Should Real Estate be Part of my Retirement Income?

in today's video i'm going to help you understand if real estate makes sense as part of your financial plan hey everyone i'm james canoll founder root financial and i'm here to teach you what you need to know to create a secure retirement now chances are good you read the title this video and you already let out an audible yes or no regarding real estate real estate is one of those things that has such strongly held opinions and it's one of those things that can be either a really good thing or a really bad thing so in today's video i'm going to go over a simple example of how real estate can fit into your financial plan so that you can see if it makes sense for you now when it comes to real estate the big question is what's the return going to be and how is that going to fit in your plan now before we go any further i would love to hear from you do you like real estate or have you had a bad experience with it let me know in the comments below as we continue to go through this video what we need though to start is a point of comparison so is five percent a good rate of return is ten percent is twenty percent we need something to compare it to so we can understand how real estate fits into everything else well a simple starting point is to compare real estate and the returns you can get there to the s p 500 not a perfect comparison but what it's doing is it's giving us something to compare to and what i mean by that is historically the s p 500 returned about 10 percent or so per year so if you own the s p 500 that's going to give you if we use history as our guide an assumed ten percent rate of return going forward the question is what will real estate give you well there's multiple different components of real estate there's the appreciation there's income there's depreciation there's other benefits so let's flush that out so we can start to understand how you can begin to calculate that well the first piece of that is appreciation if you own an asset you want that asset to grow in value now if we look at real estate the past several years the asset appreciation has been incredible it's been double digits for many years when you average it out but i don't know if that's sustainable could be might not be but what we have to start with is what's the long-term average appreciation on residential real estate if we're looking at that long term it depends upon the market that you're looking at but it's been around four percent and maybe even five percent in some areas so let's use that as a starting point if you're following along at home and want to understand the appreciation on your piece of property maybe you're looking at your your market what area of the country you're in feel free to choose what you make makes most sense but i'm going to start with 5 meaning if you buy a piece of property one of the components the return you can expect to get is the appreciation on that property to compare it to my s p 500 example if you buy a stock you expect that stock or you hope that that stock's going to appreciate in value so that's the first component here now the second component is the income you can expect to receive from that asset so you might buy a stock and hope that that stock was up in value but that stock also might pay a dividend so when you're measuring the performance of a stock it's both the appreciation and the asset value and it's the dividend income that you're receiving that makes up the return you can expect with real estate it's similar we talked about the asset appreciation and we're going to assume an appreciation rate about five percent for now but then let's assume that you're renting that real estate out what you want to understand is something called the cap rate or the capitalization rate and what that is is it's the net operating income divided by the value of your real estate so what's net operating income well really it's the income that you're receiving from your piece of real estate minus any of the operating expenses so let's take a look at an example let's assume that you have a rental property and it's worth 500 000 let's assume that you charge rent of 2500 per month which comes up to 30 000 per year now you can't include that full 30 000 per year in your return because there's some expenses that are taken out against that let's assume you have 5 000 per year on property taxes if you live in an area with one percent property tax rates let's also assume there's five thousand dollars per year in upkeep well what we have is thirty thousand dollars of income minus five thousand for property taxes minus five thousand for upkeep twenty thousand dollars is our actual net income so in this example the cap rate capitalization rate is the net operating income of twenty thousand dollars divided by the value of the property of five hundred thousand one thing to note is you're not including the mortgage in the net operating income calculation your mortgage is more of a cost of capital it's the cost of acquiring financing from the bank it's not the cost of owning the property maintaining the property so it's just the costs of things like upkeep of things like property taxes anything to keep the maintenance of the property that you have to have to pay that's included in the calculation of your net operating income so in this example the cap rates around four percent twenty thousand per year of net operating income divided by 500 000 which is the price of the property that's four percent depending on what part of the country you're in this number can be very very different i live in san diego and it's very common to see cap rates of three percent or less when you look at the asset value which is the denominator and you look at the income that some of these properties are generating you're not getting an incredibly high cap rate because people are buying the property sometimes for the appreciation or because the desirability of some of these homes i'll compare that to my brother who bought a home in midland texas several years back the cap rate on his property when he purchased it was 12 percent meaning the income he could charge or the income he received from rentian's property was a much higher percentage of the value of the home so you're going to have a wide spectrum of potential cap rates but think of this not a perfect comparison but think of this as like the dividend that you're receiving on a stock i go buy a share of mcdonald's or at t i have the appreciation of the asset and i have the dividend that that stock is paying me that's what the cap rate is the equivalent to the income that you're receiving from it is another component of your return so if we're assuming a five percent asset increase or five percent appreciation and four percent cap rate according to this example so far our total returns at nine percent now there's other factors we have to include as well and one of the biggest when it comes to rental real estate is leverage if we had no leverage and you bought your home in cash really the appreciation and the the cap rate would be the overwhelming majority of the return that you can expect the reality is though most people use leverage to purchase their property and that can significantly skew your returns to the upside and potentially to the downside let's look at an example let's go back to that 500 000 piece of real estate that you have well let's say you only put twenty percent down that's one hundred thousand dollars well if the property increases by ten percent so the value of the property goes up ten percent it's gone from five hundred thousand to five hundred and fifty thousand look at this though you only put a hundred thousand dollars down if we ignore everything else for a second you put a hundred thousand in the property increased by fifty thousand dollars your appreciation on your initial investment was fifty percent that's what leverage does is it amplifies the returns in either direction so you can see how something that generates five percent return as an asset or ten percent return as an asset when you apply leverage to that it really starts to increase what that return can look like but it also works in reverse let's take a look at that same example you buy a 500 000 home the market drops by 20 percent so now that thousand dollar home is only worth four hundred thousand once again you only put a hundred thousand dollars down which means you borrowed four hundred thousand dollars from the bank if we exclude everything else for just a simple calculation real quick your rate of return is negative one hundred percent in this example your equity which was a hundred thousand we started has dropped to zero because if you were to sell the home today theoretically you'd sell it for four hundred thousand you'd pay off a mortgage of four hundred thousand you'd be left with nothing even though you put a hundred thousand dollars in so that's how leverage really amplifies or does the reverse your returns in real estate it's not just the appreciation and the income that number is going to be manipulated by the leverage that you apply to it now the good thing with real estate is if you have cash and if you have reserves and if you're prepared for something like this you can write out some of those downturns what happened a lot in 2008 unfortunately is people overextended themselves with their mortgages and they didn't have cash reserves or savings or something that they could live on if something ever happened to their income and when their income dried up and there was a job loss they couldn't continue making those mortgage payments when they couldn't continue making those mortgage payments they were forced to sell and because there's a temporary decline in the value of real estate they had to sell at a loss so the good news here with real estate is with leverage assuming you're in a good position financially you have cash reserves you have some funding that you could access you can see those down turns through so hopefully that mitigates some of the risk and then still participate in the appreciation over time another factor in real estate investing is depreciation so when you have depreciation what you're doing is it's kind of like this phantom expense you get to write off against your income so if i have a home for 500 thousand dollars it rents out for 2500 a month or 30 000 per year i get to depreciate the value of that home now that depreciation schedule is done over a number of years but it's not a true expense in the sense you're not actually paying anything but that depreciation is a write-off against the income so in a way that tax benefit can add to a component of the return that you're going to get so that when you look at it as a whole you're looking at the appreciation of the asset value you're looking at the cap rate you're looking at the impact of leverage and you're looking at the tax benefits of depreciation once you factor all those things in you can roughly come up with the rate of return expectation for that property let's go back to the beginning i said let's start with something to compare it to if all you have is a rate of return you have no idea is that good is that bad it has to be based upon or has to be relative to something else well if we look at the s p 500 of 10 to me that's almost my personal starting point if i look at all these components to rate of return on mortgage it doesn't exceed 10 i'm