lasts for 25 years, then $6,000 divided by 25, the cost of having a roof is $240 per year. And as a long-term aggregate average, yes, that's true, but you pay that entire bill up front. And that is the thing that knocks a lot of rental investors out of the game is they see these big cash outlays and they either don't have the reserves to be able to cope with

those cash outlays or they conflate the concept of cash outlay with the concept of long-term aggregate return and they don't understand how good of a deal they have. And they think that their current holdings are worse than they actually are and so they sell them. That's actually a great way to buy good properties. Find an investor who doesn't know the strength of his or her own deal. Anyway, the benefit of an index fund is that you don't have to think about any of that. If there is a recession or a market pullback, you can draw down at a 2% rate. And if we're in a bull run and stocks are really high, at that time you can draw down at a 4% rate. So yes, you might adjust the level of drawdown based on what the market is doing, but you're not going to.

to need to maintain reserves in order to fund it. You're not going to need to put in more money after retirement or maintain an emergency fund for the sake of supporting your index funds. So it's hard to compare between the two and the way that I would approach it. First of all, you mentioned that you're 53 and you think that your properties will be paid free and clear within the next six years, which is perfect because that brings you to age 59. And going into retirement with properties that are paid free and clear is absolutely fantastic. I would highly encourage you to hold your properties free and clear once you are in retirement. So the fact that you're on track to do that is fantastic. Beyond that, I might develop a strategy that's based around your needs. So for example,

perhaps you could use the income from rental properties to cover basic bare bones living expenses and then the drawdown from your index fund portfolio could support that layer of wants because that way you could adjust the drawdown based on what's happening in the overall market. So that's one possible approach out of many, but that's an approach that I think would be pretty solid. Use the rentals to cover needs and then use the stock portfolio, the index fund portfolio, to cover wants. And that type of an asset allocation, one that starts with the end in mind, you know, one that starts with the question of how much do I need slash want and then calculates based off of that.

That, to me, makes more sense than some asset allocation that is simply a numerical percentage that's outside of the context of your own expenses. Well, thank you so much for asking that question, Mike. Well, that is our show for today. Thank you so much to Stephen, Herardo, and Anujan for calling in with your questions. And thank you so much to everybody who's tuned in and listened to today's episode. I realize this is a totally different episode than the ones that I normally create. I started it with a soliloquy that went a bit longer than even I anticipated.

But I hope that that shed some light and created some context for the role that real estate has played in my life. And how that is contextualized with my other investors. like my index fund investments, my 401k, my IRA, my HSA, my taxable accounts, and how all of that is where I've parked the money that I have made from entrepreneurship and self-employment. And if you have questions about building a business, entrepreneurship, employment, side hustling, earning more, financial independence, please afford anything.com slash voicemail is where you can call in, leave a voicemail. I would love to talk more about those topics because I think that those are the topics that have not received enough attention. And they are critically important to growing the gap between what you earn and what you spend. There are only two ways to grow that gap. You can either earn more or you can spend less.

And spending less is the low-hanging fruit for sure, particularly if you're leading an inefficient lifestyle at the start. but once you have made your lifestyle efficient, then earning more is where a lot of that power comes from. So let's talk about that. Any questions that you have about that I would love to answer. So afford anything.com slash voicemail. Please let's get together as a community and find ways that we can all make more. Thank you so much for tuning in. My name is Paula Pant.

I'm the host of the Afford Anything podcast. If you enjoy today's show, please share it with a afford anything. friend or family member. Coming up next week, we have an interview with Todd Herman. He is the author of a book called The Alter Ego Effect. And it's all about adopting an alter ego, adopting an alternate sense of self to give you the courage to push through difficult situations, to give you the courage to walk up to somebody at a conference, even if you are shy or timid about talking to strangers, to give you the courage to make cold calls if that is something that you need to do within your work or within a side hustle. He talks a lot about the practice of embracing an alter ego to be able to

push your boundaries and push past your limits. So we're going to talk about that on next week's podcast. Hit the subscribe button in your favorite podcast player so that you don't miss that episode or any of our upcoming episodes. Thank you again for tuning in. My name's Paula Pant. I'll catch you next week.