I’ve interviewed dozens of people who have reached financial independence with rental properties. Some started with high salaries; others made low or average incomes. None had trust funds. Like everyone else, they had little or no experience when they bought their first property. They learned from online courses, from mentors, from reading books and blogs. And, they learned from doing. Each story is unique, but as I interviewed more of these successful people, several recurring themes began to emerge. Here are the patterns I’ve noticed, among the people who achieved financial independence within just a few years of starting their quest.
(This post was contributed by Brian Davis of Spark Rental.)
It Starts with a Lean Budget & High Savings Rate
Think you’re going to reach financial independence in a few years by just saving the standard 5-10% of your paycheck? Think again. A “normal” savings rate of 5-10% will have you retiring in the “normal” 30-40 years. If you want to shift into the fast lane, you need to start jettisoning all those hefty expenses weighing you down. You probably don’t think it’s possible to live on half your income. But suspend disbelief for a moment—what would it take?
It would help if you didn’t have a housing payment. Many, if not most, of the people I’ve interviewed found a way to live for free, which helped them supercharge their savings rate. If you’re not familiar with house hacking, the classic approach is to buy a small (2-4 unit) multifamily using cheap, owner-occupied financing. You move into one unit, then rent out the other(s). The rents cover your housing expenses, and voila! Free housing.
But that’s not the only option. I bought a single-family home and rented out the other bedrooms. Others rent rooms on Airbnb. My partner, Deni Supplee, got more creative and brought in a foreign exchange student to live with her and her husband. Ashley and Kevin Thompson lived for free overseas, with their housing covered by Ashley’s job as an international teacher. They saved up money, then Kevin came home to the US and started investing. Nor does it stop with free housing. Most of the people I interviewed drove cheap cars, got rid of their cable TV, and minimized their dining and entertainment expenses to the bare minimum. In other words, they sacrificed what they wanted now for what they wanted most.
Clear Vision, Calculated Risks
If you don’t have a clear vision of what you want your dream life to look like, how could you possibly convert your dream to reality? Write down in exacting detail what you want to do with your time once you reach financial independence. Travel? Spend time with your children? Volunteer? Write a novel? Then answer this question: How much monthly income will it take to get there? The process of planning then realizing your perfect life is called lifestyle design. It’s a roadmap and a destination, and it usually requires a certain amount of passive income.
Which involves risk, of course; passive income comes from investments, and investments come with risk. If you invest in the stock market, it could crash. If you invest in a rental property, you could have a nightmare tenant. The beauty of rental investments, however, is that it’s easy to calculate risk and forecast returns. Before buying a property that rents for $1,000 per month, all you have to do is determine your long-term average expenses. To illustrate with imaginary numbers:
- Vacancy rate: $80
- Repairs & CapEx: $80
- Maintenance: $50
- Property Management: $100
- Insurance: $50
- Taxes: $80
- Administrative/bookkeeping/gas/car mileage: $20
- Total: $460
The risk of repairs and property damage, of evictions and turnovers? They’re built into these long-term expense estimates.
Early retirees understand calculated risk. They invested money aggressively, aiming for high cash flow and returns, but they always did their due diligence to forecast returns and minimize risk.
Leverage Is a Tool, Not a Crutch
One of the great advantages of real estate investing is the ease of leverage.
You can leverage other people’s money in the form of generous financing (e.g. 80% LTV at 6% interest). You can leverage other people’s time to manage your investment properties in the form of property managers or even virtual assistants.
It is possible to buy equities with leverage but not at nearly the same scale. With real estate, a person can take $20,000 in cash and buy an asset worth $100,000. An asset whose value will almost certainly rise over time. That will produce greater and greater rental income, even while monthly financing costs remain fixed (and eventually disappear).
Mark Ferguson put it like this: “A lot of investors want to pay cash for their properties to be ‘safe’; however, buying more properties with loans will get you where you want to be faster. If you buy three properties that have good rent to value ratios with a loan instead of one with cash, you will have more cash flow, more tax advantages, more equity, more appreciation potential, and more diversification.”
