After reading the previous article, I am guessing you are a little skeptical. I can imagine you thinking “That sounds nice, but do things really work out that way?” I totally understand.
Lets take a look at the numbers to see how this can actually play out. But first, a reminder that I am not an accountant, financial planner, or lawyer. This is not advice, an offer, or a guarantee. This is my opinion and we are talking about a purely hypothetical scenario. Always talk to your tax, legal, and financial team to understand how this may apply to your situation.
I am going to review 2 scenarios: buying an index fund (the classic passive strategy) and buying a small commercial rental property. Since every deal is a little different and no-one can predict the future, I am going to have to make some assumptions all around. However, I have tried to be reasonable – if not conservative – with the assumptions I am making. I have also included a pointer to the spreadsheet I used to generate these numbers if you want to adjust them on your own [5].
The first assumption that I am making is about the investment and your goals. In this scenario, I assume you are looking to have a post-tax cash flow of $40,000/yr (adjusting for inflation each year) from a $1M investment and that you are looking for that cash flow to last 30 years. I put the annual inflation rate at 3.7% , which is the historical average for the past 60 years based on BLS data[1]. This means that the post-tax income required grows from $41,480 in year 1 to $118,955 in year 30. I am assuming a combined state and federal tax rate of 20%, which is low for high earners [2], but I am assuming you are only paying federal, long-term capital gains taxes and are living in a no-tax state. This means that you would need to withdraw between $51,850 in year 1 and $148,707 in year 30 from a taxable account to get the desired post-tax income. A more likely tax rate would be 30%-40% (at least) if you live in a state with income tax, so we discuss the impact of this change on your resulting net worth. Since I want the income to start the next year, I am assuming that this is not in a tax-deferred account like a Roth IRA or 401(k).
Lets start by looking at the index fund. I assume that the index fund will have the exact same performance as the S&P500 did over the past 30 years [3]. I know it won’t happen exactly that way, but this seems like a more reasonable approach to modeling the actual stock market behavior than a simple average rate of return [4] which doesn’t really take into account the impact of a negative year. Using those returns, if you put $1M in the index fund, paid no fees or taxes on the re-invested dividends, and kept the money in there for 30 years, you would have $11.4M in the account at the end of 30 years. That’s pretty nice! However, if you withdrew the inflation adjusted $40k each year, you would only have $3.5M in the bank at the end of that time. Still not too shabby and over 3x what you started with.
Unfortunately, this doesn’t account for the taxes that you need to pay in order to get the $40k in spendable income. That might make sense if the money was in a Roth, but it isn’t, so you need to factor in the capital gains. If you factor those into account, you end up with just $1.49M in the bank at the end of 30yrs. Still not too bad since you have been drawing money out every year to live on and still end up with more than you started with. But here is where you need to be really, really careful about the assumptions you are making. If you assume that you are paying 35% in combined income tax instead of 20%, you run out of money after 26 years. Or if your tax rate is still 20%, but inflation is 5%, you run out of money after 28 years. And if you are really unlucky and have both 5% inflation and a 35% tax rate, you run out of money after 21 years. Ouch. Not a scenario you want to be in.
Now, let’s switch gears and look at buying real estate instead. There is a little more required on the assumption side here since the deals are more complicated. I expect that you are getting a mortgage and are putting 25% of the money down, so the asset you purchase is initially worth $4M instead of $1M – but you have a mortgage of $3M. I am assuming that the mortgage rate is 7% and you have a fully amortized, 30 year fixed rate loan (not likely in commercial real estate, but it keeps the math simpler). I also assume that your cap rate is 7% (this is the net operating income on the property, not counting paying down the mortgage, divided by your asset value). This gives you a year 1 cash flow of $40,491 – pretty much exactly what we need to live on. Rents typically rise with inflation, but expenses also increase (although not usually as much). To be conservative, I assume that overall, your cash flow will increase only at the rate of inflation (ie that the expenses will increase at that same rate as well so there isn’t any additional income generated from the NOI). This means that your yearly cash flow exactly tracks your target amount of income before taxes.
That’s nice, but how do you pay the taxes and still generate the money you need? Depreciation! That miracle deduction that real estate people love. If you assume that 20% of the value of the property you purchased is in the land and 80% in improvements (a reasonable ratio, but it will definitely depend on the property) then you can expect to deduct $3.2M in depreciation as a paper loss (even using simple straight-line deprecation on a commercial property, you would get a paper loss of $2.4M over 30 years, with the remainder coming in the last 9 years). Your total income over that time is only $2.2M so you don’t have any taxes to pay on that income. From a practical perspective, you have completely met your income goal (what you are looking to live off of) and don’t need to worry if your tax rate is 20%, 35% or 50% – because as far as the IRS is concerned, you don’t have any income. If inflation is higher, your cash flow keeps up automatically – so you are safe from inflation risk as well. No chance you are going to run out of money early!
And it gets even better. The property itself continues to appreciate in value over this time period as well. Again, to be conservative, we assume that the property appreciates at the rate of inflation. That means that after 30 years, it will be worth $11.9M – basically what the index fund would be worth if you didn’t touch it. After paying the mortgage for all that time, you own the property free and clear so that is now part of your estate. What you do with the property at that point is entirely up to you. You can keep taking the cash flow indefinitely (with a $20k/month bump since you don’t have mortgage payments anymore), sell it (you will owe long-term capital gains tax at this point unless you take advantage of a 1031 exchange or use other tax strategies), or refinance it to get cash out tax free.
So, at the end of 30 years, your estate will have either $1.5M in it if you invested in the index fund and the taxes and inflation meet expectations or $11.9M if you invested in real estate. And with the real estate investment, you don’t need to worry about your tax rate or inflation curbing your lifestyle because of the two things that real estate has going for it that index funds (and similar investments) don’t:
- the investment tends to track inflation for income and asset value, which reduces the risk of a high inflation period causing you to draw down your assets too fast and
- depreciation lets you write off a phantom expense against your income, deferring taxes (potentially indefinitely)
Obviously the world isn’t quite this simple, but I tried to make the examples sufficiently realistic so you can see why I am so excited about real estate investing. If you are interested in changing some of the assumptions I have made, I include a link to the excel spreadsheet I used below [5].
If you have any questions about this post, please email them to me at terence@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts
For further reading:
[1] https://data.bls.gov/pdq/SurveyOutputServlet
[2] https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2022
[3] https://www.macrotrends.net/2526/sp-500-historical-annual-returns
[4] https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp