I used to think it was as simple as looking at cash flow, after taking into account vacancies, capital expenses, maintenance, etc. etc. (all expenses basically) and saying that when cash flow > expenses, you're good.
The reason why? It's what every real estate investor said. In books, on BiggerPockets, etc. Even the well-experienced ones.
I'm not so sure, now. I think there are absolutely cases where you could have your cash flow > your expenses, be saving a significant chunk of your income (over and above the amount set aside for all expenses--we're assuming you project that correctly and set aside for that already) and STILL hit ER failure, simply due to the market you're invested in lagging inflation.
The critical assumption one relies on when wanting to FIRE based on cash flow > expenses is this:
more than likely rents will increase with inflation
That may be a dangerous assumption. Historically rents have risen with income, not inflation (those are sometimes tied together, but not always). And any particular area may rise less, or more, depending on that local economy.
If rents in the area you're invested in start a slow (or quick) decline while you're living in an area with increasing expenses (or even in that area, but not seeing your expenses go down, because food, travel, etc. still all cost the same), you might quickly run into trouble.
I made some posts recently about when SWR/WR is Less Than ROI.
The background, from
this post:
another big problem is you don't know what the SAFE withdrawal rate is, even if you have a return on investment.
In other words, let's pretend your return is 6%. Your SWR* might be 9% (i.e. you could spend all of the income from the property - the 6% - AND cash out refi equity every few years due to the property value increasing, to give you a total yield of 9%), or it might be 3% (i.e. you can spend half of the 6% income you're getting, and need to reinvest the other half in order to make it the money keep growing and last long term).
*Safe as in - it is sustainable long term
If you're in an area where prices stagnate, rents don't rise much, and inflation outpaces them, your SWR is lower than your yield. That is, you may be earning 6%, but if your expenses and costs rise faster than inflation, you'd better be LBYM, saving a good chunk of that 6%, and plowing some of those proceeds back into more investments to keep pace, or in 20-30 years you'll be hurting really, really bad.
So we use the word "safe withdrawal rate (SWR)" fairly loosly, usually to mean "WR" -- but the actual safe withdrawal rate is the rate that is sustainable long term, and that might be more or less than your ROI. You can't just go "I'm making 6%, I can spend 6% without eating into principal, I'm good" - because of inflation."
"And I almost never see it mentioned. Just because your return is $X, that doesn't mean you can spend it all, even if it's stable. Even if you have accounted for vacancy, repairs, etc. and are dead on accurate such that a disaster never hits and your budget is 100% correct to the penny, you still might not be okay spending the rest, because your SWR could be lower than your return.
For stocks it's lower due to volatility (sequence of returns risk). Real estate has less sequence of returns risk, but other systemic risk in expenses rising higher than income.
But in pretty much every real estate book I've read, including ones on long term buy and hold, this isn't really mentioned, or it's handwaived away with a "rents increases will cover it all" -- but that's not necessarily true.
So it's something a smart individual looking to FIRE and live a long time on real estate proceeds should consider.
This one illustrates it with numbers (using a CD to make the math straightforward, but it absolutely applies to real estate as well) from
this post:
I can't use cFIREsim, cause our portfolio is mostly real estate. But I'd estimate my chances are just north of 50% of not needing more paid work?
I'm surprised your estimate is that low. Didn't you say you continue to have a positive savings rate in retirement? Is it because you expect your expenses to go up (presumably it's not because you expect your rental income to go down)?
Well... it's really hard to get an accurate estimate. So I fluctuate between "we never have to work for money again!" and "we'll definitely have to go back at some point." My 50/50 estimate is approximately how much time I spend in each stage. ;)
I do expect my expenses to go up, but only to the level I projected pre-FIREing. We're way below that right now, and if we stayed at this low level forever, we'd have no problems whatsoever. But I don't necessarily expect them to rise past what I had projected (aka pulled out of nowhere).
