Something we’ve been wanting to write about for a while now, but have struggled with, is the story of our rental property. Lots of you have asked us questions about it, and we’ve wanted to answer honestly — but the truth is that we wouldn’t recommend that others follow our lead on this one. Because virtually every decision that went into choosing our rental went counter to what the real estate experts will tell you to do. But at the same time, we’re completely happy with our choices, and wouldn’t dream of taking them back.
First, Let’s Rewind
Back in the early 2000s, did anybody else watch Suze Orman, or just me? Anyone? Bueller?
I love Suze’s unapologetic wackiness, and her willingness to dish out tough love while still being empathetic. Over the course of a few shows, she transformed my views on spending, and what it means to “afford” something, and helped me look to the future more than I ever had before. (Mr. ONL was already a saving pro by this time, so he didn’t need this basic level coaching like I did. Plus I think Suze drove him a little nuts.)
But something I will never forget, that Suze said at the end of each show was,
People first, then money, then things.
— Suze Orman
This mantra was so well-timed for me. I was just starting to earn enough that I was no longer living paycheck-to-paycheck. I had nearly paid off my student, car and credit card debt. And I was starting to define how I saw myself in relation to money, or in other words, what I wanted my money to do out in the world — whether it be to buy me lots of things, show off my status, fund my adventures or support people and causes I care about.
Mr. ONL had had his adulting hat on longer than I had (he is three years older), and so he had already been giving to charity and doing things like sending wedding presents when friends got married (so grown up!). But other than being willing to throw down on some baller travel, he hadn’t really defined himself in relation to money either.
Fast Forward to 2013
A few years ago, when we decided to pursue early retirement in earnest, we had to make a choice: Do we want to get to early retirement as fast as we possibly can, or do we want to take a little longer to get there, but allow for some fun in the meantime, as well as the ability to keep giving to charitable causes we care about and maybe help out some family along the way?
As powerful as that siren song of freedom from work is, we made the choice that we’d try to get to FIRE as fast as we could without squeezing those two categories too much. And that’s why we’ve continued to travel a bit, go to music festivals and take on a few other splurges along the way (we can’t sacrifice now for the future, after all). It’s also why we’ve made the deliberate choice to follow Suze’s advice and put people ahead of money.
Choosing People Over Money and the Definition of Financial Independence
There are as many definitions of financial independence as there are people pursuing it. But I’d be willing to wager that most people would include the concepts of freedom and happiness in their definition. For us, we might articulate it differently on different days, but it’s fundamentally something like:
Financial independence is the freedom to follow what makes us happy, and to live our best lives.
And what a beautiful thought that is! What we came to realize, though, is that our happiness would be shallow if it didn’t include taking care of those we care about. Not that we have to provide for everyone, of course, but if we saw someone struggling, especially financially, we wouldn’t be able to stick our heads in our Scrooge McDuck-style pool of gold and just pretend there wasn’t something we could do. Just as we wouldn’t be happy if we couldn’t support important causes close to our hearts. That realization led us to our modified definition:
Financial independence is the freedom to follow what makes us happy, and the privilege to be able to help out those in need.
This definition feels closer to what our hearts want, but we only got there after lots of self-reflection. But here’s a bonus: when has helping out another person not ended up making the helper happier? Um, never, that’s when. Helping feels amazing, and it’s good to remember that when we feel too stretched or busy to lend a hand.
Related post: Why We Ignored The Experts and Loaned Money to Family
So what’s all this got to do with our rental property? Let’s talk about that.
The Story of Our Rental
Around the time when we were formulating our FIRE plan, we started talking to a relative about downsizing their home and moving closer to us so that we could spend more time together and help out with some things. The problem: because of the housing crash, this relative had very little home equity, and wouldn’t be able to buy a home closer to us. Renting was an option, of course, but it would be incredibly difficult to find a rental that would provide for this person’s special needs, and the possibility of rent going up each year was a scary thought given the fixed income this person lives on.
I can’t remember when we had the idea, but at some point we realized that we could buy a home specifically to rent to our relative, and we could do all the things a traditional rental wouldn’t offer: ensure a good location with access to public transit and walkable services like groceries, provide assurances that rent would go up only when necessary to cover expenses and not just to make more money, and, of course, ensure that our relative would never get evicted or foreclosed on for financial challenges.
We started exploring the idea.
Real Estate Investment Math
As with all things financial, there are differing opinions about what constitutes a good real estate investment, and we won’t try to capture all of that here. (Go check out Bigger Pockets if you want a more in-depth education on the topic.)
