Financial Independence, Retire Early (FIRE). The FIRE movement is more than just impressive – it’s a way of life for many millennials. Millennial’s know diversification is key to a successful investment strategy, and those working on FIRE strategies understand the one-two punch of eliminating debt and stashing cash into index funds leads the way towards their goal of retiring at an early age.
Stocks, bonds, real estate; are the three pillars of a sound investment strategy. Stocks for growth, bonds for income, and real estate as an inflation hedge all work together to build a solid investment foundation. Real estate is just one of many asset classes a diversified investor considers.
It’s not uncommon for investors to have 10-15% of their assets in real estate. It may seem counter-intuitive, at first, to consider purchasing an asset that requires mortgages when the whole idea of FIRE investing is to eliminate or reduce debt for the benefit of retiring early. However, real estate is the one asset class that allows the buyer to use long-term leverage to purchase an immediate income investment.
The availability of mortgage money occurs when passive investors place their money into a financial institution. Financial institutions loan that cash in the form of mortgages. Banks, Savings & Loans, credit unions, mortgage bankers, and brokers are your access point to use other people’s money to buy real estate.
Unlike a margin account for purchasing stocks and bonds, people are so confident in the long-term value of real estate assets they will loan you money for 30-years! That’s not even the best part; with investment property tenants (paying customers) pay rent, that helps to make the mortgage payment—this is why FIRE investors should consider a well-diversified investment portfolio that includes real estate. From How to Fire: Pros and Cons of Real Estate Investing for FIRE:
I will tell you plainly right here, and right now, a key to "the game" is hiring professional property management. Being an owner doesn't mean you have to be a manager. Granted, this increases the costs of running an asset; however, this is more than made up in better, more efficient operations and fewer sleepless nights.
Get a mortgage? Yes! On your journey to becoming a well-rounded investor, real estate is a healthy part of your investment strategy. "But, I thought FIRE was all about becoming debt-free?" That is true; the use of debt must make sense and fold into your FIRE objectives. With real estate as part of your investment strategy, then, long-term, the goal will be to own real estate assets debt-free, but that doesn't mean you have to start there.
A mortgage is a financial bridge to gaining control of real estate assets. Grinding the mortgage debt down to zero takes time and planning. Compressing this timeline as a FIRE investor requires reducing the mortgage term, usually by making payments higher than the lender's amount. How does that work?
A mortgage is a financial bridge to gaining control of real estate assets. Grinding the debt down to zero takes time and planning.
A $100,000 mortgage secured for 30-years at 5% interest results in a principal and interest payment of $536 monthly. To reduce the term of this mortgage to 20-years, you must pay $660 monthly, or $124 more each month. This additional payment of $124 each month reduces the duration of the mortgage by ten full years.
To reduce the term from 30-years to 10-years, in round numbers, requires doubling the mortgage payment. How does this work? The short answer is that mortgages are structured to pay interest first and principal second; therefore, your very first mortgage payment (1 of 360) is practically all interest. Your last mortgage payment is (360 of 360) is all principal.
The trigger to reducing the mortgage term is that additional payments (above the required monthly payment) all reduce the principal balance outstanding. When that occurs, you are reducing the amount owed and shortening the term of the mortgage. That is how and why owning real estate can fit into a FIRE investment strategy.
Indeed, millennials must often overcome obstacles to get FIRE revved (considering things like low starting salaries and student debt). However, the potential rewards are enormous in making lifestyle choices early in life that can create benefits for a high standard of living for your entire life!
The best method for purchasing real estate that allows you to stay on the FIRE bandwagon for life is to buy a small multi-unit rental property: 2 to 4 units. Why? Because with a small rental property, you are purchasing a place to live and gaining rental income from the other rented units that pay down the mortgage on the entire property, including the unit you live in.
Mortgage lenders look at this purchase the same as if you were purchasing a single-family home. The lender will require that you live in one of the units purchased, and they presume you are renting the other units.
Here is the good news: loans on small multifamily homes are available with a 20% down payment (and sometimes only a 10% down payment). Even better, for small multifamily purchased as a homeowner, the down payment requirements may be as low as 5%. Just know that mortgage insurance will likely be a requirement of a loan with a lower down payment.
