Rental properties and Safe Withdrawal Rate calculation

[Nifty]

Safe withdrawal rate is a powerful tool for assessing one's ability to handle retirement, and so much research has been presented on it that I would love to be able to use it myself. Tools like cFireSim are available for looking at FI from a cash in vs. cash out perspective, but after spending so many hours reading EarlyRetirementNow's many-part research on SWR, I'd love to assess my own SWR!

However, once one moves from having a pure stock/bond portfolio to have actual alternative investments, it becomes harder to account for the various sources of income. It then becomes more individualized. However, I have a feeling I’m not the only one playing with my FI spreadsheet and struggling with incorporating real estate. I've spent a few hours searching threads and haven't seen discussions on this topic that answered what I feel like I am asking.

My discussion topic today is accounting for income & the asset of rental properties with mortgages. The simplest way I’ve read is not to include asset in the denominator of your WR division, and simply subtract net rental income from living expenses, and the remainder of expenses is divided by stock portfolio = Withdrawal rate percentage. However, with a mortgage on the property, this simplified calculation is in my opinion too conservative, as it does not account for (1) the principal paydown from the mortgage payment and (2) price appreciation of the house. I would liken this simple method to a dividend investor who waits until he has enough dividends to cover his expenses before retiring. This person therefore never touches principal and dies with way too much money! I think its flawed to count only on the rent income of a house and not factor in the huge asset you are earning over the mortgage life of an appreciating house

Regarding (1), although principal paydowns are not the same as expenses, I agree they should still be quantified. More equity in the house does not improve returns at all - it doesn’t improve your net income, and it doesn’t make the house appreciate more. Although withdrawing from your stock portfolio to add more home equity is a reduction in the return of your overall portfolio, it’s not a true expense since it’s net worth neutral.

---An initial thought was to add back the principal paydown portion of the mortgage to my expenses ( if I had $20k of expenses after accounting living expenses less net rental income, but I paid $8k of principal on the mortgage that year, then my actual expenses numerator for WR % is $12k). However, I believe this incorrect as that $8k was taken out of my stock investments, where it returns say 8%, to pay the mortgage, and put into equity where it returns 0%.

---The way I’m leaning to is to look at the rental property as just a type of stock. Just like with stocks the dividend portion of total return isn’t relevant to the SWR %, we could treat rental real estate the same. As such the calculation would be living expenses, with no adjustment for rental income / (stock portfolio + equity in rental).

I’m still second guessing my latter suggestion above. I realize to a certain degree I'm trying to force square real estate peg into a round SWR hole. How else does everyone do this?!

[marty998]

I'll bet that everyone else doesn't sell their properties and do end up with "too much".

There used to be a popular strategy down here called "living off equity".

Say you have a real estate asset base of $1.2 million and no debt. Each year you take out a loan of say $30,000 to cover your living expenses and let the loan capitalise. So long as your properties grow in value by 3-4% each year, you will still always have $1.2m of equity.

Many ways to skin a cat.

[maizefolk]

---The way I’m leaning to is to look at the rental property as just a type of stock. Just like with stocks the dividend portion of total return isn’t relevant to the SWR %, we could treat rental real estate the same. As such the calculation would be living expenses, with no adjustment for rental income / (stock portfolio + equity in rental).

I’m still second guessing my latter suggestion above. I realize to a certain degree I'm trying to force square real estate peg into a round SWR hole. How else does everyone do this?!

So the issue I see with the formula you're using is that it doesn't adjust at all for either the amount of leverage you are using or the cost of capital.

Consider three scenarios:

Paid off $100k house, rent is $1,000/month
$1M house, 900k mortgage at 3.75% rent of $10,000/month.
$1M house, 900k mortgage at 7.5%, rent of $10,000/month.

Your formula would suggest all three of those scenarios could support the same $4k a month in living expenses at a 4% SWR.

[Nifty]

So the issue I see with the formula you're using is that it doesn't adjust at all for either the amount of leverage you are using or the cost of capital.

Consider three scenarios:

Paid off $100k house, rent is $1,000/month
$1M house, 900k mortgage at 3.75% rent of $10,000/month.
$1M house, 900k mortgage at 7.5%, rent of $10,000/month.

Your formula would suggest all three of those scenarios could support the same $4k a month in living expenses at a 4% SWR.

You're right that it doesn't account for that. For my own personal rental properties the total return of: net income + YOY growth in equity (assuming 1.5% appreciation) is about ~10%. That total return is close enough to stocks that is why my thought is that it's reasonable to include the equity in the denominator of SWR along with my stock investments. One must assess their total return on the real estate to do this.

[cchrissyy]

in cfiresim there are rows for other income. look near social security and pensions.

anyway, I put rental income there. I have a number in mind for profit after expenses so that's where it goes. I enter it twice, one row for the years where the mortgage is still being paid and another row where the profit is a higher level because that expense is gone.

this works if you never intend to sell or withdraw the equity and are simply trying to include the income stream.