But most people will tell you to at least follow the one percent rule to ensure that you will be able to generate positive cashflow on your rental, above and beyond your mortgage, repair expenses and income tax on the rent. The one percent rule says, generally:
The rent you will be able to charge should be at least 1% of the mortgage you have to take out to buy the property. (Or, alternately, 1% of the purchase price.) If you plan to buy a place for $125,000 with 20% down ($25K, leaving a $100K mortgage), make sure you can charge at least $1000 per month in rent, or $1250 if you’re following the purchase price version of the 1% rule.
Professional landlords us the one percent rule as a general guide to determine if a property is a good investment or not. If you know that rents in your area average $1000 a month for one-bedroom apartments, and there’s a four-plex of one-bedrooms for sale for $375,000, then the one percent rule tells you that’s a great deal. If it was priced at $500,000, it wouldn’t be such a great deal.
As you can probably guess, we did not follow the rule. We cared far more about finding the right property in the right neighborhood, and we knew that would mean having to stretch our number up a little higher than the amount of rent we’d be charging would justify alone. In the end, instead of meeting or exceeding the one percent rule, we ended up with:
- .86% of the mortgage amount in monthly rent
- .69% of the purchase price in monthly rent
If we were professional landlords, we’d be getting a failing grade so far.
The Added Fun of Income Tax
Not hitting the one percent threshold for our rental economics means that we generate essentially no cashflow each month while we’re paying off the rental mortgage, something we plan to do right on time for the full 15-year term instead of paying it off early (unlike with our primary residence). We could squeeze out a little cashflow by refinancing into a 30-year mortgage, which would lower our monthly payment, but as anti-debt as we are, that idea holds just about zero appeal.
But aside from the mortgage, insurance and property tax, the real killer right now is income tax. We’re in a pretty high bracket while we’re still working, and every penny of our rental income goes straight into that highest marginal bracket. Ouch. Of course we deduct everything we can on the rental income tax schedule — depreciation, maintenance expenses, insurance, mortgage interest, etc. — but the IRS still sees it as a profit despite the fact that we’re making no money on the rental just yet. The flipside is that we’ll pay close to no tax on the rental income after we retire because it will all fall below the taxable threshold.
Playing the Long Game
So on the one percent rule we’re failing, and on the positive cashflow front we’re failing even worse. (It’s costing us a few hundred dollars a month in income tax right now.) This is the very definition of a bad investment.
We’re playing the long game all the way here. We bought a home in an area where property prices rise faster than the rest of the region, and the house has already gone up in value 20+ percent in the two years since we bought it. So at some point when we sell, we expect to see a sizeable payoff. We also know that it will flip from cashflow negative to cashflow positive after we quit our jobs and drop down several tax brackets, and once the mortgage is paid off. Then it will net us enough to cover a sizeable portion of our expenses each month. Finally, the house provides several of our contingency plans in case our own early retirement plans don’t deliver as expected. We could move into the rental with our tenant if we really had to, and it’s a comfort knowing that’s an option, albeit one we hope never to need!
No Price Tag on Peace of Mind
On some level, it’s weird to even break down the numbers on our rental property, because it was never about making us rich, or even really about making us financially independent. It was more a matter of, “We can help, so we will.” And that’s not just good for our relative who rents from us, but for us as well. We sleep better at night knowing that person is safe and sound nearby, in a home that can never be taken away. And that’s worth more than whatever money we’re spending to make it possible.
Shifting Our Timelines
Buying the rental was the first big decision we made to help out a loved one, and making a personal loan was another. While we’re not clamoring to get into any more financial arrangements with family (we don’t recommend anyone make a habit of this!), we’d make both of the same decisions again in a heartbeat.
That said, the decisions have had a real-world impact on our early retirement timeline, though that impact has possibly been offset by recent saving progress. While our net worth has remained the same, just shifting some of our taxable savings into rental property equity for the rental, and some of it to loan principle that we own, we did see our taxable savings drop in both instances. When we bought the rental, we knew that doing so would add at least six months, possibly more, to our saving timeline. But it would also add a passive income stream to our later years of early retirement and beyond, hedging us against market fluctuations and better diversifying our portfolio. It felt like a good trade.
All in all, we’d say the choices we’ve made are worth it. We’ll be arriving at early retirement maybe a tiny smidge later than we otherwise would have, but we’ll have a more solid plan when we get there with more income streams in place, all of which feels like a win-win to us. Plus knowing that people we love are safe and secure — we can’t put a price tag on that.
So many questions for you guys! Do you own a rental property (or multiple), and do you always stick to the 1% rule? Has anyone else bought a property and ignored the 1% rule for good reason? Anyone else wrestling with how best to support those you love without spending down your nest egg or jeopardizing your own security? We’d love to know about all of this. Share, share away in the comments!
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Categories: we've learned