Commercial multifamily apartments are those that have five or more dwellings. Multifamily properties with only 2-4 units are “non-commercial.” These properties can be purchased by individuals using typical mortgage loans available to any home buyer. This means a "FIRE investor" can purchase an investment property as their personal residence using homeownership mortgage financing. Why is that exciting? Many reasons; homeowner mortgage loans require a lower down payment than investment property mortgages, AND the buyer is concurrently purchasing a place to live that comes with built-in rental revenue to assist in paying down the mortgage.
When you buy a single-family home, you buy one house with a mortgage paid by you, the occupant. When you purchase a small multifamily property, you are purchasing 2-4 homes with one purchase. What comes with this purchase is rental income; rental income makes mortgage payments.
The beauty of purchasing a small rental property is that you can have the best of both worlds, a place to live, and rental income. Part of being a FIRE investor is figuring out ways to pay off debt faster while building your nest egg.
Small rental properties meet both of these goals simultaneously by providing you with a place to live along with rental income that pays your mortgage with rental income from the other units that you own but are not living in.
Let’s get into the brass tacks of how FIRE and real estate can work together. Investing in FIRE requires extreme savings. If you are in the market for a home to purchase, a lender will generally allow you to borrow two to four times your annual household income.
So someone earning $50,000 a year can stretch and perhaps purchase a $200,000 home. That’s great, but it doesn’t meet the FIRE criteria because it is a 30-year loan.
There is a better way; a FIRE investor would want to obtain a 15 or 20-year mortgage. This shorter term increases your payment and decreases your buying power (you can’t borrow as much with a shorter loan term). Purchasing a small rental property with rental income gives you that added income to make a shorter-term mortgage work. How? Because of the rental income from the property.
Purchasing a home is a good thing. Everyone needs a place to live. Buying a home provides the homeowner with a fixed cost of living for housing as compared to renting. As a property owner with a fixed-rate mortgage, your payment remains level versus a renter where rent can increase year after year.
The upside to purchasing a home is that every month part of your mortgage payment is applied to the loan balance. So rather than paying rent that helps to pay off someone else’s mortgage, every month, part of your payment goes towards paying off your mortgage.
If you were to own a small multifamily property, the upside is even more significant. First of all, if you own a 2-4 unit building, unlike owning just one house, you now have other people paying rent to you, and this rent is going towards paying off your mortgage!
In 1995 George E from Baltimore purchased his first 3-plex at the age of 26. He lived in one of the units for five years- rent-free. The other units paid all expenses: mortgage payment, real estate taxes, property insurance, and property management.
George sold the property in 2007 (12-years later) for four times the original purchase price. That sounds good, but what was his return on investment?
Using $100,000 as of the original purchase price and selling 12-years later for $400,000 creates a return on investment of 11.6%. The actual return on investment is higher because the mortgage was paid down over the 12-years of ownership, and he lived rent-free for many years. (Caveat: the recession of 2008 would have changed this paradigm significantly. However, no investor can time the market – no one.)
The Pros:
The Cons:
Austin P lives in coastal California. He is 32-years old and newly married. In 2018 Austin purchased a duplex “fixer” for $300,000. It was in such bad shape no one would give him a mortgage. He used his nest egg and borrowed from friends and family to make it happen. Austin does taxes for a living. He bargained with contractors to work on his property in exchange for doing their taxes.
Austin estimates that he added $25,000 in “sweat equity” to the property and $50,000 in cash and bartered services. It took almost one year before he had an occupancy certificate to move in and rent the other side.
The property appraised for $540,000. Austin took out a new first mortgage to cover all costs: $372,000 (paying principal and interest to everyone that loaned him money on the original purchase. The new mortgage payment is $1,996 a month. He lives on one side—the other side rents for $1,750 a month. Yes, there are annual real estate taxes and insurance to pay. However, his out-of-pocket is less than that of his renter.
In exchange for doing the work that included; finding the property, investing his own money, getting the short-term loans, finding the contractors, and getting the job done, his reward is that he has a place to live for less than rent creating $168,000 in equity.