Still, leverage is a double-edged sword. It allows you to multiply the effects of your cash, which is great if you invest well. You multiply your earnings!
But you can also multiply your losses if you invest poorly.
Use leverage as a tool to reach your goals faster, to multiply your earnings. But the more debt you take on with a property, the lower your cash flow, and the higher your risk.
If you can’t afford to put down at least 10-20% on a property, you probably can’t afford to buy it.
Remember: calculated risk!
Focus on the Fundamentals
It’s shocking to me how many new investors focus on the wrong details.
I see people with no investment properties ask questions like, “Should I hold title under an LLC or an S-Corp?” or, “How do I use a 1031 Exchange to avoid paying taxes on a property?”
Forget about those details. Ask those questions after you’ve gotten your feet wet and actually made some money on a property or two.
Instead, focus on the fundamentals: how do I find a good deal? How do I accurately forecast cash flow? How do I find high-ROI and low-maintenance tenants?
In other words, the fundamentals of actually making money with rental properties.
None of the “advanced” stuff will matter if you lose money.
Evan Roberts, a fellow investor from Baltimore who recently reached financial independence with rentals, emphasized the importance of learning the basic numbers behind investing in rentals. “Always stick to the numbers when determining whether to pull the trigger on a property. If it doesn’t look good on paper, walk away. Profits in real estate are made when you acquire the property, and there’s little you can do to make a bad deal a good deal.”
The Most Common Mistake? Underestimating Expenses
I always ask people who have reached financial independence through rentals about what’s gone wrong. Mistakes they’ve made. Bumps in the road to early retirement.
One I hear frequently is failing to adequately screen contractors. That includes both renovation contractors and service providers like property managers. On their first few property deals, many of these investors hired the wrong people, who ended up costing them money.
But the most common mistake I’ve heard is simply underestimating expenses.
That includes everything from closing costs to renovation expenses to carrying costs to ongoing rental management expenses.
Ashley and Kevin Thompson have a story that most real estate investors can relate to: “at one point, we miscalculated the rehab costs for one of the properties that turned out to have a lot more structural damage behind the drywall than we had anticipated. We ended up having to spend about $10,000 more than expected.”
Everything you do will cost more than you initially expect when you’re first starting as an investor. Set aside a large cash cushion for cost overages.
Just don’t tell your contractors about it, or they’ll find an excuse to help you spend it.
Full Circle: Resisting Lifestyle Inflation
Nearly all of these investors started by chopping their expenses to accelerate their savings rate. That provided the funds they needed for their first down payment.
Then they bought their first property. And their second. Then a third, fourth, fifth. And suddenly – wow! They’re generating all this great income from rental properties!
What does the average person do when they get a raise? They turn around and raise their expenses: a nicer apartment, or a new car, or more dinners out. It’s known as “lifestyle inflation,” and it’s a very real phenomenon.
What do people who want to reach financial independence do as they earn more money? They keep investing ever more money, not less. After all, their goal is to generate more where that came from…
…until they no longer need their day job. Their bills—which are low—can be covered by their investment income alone. But only if they resist lifestyle inflation.
Which doesn’t mean you can’t have your perfect life. That’s what lifestyle design is all about! You dream it; you build it. But the more expensive your perfect life is, the longer it will take you to cover those expenses with investment income.
Would you rather retire in four years with an inexpensive lifestyle or retire in eight with a more luxurious one? There’s no wrong answer.
But there is a trick to it: don’t allow yourself lifestyle inflation until your original (low) expenses can all be covered by your investment income. After that, start splitting some of your investment income between higher expenses and more investments.
You’ll be tripping the (designed) life fantastic in no time.
Brian Davis is a real estate investor and co-founder of SparkRental.com, which provides landlord tools including state-specific lease agreements, free landlord training videos, and RentDeduct, which pulls rent directly from tenants’ paychecks. When he’s not writing or investing, Brian travels internationally—his current home base is Abu Dhabi.