How Much Capital Do I Need to Replace My Salary?

[Generated by Gemini]

Starting this week, I will write about some FAQs from clients and prospective clients. I hope these will be helpful for you. If you have any questions that you want me to address, please reply to this email and let me know.

The first question I wanted to discuss is how much capital you need to replace your salary. In other words, how much cash will you need to generate a 25 to 30-year paycheck that increases fast enough to keep pace with inflation? This is a question I receive fairly often, but the answer is not simple, so I decided to provide a detailed answer here.

Before we can talk about how much you need to retire, there are a few things we need to clarify.

How Much Per Month Will You Need?

You can’t figure out how much you need before you can retire if you don’t know how much you need to live in retirement.

How much do you need to replace your current income? This will be different for everyone. I have read that you should add up all your recurring expenses (debt service, etc.) but do not include your business expenses like suits, cost to commute to work, etc. However, I think this is not realistic. If you are retired you will have time and will want to travel, go out to eat, etc. So, while you will save on business expenses, you will likely spend more on entertainment, etc. About all you can do is make an educated guess.

For How Long?

This is an important question. You will need an income that lasts for the rest of your life. If you need a guess, here is an Actuarial Life Table. I would be conservative and add a few extra years to your retirement estimate. In the rest of this article, I will assume a 30-year retirement.

Also, if you invest in real estate in a city where rents increase faster than inflation, your children and their children will continue to receive monthly income from your properties. This is how generational wealth is created.

Inflation

Every time you go to the store, it costs more to buy the same goods. So you have an idea of the impact of inflation on the future buying power. Suppose today you need $7,000/Mo to maintain your expected retirement lifestyle. If inflation averages 5% over the next 30 years, how much will you need in future years to have the same buying power as $7,000 today?

• After 10 years: $7,000 x (1 + 5%)^10 ≈ $11,402

• After 20 years:: $7,000 x (1 + 5%)^20 ≈ $18,573

• After 30 years:: $7,000 x (1 + 5%)^30 ≈ $30,254

Summarizing, you will need $30,254 in 30 years to purchase the same amount of goods and services as $7,000 will today. Inflation is brutal.

How Much Capital Is Required?

It depends on where you invest.

A City Where Properties Are Low Cost

For example, suppose the cash flow from each rental property nets after all expenses (cash flow) $300/Mo. If you need $7,000/Mo, the calculation is easy:

• $7,000/$300 ≈ 24

If you invest in a city where each property costs $250,000 and your only acquisition cost is the 25% down payment, the amount of cash from savings will be:

• 24 x $250,000 x 25% ≈ $1,500,000

That is a lot of after-tax savings to accumulate. More importantly, low-cost cities are unlikely to see appreciation and rent growth that consistently outpace inflation. These properties are inexpensive because demand has been weak for years. If you buy in such cities, all acquisition costs must come from your savings, and you’ll likely need to buy additional properties over time as inflation erodes your buying power.

A City Where There Is Rapid Appreciation and Rent Growth

Suppose you invest in a city where existing home prices and rents are increasing by 8%/Yr, and each property costs $400,000. Again, I will assume that the only acquisition cost is the 25% down payment.

What will be the cost to acquire the first property?

• 25% x $400,000 = $100,000

Because you invested in a city where prices are appreciating by 8% per year, you can reinvest the accumulating equity to buy more properties. For simplicity, I’ll assume all additional properties cost $400,000—though in reality, they’ll also be appreciating in value. Also for simplicity, I will assume the $300,000 mortgage principal does not decrease.

So, how many years will you need to let the property appreciate before a 75% cash out refinance will yield $100,000 for the down payment on the next property?

• After one year: $400,000 x (1 + 8%)^1 x 75% – $300,000 ≈ $24,000

• After two years: $400,000 x (1 + 8%)^2 x 75% – $300,000 ≈ $49,920

• After three years: $400,000 x (1 + 8%)^3 x 75% – $300,000 ≈ $77,914

• After four years: $400,000 x (1 + 8%)^4 x 75% – $300,000 ≈ $108,147

So, after about four years, a 75% cash out refinance will pay the down payment on another investment property. And, now you will have two properties appreciating. And, the more properties you accumulate, the shorter the time before you can acquire another property.

Considerations

1. In reality, you will need more capital to acquire and bring to market a rental property. For example, below is a rough estimate of the cash needed to acquire and bring a $400,000 property to market:

   • Down payment: 25% x $400,000 = $100,000

   • Closing cost: 3% x $400,000 = $12,000

   • Renovation (guess): $20,000

   Total cash to buy, renovate, and monetize the property: $132,000

2. Nothing in the real world follows a straight line. This is also true of appreciation and rent growth. Some years will be higher than average, and some lower. I used an average appreciation rate of 8%/Yr to keep the example simple.

3. Rents follow prices. So if prices are increasing, rents will follow. Because rents are also increasing in this example, you will need fewer properties over time to meet the $7,000/Mo goal, assuming $300/Mo initial cash flow from each property and 8%/Yr rent growth.

   • Purchase Year: $7,000 / ($300 x (1 + 8%)^0) ≈ 24 properties

   • After 5 years: $7,000 / ($300 x (1 + 8%)^5) ≈ 16 properties

   • After 10 years: $7,000 / ($300 x (1 + 8%)^10) ≈ 11 properties

   From another perspective, if you want to retire today, you will need 24 properties. If you want to retire in 5 years, you will need 16 properties. If you want to retire in 10 years, you will need 11 properties. Note that this only applies if you buy all properties in a city where rents and prices have consistently increased faster than inflation.

As you can see, due to rent growth, you will need fewer properties (less capital) if your retirement time horizon is further.

Spoiler Alert: The calculations above are overly simplistic because inflation will increase the monthly income you will need. I did not include this fact in the calculations to keep the example simple.

The real estate version of how much capital you need to retire depends on:

• Your monthly retirement run rate

• Investing in a city with rapid and sustained appreciation and rent growth exceeding the inflation rate. If you invest in any city where rents and prices don’t consistently outpace inflation, your buying power will continuously decline, and you will have to acquire more properties continuously, costing more capital.

If you want to know how to select cities with rapid and sustained appreciation, click here. With the (right) real estate-backed retirement, you will have the peace knowing that you will not run out of money during retirement, your income will continue perpetually, and your children (and their children) will benefit from it too.