Note: This post was first published in June 2020 and updated in November 2021
A while ago, Peter Kim (a.k.a. Passive Income MD) published a post titled “Buy one property per year and retire early”, which I found to be fascinating reading.
Somewhat unfairly, Peter took a bit of flack in the comments for making assumptions that some people thought were too high level and others thought were unreasonable.
The bottom line is that real estate investing is an extensive and complicated topic. You simply can’t cover off all the angles in a single blog post.
That being said, I thought Peter touched on an intriguing topic and have long wanted to pick up on his good work and expand on the analysis.
Were his assumptions really so unrealistic? Having come across many people who created significant wealth through real estate, my gut feeling is no. In addition, I have extensive experience myself, with a couple of nice home runs in the real estate department.
At the same time, there’s nothing like solid, hard data to back up one’s intuition.
Today, I am going to deconstruct, step-by-step, the path to wealth through buying real estate.
To underpin the analysis, I have built up a detailed spreadsheet. You are welcome to download it here so that you can follow the maths along the way.
Note: if you are confused by some of the terminology below, I highly recommend reading this book. It’s one of the best primers for real estate investors I’ve ever come across.
Another important caveat to make is that all of my investments are stateside. Sadly, the UK government has made life pretty tough for retail landlords, though some people still find a way to make it work (scroll down to comments for more information).
With that in mind, let’s kick off.
Let’s start with some basic parameters. To keep things simple, I am assuming the following.
- You buy a property for 100k with a down payment of 25%
- Your bank gives you a 25-year mortgage with a 4% interest rate
- The monthly rent on the property is 780. Note: this is designed to result in a 7% cap rate, addressing one of the questions readers had for Pete
- The property will be vacant one month every two years (which translates into a 4.2% vacancy rate)
- Your operating expenses are as follows:
- Property taxes (1,000/year)
- Insurance (200/year)
- Miscellaneous (500/year)
- Furthermore, you will spend 3% of your gross rental income on repairs and maintenance. Over the course of 10 years, this will add up to ~3k
- The rent, as well as expenses, increase by 2.5% per year, in line with long-term inflation (hopefully not wishful thinking post latest numbers!)
- Property value also increases in line with inflation at 2.5% per year
- You are in a 20% tax bracket
- …and I’ve kept things simple by ignoring depreciation
The Basic Maths
Let’s now run a simple profit and loss and a cash flow statement for the property above (you can play around with the numbers in the spreadsheet):
In the first year, the property will generate ~9k in net rental income and ~2k in operating expenses. This nets out to roughly 7k of net operating income, working out to the 7% cap rate I’ve referenced in the assumptions above.
Once you’ve accounted for the ~3k of interest on your mortgage, your operating income before taxes works out to ~4k.
Subtract 800 in taxes (20% tax rate) and you are left with ~3,200 of net income.
Of course, income and cash are not the same things. To determine how much cash you will have left over at the end of the month, you need to start with your net operating income and subtract the entire mortgage payment (principal + interest) as well as taxes.
So while your income is ~3,200, your cash flow in the first year of ownership will be roughly ~1,400. You can see it on lines 61 – 65 of the spreadsheet.
Now that we know what the first year looks like, let’s take a longer-term view.
Your First Property: A Long-Term Perspective
Broadly speaking, three things will happen over the coming years:
- Your property will appreciate while your rental income (and expenses) will also increase
- Your mortgage balance will decline, meaning the value of your equity will increase
- The amount of cash the property spins off will increase every single year
You can follow the detailed maths in the spreadsheet, but in summary, this is what the next decade will look like for you:
Having invested 25k at the start of year 1, you will have accumulated $92k of equity by the end of year 10.
The net increase is $67k. Roughly 21k of this will come from cash generation and the other $46k is from mortgage paydown.
And if you extend the holding horizon to 20 years, your initial 25k investment grows to almost $200k.
On an annualized basis, this represents a return of 15.3%. If there’s a perfect illustration of the power of leverage and compounding, this is it.
But what if you didn’t want to stop at just one property?
Building A Real Estate Empire
Imagine for a moment that you were able to buy one such property every two years.
A 25k down payment implies saving up just over 1k/month. The number isn’t inconsequential but equally, it isn’t unattainable.
The graph below depicts one’s equity growth in this scenario:
Over a decade, you put 125k to work – and end up with 334k. You do need to keep in mind that the last couple of properties you acquire (in year 8 and year 10) will have very limited time to generate wealth.
But if we extend the time horizon to twenty years, those properties will have had sufficient time to appreciate in value, start throwing off more cash – and pay off substantial chunks of the mortgages along the way.
As a result, your journey now looks like this:
The 125k you put to work is now worth well over $1m.
Is twenty years a long time? Sure.
But crucially, it’s still short enough to allow you to get into the real estate game in your 30s – or even 40s – and still come out way ahead of where most people will end up in their 50s or 60s.
And for fun, let’s chuck in a graph of what life would look like if you bought one property every year for ten years.
Life just keeps getting better
But I Thought You Loved The Stock Market?
Of course I do. It’s one of the most democratic wealth-building tools there is.
For fun (and comprehensiveness), let’s compare what your returns would be had you invested your hard-earned dough in the stock market instead.
If you were to put 25k in the stock market every other year, in 20 years you would end up with just over 500k.
Seems like real estate blows the stock market out of the water. Or does it really?
For a basic rate taxpayer here in the UK, employer matching and tax breaks mean you can easily double your money on the spot.
Put another way, that means that your actual returns are significantly higher than what the stock market is delivering:
Taking the above into account presents a very different picture:
After twenty years, you end up in pretty much the same spot! No wonder I love the stock market too.
But before we get too excited, let’s run through some crucial differences between the two alternatives:
Long-term, 8% is probably where you will cap out on nominal stock market returns (assuming inflation in the 2-3% range).
In contrast, a 7% cap rate is probably on the conservative side in real estate, with many investors putting their money to work at significantly higher rates.
While it’s possible to defer taxes on stock market investments, real estate offers many more opportunities to do so.
You are essentially running a small business, which you can incorporate and use to write off eligible expenses. Over time, the incremental tax breaks can really add up.
This is the most important point. The analysis above assumes that whatever cash your properties spin off just sits on the sidelines. It also assumes you never re-finance any of your properties to release additional equity.
However, the true game of real estate investing is to use both the cash your properties generate and the equity you build up to buy more properties. So in reality, you don’t need to put nearly as much money to work to achieve the outcomes above.
The reason I didn’t reflect this in my analysis is that the modeling can get pretty hairy. But make no mistake – this is where the real magic happens in real estate.
As great as workplace pensions may be, they come with a lot of restrictions on when and how you can access your cash.
With real estate, you don’t have to wait until you are in your late 50s to get your hands on the pot of gold.
Once in a while, the government finds itself in a real bind – and looks to us to lend a helping hand, whether we want to or not.
Workplace pensions come with a cap on earnings – and total value. Real estate doesn’t.
Another one for real estate.
I have been very open and candid about views on real estate investing – including some of the challenges few people talk about.
But the bottom line is that notwithstanding the complexities, it remains possibly the best way to build wealth.
You may choose to ignore it for a variety of valid reasons – but do so with your eyes open.
Thank you for reading – and happy (real estate) investing!