SWR with a Portfolio including Property

[Aussiegirl]

Hi All,

I understand the conventional wisdom around 4%, have read all the studies, looked at different withdrawal methods.  The one thing that none of them take into consideration is when there is a large chunk of the portfolio in property, especially geared property.  We have a very good understanding of our expenses, which will come down post retirement due to the usual work related expenses coming out.  Given for the first few years we're likely to do more travel etc, I haven't decreased our annual nut but assumed the work related expenses get used in travel, additional hobbies or something similar.   In a bad year on the markets, we could drop these expenses by around 20-25%.

To give you a bit of an idea of where we sit, we have 37x our annual nut in total net assets (excluding our home).  However, only 10x our annual nut is in equities and 3.4x our annual nut in cash.  The other 23.6x our annual nut is in net housing (Current Value - Loans). 

The problem - while the housing increases in value, and generates more cash each year, it doesn't provide any significant cashflow that would support retirement spending.  Therefore I'm not sure how to treat it for the 4% rule as it would need to be sold to provide cashflow.   If we sold up, paid the sales commissions and taxes, we'd end up with about 30-32 x our annual nut.  I don't really want to do this - I like the diversification but know that we either need more equities to even up the asset allocation or we need to sell at least some property.  All of our savings at the moment go into equities.

We're not in a position to retire at the moment - life circumstances not related to money, but would be in a couple of years.  My question is, given that we have such a high percentage of property, what SWR should we be aiming for our assets overall?  Or should we just be aiming for a SWR on the shares & cash of say 6% (17x our annual nut) and just ignore the property?   

Financial security is one of my main goals - one of my biggest fears is being 90 and having no money.   But I do need to balance that with "enjoy now, because you don't know what tomorrow holds".

[Blindsquirrel]

   I guess an explanation of the low cash flow on the property would help a bunch? What is it? Would you sell or exchange for something that throws off cash?

[Another Reader]

Why do you own the rental properties?

I'm not sure you have a plan for these assets.  Like a lot of people, especially in Australia, you probably bought geared (leveraged) investment properties "because real estate seems to always go up."  However, you don't eat assets, you eat income.  Either the properties have to cash flow, or they have to be sold to produce income.  Your FIRE plan should include deleveraging these properties and using the net income they produce as part of your retirement income, selling the properties periodically and using the net proceeds for income or to reinvest in something else for income, or some combination of these paths.

The direct answer to your question is to estimate how much income the real estate can be expected to produce at FIRE.    Subtract that income and any pension or other guaranteed income from the income you estimate you will need at that point.  Your paper assets will need to provide the remaining income needed.  If you think 4 percent is a safe withdrawal rate, then do the math to see what you need in paper assets.

[Aussiegirl]

   I guess an explanation of the low cash flow on the property would help a bunch? What is it? Would you sell or exchange for something that throws off cash?

I just assume that any spare cashflow goes to paying off the loans.    So in my FIRE calculations I don't include any income from these until they are paid off.  That's why I was wondering whether I needed to have a portion of equities that would sustain a SWR until they were paid off, or it means that I need to sell them.

Why do you own the rental properties?

I'm not sure you have a plan for these assets.  Like a lot of people, especially in Australia, you probably bought geared (leveraged) investment properties "because real estate seems to always go up."  However, you don't eat assets, you eat income.  Either the properties have to cash flow, or they have to be sold to produce income.  Your FIRE plan should include deleveraging these properties and using the net income they produce as part of your retirement income, selling the properties periodically and using the net proceeds for income or to reinvest in something else for income, or some combination of these paths.

The direct answer to your question is to estimate how much income the real estate can be expected to produce at FIRE.    Subtract that income and any pension or other guaranteed income from the income you estimate you will need at that point.  Your paper assets will need to provide the remaining income needed.  If you think 4 percent is a safe withdrawal rate, then do the math to see what you need in paper assets.

I do have a plan, I just didn't expect to be retiring this early.  The plan was always to progressively sell some of the assets when I retired (to manage tax) and use the proceeds to pay off the others leaving a paid off, or near paid off assets OR to just pay the assets off (which is what my current FIRE spreadsheet assumes).    Problem with the second approach is that it literally takes all the cashflow until we are traditional retirement age, which is when I was planning to retire when I started down this path. 

We chose to pay our home off in preference to the investment properties as our home interest is not tax deductible here, where as investment property interest is tax deductible.

I like the idea of keeping the properties, solely because while property does move in fits and starts, it generally has pretty good appreciation over time.  Having the property also provides a good hedge against inflation as well.   But you're right, we should probably sell some and pay off others.   I'll run some numbers on that.