Buying a property doesn't mean you have to rent it out, right? One of the first benefits of ownership can be taking yourself from renter to homeowner. Rather than paying rent, which can go up every year, homeownership, when you have a fixed-rate mortgage, means that your monthly housing expense is the same amount each month. Following are some of the upsides to real estate ownership:
A place to live – everyone needs a home. In purchasing a small rental property, you gain that and create a place for others to call home.
Rental income – income is the primary benefit of owning small rental property. The best part is that, as a property owner, you get to collect rent from other people and apply that money towards paying your mortgage.
Mortgage paydown from rental income – although just a small portion of your mortgage payment is applied to principal pay down, the good news is that this occurs month after month after month. Like any quality investment, it’s the buy-and-hold investor that makes the most money!
Potential appreciation – although you can’t count on appreciation, it does happen. Think of property appreciation as a gift and not a right. If you happen to be the benefactor of real estate appreciation, say “thank you.”
Potential tax benefits – tax benefits are not a reason to purchase real estate. Tax benefits can be an ancillary part of owning real estate and must be watched by professionals to ensure they are always in order.
An investment with income growth potential (rental increases) – like equity, rental increases are not guaranteed. Consider setting all rental income over expenses into an account for future repairs. Any rental income above that amount should be paid towards your mortgage to accelerate the payoff date. This strategy dovetails into how FIRE investors invest.
Every investment has risks. Real estate investing is no different. You must pay attention to details. There are no second chances with having your property insurance lapse or making the mistake of paying late fees on the mortgage or real estate taxes. These gaffs take away your investment return, or worse, risk loss of the entire property.
There are five things you must do to make this FIRE real estate strategy work for you.
Get your credit score in order. Never will your credit score be more critical than when you go to apply for a mortgage. A credit score under 720 may not exclude you from consideration for a mortgage. However, the interest rate offered to you will increase the lower your credit score. Here is the short-list of documents you will need when applying for a mortgage:
You must live in one of the units. Today, mortgage underwriting criteria allow a “homeowner” to purchase a 2-4 unit building with the same type and loan-to-value as a single-family home. As we’ve discussed throughout this article, there are many benefits to you for considering this real estate strategy. However, using a home loan to purchase a small rental property will likely require that you live at that property for not less than two years. In other words, you can’t just buy a rental property and not move in after closing. It will have to be the place you call home for a season.
Hire Professional property management. If you don’t remember anything else from this article, please remember this; a professional property management company is key to your success. Nowhere in this article have we discussed the ins and outs of how to manage a property because you shouldn’t be trying to manage it. You are the owner/investor and not the property manager. Leave this to the professional property manager.
Get a fixed-rate mortgage. The entire underlying premise of how this real estate investing works using in your favor using FIRE is based on having a fixed, known, never-changing mortgage payment with a fixed-rate mortgage. No fixed-rate mortgage, no living secure with the knowledge that your mortgage payment will remain level for the entire term of ownership.
With a fixed-rate mortgage, no matter how much anything else changes, you always know what your mortgage payment will be during the term of ownership: no guesswork, no surprises, no huge increases out of the blue. If your mortgage interest rate is for the entire duration of the loan, then so is your payment amount to the lender.
Pay attention to market trends. Anyone astute enough to be investing from a FIRE perspective knows you don’t wait until the day before retirement to liquidate your investments and sail off into the sunset. FIRE investing takes planning and requires you to consider market trends and changes and to consider their impact on your investments.
An investment in real estate is no different; planning is required. There are indeed better times to buy and better times to sell; however, no one can time the market. Just be aware, be prudent, and recognize real estate, too, has a place in your investment portfolio that can benefit you and your family for years to come.
Sure, you can keep renting. Some FIRE enthusiasts see real estate as making money too slow to have any meaningful impact on their objectives. I don't see it this way. If you live in a major city, the time will come when rents increase five or ten percent in just one year. And then again at the same rate for another year. And there you are, paying twenty percent more in rent than only two years early.
I can hear you now; "I should have bought a house or a duplex." Yup. Should-a. Twenty-twenty hindsight is always perfect. I’m suggesting you can see the future now. Decide to purchase one piece of property. It’s yours to keep with a fixed-rate mortgage. Better still, buy a small rental and let some other folks help you pay down the mortgage!