It's more that I think my SWR is lower than my ROI. So while I think we can get along just fine on cash flow for decades(?), we could still hit ER failure. With my type of income, over time it could fall in real terms if expenses outpace inflation and/or rents underperform inflation.
So we do have a positive savings rate, for now. But that's not even enough to guarantee having "enough."
For example, i someone had 1MM and wanted to spend in line with the 4% rule, and had a higher ROI than that 4%, so they had a positive savings rate, and a flat inflation rate, but it was higher than their savings rate, they'd run out of money, even with a positive savings rate.
Hypothetical: Person has 1MM, is invested in a one-year CD that paid 5% (and had access to this investment forever, in this hypothetical), and they spent 4% (40k), and reinvest 1% of it (10k), with a 3% inflation rate, the first year they'd spend 40k, reinvest 10k. The next year, at 3% inflation, they'd spend 41200 (an extra 1.2k over the year before), but they'd have only generated an extra $500 (5% return on the extra 10k invested). Their expenses are growing faster than their reinvestments.
Eventually the amount they withdraw (the initial 40k, but adjusted up for inflation) will be higher than the interest generated, so they won't be reinvesting any anymore. This happens in year 11. They then have a negative savings rate, and start eating into principal to maintain their lifestyle. At the end of year 18, their portfolio has fallen back below it's original 1MM.
After 30 years, they'd have about half their initial starting capital (~500k), and only generating ~30k (with their expenses being ~94k annually at that point). By year 37, they're out of money.
This is someone with a guaranteed investment return of 5% and a positive savings rate of 20% (1% of their 5% return), and they ran out of money after less than 40 years!
Now, obviously they only had a real positive return of ~1.94% (5% nominal, 3% inflation) and were withdrawing 4%, so we can see disaster coming when we understand real return. But you can easily see why someone who says "I have a withdrawal rate less than my ROI, and a 20% savings rate!" would think they're in good shape, even though they're headed for disaster.
This is the situation I'm in. My ROI on my rentals (just my cash on cash return, not counting appreciation and principal paydown) is much higher than my "WR" (aka spending amount). Due to this, I have a positive savings rate.
Yet my "WR" may still be too high, and I may still be heading for portfolio failure. I don't know. But it is an added risk, if expenses outpace inflation or rents underperform inflation. Then I could have a real return, like our doomed investor, of less than my spending rate, all while having a positive savings rate, and not even know it.
That is my bigger worry. Not my expenses increasing, or my portfolio not putting out enough cash flow to support me over the next decade or two. It's multiple decades down the line--will I have reinvested enough, along the way, to avoid that scenario?
I think this is something almost
no one in real estate realizes. If your income goes up in line with inflation, as it likely will the majority of the time, sure.. your SWR may be the ROI. Or higher! You might be able to spend MORE than your cash flow (deficit spending and selling a property every once in awhile to cover that) and still be fine, if your income is increasing much faster than inflation. You could have an ROI of 6% and SWR of 9%.
But typically, it'll keep in line with inflation, and an ROI of 6% may equal a SWR of 6%, and you'll be just fine (again, assuming proper set asides for CapEx, vacancy, etc.).
But just because this is the case the majority of the time doesn't mean it always will be. And that possibility, of rents declining in real terms (even if they are rising overall, if they aren't rising as fast as inflation--and you can only push rents to what the local market will bear), you may be in trouble. Even if you're not only not spending all your cash flow aside from set asides, but reinvesting some of it! It may not be enough.
It's a risk to be aware of, and hedge against, IMO.
As you can tell, I've put some thought into this lately, as I FIRE'd on real estate a year ago, and I'm trying to account for any risks that I can. And this is, from what I've seen of the real estate field, and people telling you how to retire on passive income "an unknown unknown"--I'd rather turn it into a known unknown, at the very least.
Hope that helps give you (and others, who have posted here and who haven't) something new to consider. :)