Australian Pension
In Australia we don't have the concept of a pension like you (I'm assuming you're in the US).    Our pensions are funded out of general government revenue and they are both income and asset tested.   The rules for a home owning couple (non home owner limits are larger) are:

1.  Income test:  your pension starts to reduce once your income per week is >A$144 (US$103) and cuts out completely when your income reaches A$1,451 (US$1,044.72)

2.  Asset test: your pension starts to cut out once your assets are > A$291,500 (US$209,880) and cuts out completely when your assets are > A$1,078,500 (US$776,500).   This test is changing in 2017 such that full pension is received under A$375,000 (US$270,000) but cuts out completely at A$823,000 (US$592,560).
 
It will be the asset test that gets most RE folks. 

I assume at all times that I won't get a pension.   Its a safely net, just in case the market goes haywire!

[Another Reader]

You can create several models without deciding which you will follow.  Start by assuming a fairly low compounded rate of rent growth, expense growth, and value growth for the real estate.  Try different combinations of paying off mortgages, selling properties to create cash income, and selling properties and reinvesting in paper assets for income to see how much income is reasonable to expect at your FIRE date.  Then plug in positive and not so positive scenarios for both real estate and equities.  Consider the effects of rising interest rates on your leverage (gearing).  Play with these models until you have a feel for what changes in assumptions do to your outcomes at your desired FIRE date.  Understanding the impact of the various factors will help you make decisions as you get closer to your target date.

Once you have a rough idea of what is reasonable to expect from the properties that remain under various scenarios, the rest of the income will have to come from your paper assets, assuming you have no pension.  Back into how much you will need via your selected SWR for each scenario.

Does that make sense?

[Aussiegirl]

Makes sense, Another Reader.   I have got a good retirement model up and running, so will do as you suggest and see what the results are.   I've been assuming that any sale proceeds going into paying off the remaining housing debt, but you're right, putting it into paper assets decrease the SWR that I need to  pull from the paper assets, plus it automatically deleverages things. 

Will let you know how I go.  As you say, there has to be a combination that gives an outcome that I'm comfortable with.

[Vee2001]

I'm also primarily in real estate (and plan to retire off of it) but I find us hard to compare.  I'm counting on positive cashflow of my rentals, it seems like you are counting on property appreciation.

I'm sure it is dependent on the market but I would be very hesitant to heavily leverage myself and count on the property appreciation to carry me through.  I bought one of my properties just before the 2007/2008 downturn, I didn't care that the 4-plex lost (on paper) $200k of value because I had positive cashflow on it the whole time.  Even if the value dropped or stayed the same for 10/20/30 years, I don't really care as long as the rent stays the same or goes up.

Now compare that to if I bought, broke even or was slightly negative on the monthly cashflow and am hoping for long-term appreciation.  In most markets (of the US), I'd still be underwater on my mortgage.  I know plenty of people that did just that and lost their ass during the downturn.

My opinion, either find a way to turn the properties into positive cashflow and base your retirement off of that or to rotate out of the properties (with the least tax implications) and put the money into low cost index funds.

For me, I'm trying to have my rental cashflow cover at least 130% of my expected personal expenses in retirement and have ~$200k in liquid assets (cash/stocks).  When I calculate my expenses I also err on the high side of everything.  I'd rather end up 200% funded then 70% funded. 

[alsoknownasDean]

Essentially you're holding on to a growth asset, (at least it's designed that way here in Australia, given negative gearing and all), not an income asset. Is it time to change assets to ones which produce a more steady income over those which are expected to increase in value?

It doesn't matter whether the asset type is property, shares, bonds or magic beans.

By the way, what about super? You've got that too, right?

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[JrDoctor]

You are saying that housing worth 32x (after tax and everything else) is unable to provide a rental income large enough for your living expenses.  How out of whack must house prices to rent be?  Either house prices are ridiculously overvalued or rent is very cheap?

[deborah]

You are saying that housing worth 32x (after tax and everything else) is unable to provide a rental income large enough for your living expenses.  How out of whack must house prices to rent be?  Either house prices are ridiculously overvalued or rent is very cheap?

Both - this is Australia

[zephyr911]

You are saying that housing worth 32x (after tax and everything else) is unable to provide a rental income large enough for your living expenses.  How out of whack must house prices to rent be?  Either house prices are ridiculously overvalued or rent is very cheap?

Both - this is Australia

If your rentals were 100% debt-free, what kind of cash return would you get?

[alsoknownasDean]

You are saying that housing worth 32x (after tax and everything else) is unable to provide a rental income large enough for your living expenses.  How out of whack must house prices to rent be?  Either house prices are ridiculously overvalued or rent is very cheap?

Both - this is Australia

If your rentals were 100% debt-free, what kind of cash return would you get?