asking myself why on earth am i doing this why would i accept something less than 10 percent because with real estate i have to deal with tenants i have to deal with maintenance i have to deal with things breaking or repairs be neat made there's just stuff that's going to require my energy my attention my time why would i do that for a return that's less than quite frankly a passive return on a whole bunch of some of the best companies in the world if i can get 10 for just putting my money somewhere yes i have to endure the ups and downs of the stock market i didn't understand that but i'm not attending meetings i'm not having to find tenants i'm not having to deal with repairs i'm not fielding phone calls in the middle of the night i'm just letting my money ride so that's my personal benchmark yours may be something different but to me i would like to look at that to say if i can use real estate and get a significantly better return than that then it probably makes sense if i'm looking at a return that's equal to or less than that it probably doesn't make a whole lot of sense at least the way i look at it personally now that's just a financial approach you also have to look at the non-financial aspects real estate's not just a spreadsheet decision it's really what makes sense for you too maybe you love real estate because you like something tangible maybe the stock market just doesn't make sense to you now i personally love it i think that if you diversify and you invest the right way it's wonderful but maybe that's not you maybe you like having something tangible you like being able to touch it and see it and know that it's there real estate could be an even better investment because of the personal preferences in that example maybe your desire is to keep property in the home for future generations i've talked to many people who say yes we like real estate not just because of what it does for us but we want to be able to pass these homes on to children in the future maybe there's memories at those homes maybe it's just a legacy play that they have but the other benefit of real estate is that it's something that can be a legacy play if you choose it to be on the other hand maybe you just don't want to be a landlord maybe you run the numbers and you say yes i see real estate it's got a pretty good return when i look at the numbers but i don't want to deal with it i'd rather spend my time doing things i love traveling spend time with friends spend time with families i don't want to be a landlord and i don't want to get a property manager maybe real estate's not for you maybe you're not comfortable with some of the risk factors i know some people think of a piece of real estate as more secure than maybe an investment in the s p 500 or diversified mix of stocks i personally disagree you know if you look at one single piece of real estate there's risks there what happens is something happens that piece of property or there's an economic downturn in that area or there's just horrible tenants for the places destroyed that's one piece of real estate and yes it's tangible but compare that to an investment in the s p 500 or a global stock market index what you're getting is ownership of some of the best run most profitable companies in the world and if you go on a walk down the street right now you're probably going to see some fords or some teslas driving by you might walk past a chipotle or mcdonald's you might see a bank of america or wells fargo on the corner you might pull out your iphone to call your friend or check your apple watch to see what time it is when you're doing any of those things those are companies that you own when you're investing the stock market so as you're seeing the next amazon truck go by understand that when you own the stock market or you own a fund that owns the entirety of the stock market it just seems like a value on a piece of paper or digits on a screen but what you're actually getting is ownership in the best run in the most profitable companies in the world and when you compare that to a single piece of property you have to understand what's truly more risky so at the end of the day there's not a perfect answer that's right for everyone there's financial factors that you need to consider there's non-financial factors that you need to consider but what you absolutely need to do is run the numbers for you understand what makes more sense financially as part of your plan but also understand what makes more sense for your personality so at the end of the day whether you choose to invest in the stock market or real estate or anything else you always need to know how does this tie into your retirement plan if you want to understand the five steps to understanding if you're on track to retire be sure to check out this video above thanks for watching this is james knoll with root financial partners if you enjoyed this video please be sure to share it with someone else you think would benefit from this information and also please be sure to like and subscribe for more content just like this finally if you'd like to see how we help clients create a secure retirement be sure to check out our website at root financialpartners.com [Music] you

Channel: James Conole, CFP®

Views: 5,969

Keywords: investing, retirement planning, tax planning, financial planning, retirement, personalfinance, taxes, dividend investing, financial planning at 50, how do I retire?, long-term investing, financial planning at 60, roth conversions, roth ira, IRA, individual retirement account, benefits of investing, pros and cons of investing, donor advised fund, financial education, real estate

Id: zn-9paGn08w

Length: 15min 26sec (926 seconds)

Published: Sat Aug 20 2022