Real estate investing is one of the most powerful mechanisms to achieve financial independence. Financial independence, or financial freedom, is the concept whereby a person does not need to work a typical day job in order to survive; they instead make money in a passive manner and are able to support themselves solely through passive means. Financial freedom equates to the ability to support your lifestyle (which includes your living space, car payments, tuition payments, food, healthcare, and all other daily expenses) without having to go to work every day, and this is done by securing an investment which earns you money on a periodic basis. So, in the same way that many people earn a paycheck every two weeks, a person can own an investment that pays out quarterly dividends, annuity lump sums, or monthly profits – any periodic sum of money which completely supports a person’s financial needs.
There are multiple ways to achieve financial freedom, and real estate investing is just one of them. Many people choose to invest in the stock or bond market, or to work hard at building a company which eventually gains so much success that they are able to live off of the company’s proceeds. Recently, many people have tried their luck in the “bitcoin” or electronic currency markets. These are all means to obtain a steady stream of money on a periodic basis. However, the main concern with these methods of investment is the volatility – it is somewhat difficult for a person to predict how much money they will earn, or whether they will one day lose it all. Real estate investing provides a method to achieve financial freedom that is structured and conducive to long-term financial planning.
Investing in real estate is a broad concept, and there are multiple avenues that you may choose to go down. Buying a property “wholesale” requires a bit of start-up capital and a healthy understanding of a property’s resale value, but this is meant for investors who are looking to turn a quick profit. Similarly, “rehabbing” a property, or fixing and flipping a home, involves buying a property that needs a fair amount of repair or replacement. Once the property is “flipped” into a marketable living space, the investor sells the property at a profit, over and above what he or she paid to purchase the property as well all the expenses associated with renovating a rundown property. Once you get into the realm of renting a property out for an extended period of time, you’ll begin to build financial independence. This can be done through the buy-and-hold strategy of both residential and commercial real estate. Let’s explore each of these.
Passive Income from a Residential Property
The buy-and-hold strategy of real estate investing involves buying a property and holding it for the long-term. One example of this is a real estate investor purchasing a single-family home and renting it out to a family for fair market value. The savvy real estate investor understands the amount of rent that he or she can charge based on comparable market analyses and understanding the level of demand at play in the real estate market for that area. When an investor builds out a financial plan, he or she understands how much needs to be paid towards the mortgage (if there is one), property insurance, real estate taxes, and the homeowner association (if there is one). The total amount of expenses is subtracted from the fair market value of rent that the investor can charge for a home of that size and stature, and with any luck, the investor will have a healthy chunk of profit left over.
Once this investor secures a tenant, the tenant will likely sign a one-year lease. This secures 12 months of profit for the investor, which is helpful for him or her to financially plan and budget for additional investments. This investor may also work a day job, earning a paycheck every two weeks. But their rental property is now bringing in a monthly check – this is the equivalent of earning an extra paycheck a month, who wouldn’t want that? Sure, it will take some initial capital to secure the property, but a quick financial calculation will help determine how much time it will take for the investor to recuperate those funds. Plus, buying a property and holding it for the long-term has the added bonus of potentially selling the home for a healthy capital gain several years down the road. So, not only does the rental property provide a healthy flow of money each month, but it can be sold later on for a lump sum. Another benefit to the buy-and-hold strategy is that the tenant is paying down your mortgage for you and building equity for you in your house. You’re essentially earning equity each month without having to use your own money, and you’re providing your tenant with a lovely place to live. It’s a win-win!
Passive Income from a Commercial Property
There are several differences between investing in residential rental properties and dealing with commercial rentals. For one, the requirements of a residential tenant are quite straightforward. Ideally, you’d secure a tenant with a healthy credit score, enough income to cover the rent each month, and a clean background check. These are the baseline requirements for most landlords of residential rentals. On the other hand, the tenant in a commercial transaction is a business, not a person. Evaluating a commercial tenant entails reviewing a company’s financial statements, bank statements, and even tax returns. There are many more metrics that go into determining a business’ profitability and, therefore, ability to pay their rent that a commercial landlord needs to consider than for a residential tenant.