I'd have a guess at a 3-4% a year rental yield (maybe less after expenses).

Mortgage rates here are usually in the 4-5% range, and it's common for leveraged rental properties here to be revenue negative, even before expenses, with the focus on capital growth. Hell, it's often intentional (as a tax minimisation method).

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[Aussiegirl]

Essentially you're holding on to a growth asset, (at least it's designed that way here in Australia, given negative gearing and all), not an income asset. Is it time to change assets to ones which produce a more steady income over those which are expected to increase in value?

It doesn't matter whether the asset type is property, shares, bonds or magic beans.

By the way, what about super? You've got that too, right?

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I think this is what I need to do, swap out some assets into another I think.  Certainly start the switch anyway once I RE to manage the tax hit.   Only one property is cash flow negative, the rest will slowly pay themselves off over the coming years.    Yes we have super, it has a property and equities.   The property in the superfund should have largely paid itself off by the time we can access the super.  We would probably then sell it, capital gains tax free in pension mode. 

I'm also primarily in real estate (and plan to retire off of it) but I find us hard to compare.  I'm counting on positive cashflow of my rentals, it seems like you are counting on property appreciation.

Now compare that to if I bought, broke even or was slightly negative on the monthly cashflow and am hoping for long-term appreciation.  In most markets (of the US), I'd still be underwater on my mortgage.  I know plenty of people that did just that and lost their ass during the downturn.

The real estate market is very different here - bank lending is much more stringent and the banks have full recourse back to the owner and their other assets, or their future cashflow such as wages.    The only way to get out of paying back any short sale amount is to declare bankruptcy, which is a last resort.  There are a few nasty consequences of this course of action.     Very little of our real estate would be cash flow positive on purchase unless you put down a very chunky deposit (25% or higher) - and even then most capital cities wouldn't be cashflow positive. 

You are saying that housing worth 32x (after tax and everything else) is unable to provide a rental income large enough for your living expenses.  How out of whack must house prices to rent be?  Either house prices are ridiculously overvalued or rent is very cheap?

No, total net assets would be approx. 32x.  Housing is about 24x.   Yield on the portfolio (at its current value) is 4.1%, on the purchase price it varies from 5% for the most recent purchase (still cash flow negative) to 15%.

If your rentals were 100% debt-free, what kind of cash return would you get?

About 1.5 - 2 x our annual nut per annum after expenses.  Paying off would mean dedicating 100% of the cash flow from the portfolio to repayments for the next 15 odd years (and getting rid of one property which doesn't fit with our investment philosophy, it was our home at one stage). 

[Another Reader]

I think what Zephyr was asking was what is the unleveraged (free and clear) cash on cash return of the properties.  IOW, what is the net operating income after all expenses, divided by the market value?  From what I have seen, free and clear property cash returns are in the 2 to 3 percent range max.

This is why I asked about your plans for the properties.  It seems very difficult in Australia to retire on the income from a small portfolio of rental properties.  Rents have to increase dramatically or you have to pay properties off to develop any cash flow.  You have to own a lot of real estate to create an adequate income.  You have interest rate risk on your mortgages.  With negative cash flow, a job loss or extended vacancies could cause you to lose the properties.  I might not put so many eggs in the real estate basket if I lived there. 

[Minion]

This site is also worth a look:

propertychat.com.au

[Aussiegirl]

This site is also worth a look:

propertychat.com.au

Thanks Minion, I'll check that out.

I think what Zephyr was asking was what is the unleveraged (free and clear) cash on cash return of the properties.  IOW, what is the net operating income after all expenses, divided by the market value?  From what I have seen, free and clear property cash returns are in the 2 to 3 percent range max.

This is why I asked about your plans for the properties.  It seems very difficult in Australia to retire on the income from a small portfolio of rental properties.  Rents have to increase dramatically or you have to pay properties off to develop any cash flow.  You have to own a lot of real estate to create an adequate income.  You have interest rate risk on your mortgages.  With negative cash flow, a job loss or extended vacancies could cause you to lose the properties.  I might not put so many eggs in the real estate basket if I lived there. 

Approximately 3% after costs if you exclude the mortgages / have them paid off. 

The houses would slowly pay themselves off over the years until I hit traditional retirement age, where they would be debt free.   I would have to fund the next 20-25 years of retirement with another stash to go this route.   You've hit the nail on the head though, its the interest rate risk that keeps me up at night (or would keep me up once I RE'd).

I know that I need to sell at least one of the properties, lower yield, higher gearing and fortunately, the lowest capital gain so limited tax consequences.     Its just a hard decision to come to as every time I've ever sold a property, I've come to regret it later.  But I guess this is more about "sleep at night" factor rather than wealth accumulation now.

Thanks!