Another major difference between residential and commercial tenants is that commercial tenants typically have a longer time horizon and often sign multi-year leases. In addition, commercial rents are almost always higher than residential rents, given the many facets that go into determining market rent compared to neighboring tenants and competitors. Both of these factors are appealing to the investor who owns the commercial property, as a higher rent equals a higher profit and a longer time period to collect this profit. This is a solid way to build financial independence as commercial tenants are often a stable and high-quality tenant.
The Math Behind Financial Independence
Let’s conduct a brief thought experiment to really drive home the point behind financial independence. For starters, let’s say you work a normal, 9-to-5 job and you earn $39,000 per year after tax. You get paid every two weeks, which equates to 26 paychecks per year. Each paycheck is $1,500 in income.
$39,000 annual salary / 26 paychecks per year = $1,500 per paycheck
Now let’s say you’ve saved up a fair amount of money and you’d like to invest in real estate and start on your path to financial independence. You find a two-bedroom condo in your area that doesn’t need any major repairs or improvements, just a fresh coat of paint. With the help of your mortgage broker, you obtain a loan and within 45 days you close on your first property. Congratulations!
Here’s a breakdown of your monthly costs for this property:
Mortgage payment $600
Property insurance $50
Real estate property taxes $50
Condo association fees $150
Total monthly expenses $850
With the help of your real estate agent, you determine that you can charge $1,350 per month for a two-bedroom condo in your area, and you secure a qualified tenant who agrees to the stated monthly rent.
When the 1st of the month rolls around, you collect a rent check for $1,350. After paying your mortgage and condo association, as well as funding your escrow account for the annual property insurance and real estate property tax payments, you are left with $500 in profit.
$1,350 rental income – ($600 mortgage payment + $50 property insurance + $50 property taxes + $150 condo association fees) = $500 profit
After one year, this amounts to $6,000 profit. This profit figure does not convey the benefit to you, the property owner, of having a tenant pay down the mortgage each month and essentially building your equity in the property at no cost to you.
Remember that, in addition to this rental income of $500 per month, you earn $3,000 per month ($1,500 per paycheck) at your day job. Let’s figure out how many properties you would have to own in order to earn the same amount from rental income that you do at your day job. For the sake of simplicity, let’s assume that you only buy properties with a $500 estimated profit margin.
$3,000 monthly wages / $500 monthly rental income = 6 properties
6 properties * $500 monthly profit each = $3,000 monthly rental income
At this point, owning just six properties would provide you with the same level of income that you earn from working 40 hours a week at your day job. These six properties are essentially replacing your full-time job, and this is the true motivation behind financial independence – achieving a level of income that enables you to live at your current living standard without being tied to a paycheck. This may sound like a massive goal, and it is, but it’s by all means achievable with the proper planning and dedication. Even if it takes you 10 years to amass six properties which all achieve the desired level of profit, that’s ten years until you gain financial independence.
One of the luxuries of starting to amass real estate investments while you’re young is that there isn’t any rush for you to gain financial independence for the purpose of retiring early. You can choose to continue working as long as you want to, earning additional money from your properties on the side and funneling that money back into your investment business by buying even more properties. In this way, you’re not dependent on the income from your properties but instead can support yourself with your day job. On the other hand, if you’re a bit older and have your sights on retirement in the next few years, real estate investing is still a viable option to achieve financial independence. You’d likely have some money put away in a retirement fund which would supplement any additional income from real estate.
Financial independence is an empowering concept that is within everyone’s grasp with the proper planning and, most importantly, execution. Real estate investment is just one of the many possible vehicles to achieving financial independence, and it has many benefits in addition to the financial aspects. When you amass properties that provide you passive income over the course of your life, you also have the opportunity to pass these properties on to your heirs. In this way, you can instill the concept of financial independence in your loved ones at a very early age and facilitate this for them to an extent until they can manage their finances on their own. The key to achieving financial independence is to find a means of earning passive income. This money will flow to your bank account whether you’re working or lounging on a beach on a remote island – and then you’ll truly feel financially free!
Charles Carillo is the founder and managing partner of Harborside Partners. He has extensive knowledge in renovating and repositioning multifamily and mixed-use commercial real estate. Prior to launching Harborside Partners, Charles founded an online payment processing company with partners and clients in 4 continents across the globe. Charles holds a BS from the Connecticut State University.