Latest posts by FIRECracker (see all)
- Fear Will Hold You Prisoner; a Diversified Portfolio Will Set You Free - October 24, 2016
- Buy Your Freedom; Rent the Rest - October 21, 2016
- Mission Impossible: Retiring Early and Travelling the World…with Kids? - October 17, 2016
The week after I came back from my world trip, my friend Selena invited me over to her place.
Selena lives with her husband, Rick, in a shiny new condo building in downtown Toronto. Even though it has a pool and roof top patio, Selena and Rick hardly ever uses them.
“I’m so happy you’re back”, she said, giving me an air kiss on each cheek. “I was worried you’d have too much fun traveling and never come back.”
“Actually…” I said sheepishly, “I’m just here until June. Then we’re heading off to Japan.”
“What?! You’re going to keep traveling? How?”
I resisted the urge to roll my eyes. Selena was one of the first people I told when we become Financially Independent, and one of the last people I saw before we left on our trip. “Passive income, investments. Remember? We talked about this?”
“Oh wow, that sounds so awesome,” she said, sighing. “I wish we could do it too…but we’re never going to be able to stop working.”
“Why? “ I asked.
“Well”, she said, averting Rick’s, eyes. “Because we need at least $100,000/year to live on.”
I looked around. Montauk Sofa, Herman Miller office chair, Harry Winston catalogues on her desk. No surprise there.
Rick rolled his eyes but didn’t say anything.
“And with those kind of expenses, we’ll NEVER retire.”
“Does the $100,000 a year include your mortgage?”
“Okay, so how much was this place?
For a condo? My eyebrow shot up.
“I know, I know. It’s expensive. But you know me and expensive things.” She said, picking up her Louis Vuitton purse and cradling it like a $10, 000 designer baby. “I mean, look how pretty Sally is! How could anyone resist her? Don’t you think she deserves to have two sister bags?”
Selena is more protective of her bags than most people are of their kids. One time she left “Sally” on the couch under Rick’s coat, and he, unknowingly, sat on it. When she found out, she pulled out the Lego Millennium Falcon he spent 8 months putting together, smashed it to pieces, and then threatened to set the whole thing on fire. To this day, she leaves the Lego pieces near the front door, a warning to would-be bag abusers.
But Rick, clearly hadn’t learned his lesson. “You already have ten of those things! And they cost at least $5000 a pop!”
Selena didn’t say anything, just glanced at the broken Lego pieces, then back at him.
“Okay, Selena,”I said, hands up in surrender and stepping back a safe distance from “Sally”. “What if you could rent this place instead, keep all your expensive things, and still retire sooner?”
“What? How is that possible?” She demanded.
“Well, let me show you…”
Scenario 1: Buy the $588,888 Condo and Live the Boomer’s Dream.
With a 25% down-payment, 2.89 mortgage rate, 25 years amortization, Selena and Rick’s monthly payment is: $2065.
Doesn’t sound too bad, right?
Since she owns, she also has to pay for condo fees, insurance, and property taxes, utilities, and parking.
(All costs above are monthly)
To rent, she can get a similar condo in the same area with 2 bathrooms (Selena’s only has 1) and FREE parking, for only $1990/month!
If we look at the Price-to-Rent ratio:
PR ratio = selling price / rent *12 months
= $588,888 / $1990 *12
Okay, so what does this weird number mean?
You know how Wall Street suit people love throwing around the term P/E ratio? Like “this P/E ratio is WAY too high. That stock’s heading for the crapper. “ or “Man, that is a sweet P/E ratio. I could totally go for some of that…”
Well, what they are referring to is the Price/Earnings ratio—a measure of the stock’s price relative to the company’s earnings earnings. Historically, a P/E ratio of 16* is considered pretty good. Anything above that, and it’s considered overvalued.
And in this case, the Price/Rent ratio is just like that. The rent is that home’s “earnings”. Now if we invert that number, 1/24.66, we get a return of 4%. This is pretty shitty by real-estate investor standards.
If you ever get a chance to check out Paula Pant’s “Afford Anything” blog, read her “Renting is throwing Money away?” article . It’s mind-blowingly awesome. (Seriously, go check out her blog. The woman made a cool $1 Million with real-estate investments by the time she was 28! And I, um, sort of have a secret girl-crush on her. Ahem.)
If she says she won’t touch a property unless the P/R ratio is 8.33 or less**, you know this Condo is an investment dud.
That being said, with a combined income of $200K/year to blow, Selena and Rick can pretty much party it up right?
Okay, ladies and gents, let’s see what happens if Selena and Rick continue owning this non-producing piece of real-estate trash.
Assuming that their take home pay is around $150K (not exactly the Millennial norm, I know) and their costs are 100K, their savings rate is around 30%. Pretty good, considering the national savings rate is a paltry 5%.
Now, if you look at the graph I made below, you can see that with a 30% savings rate, they have to work for 30 years. (I don’t want to bore you with all the math behind this, but if you really want to see it, click here)
When I told Selena this, she just glared at me and crossed her arms. “Yeah, 30 years is a long time, but so what? How is renting going to fix that? I still need to keep working forever to pay the rent, don’t I?”
“Actually no. By renting you can bring that number down from 30 years to 10 years”
“No really. I can prove it”…
Scenario 2: Follow the Millennial Revolution Instead:
So now that we know their expenses are 100K/year (hey, purse dry cleaning is expensive! Don’t judge), that means her variable expense is $100K minus the cost of rent, or 100K – $3412*12 = $59,056.
So if they rent instead, their total expenses go down from $100,000 to $82,936 ($59,056 + $1990*12). That’s a WAY sexier, WAY bigger 45% savings rate!
Now, I know an extra 15% doesn’t sound like much, but…
Look what happens when we plug it into the FI chart:
Her retirement period goes from 30 down to 20!
BAM! She got 10 years of her life back, just like that! And not a single LV bag was harmed in the process. All she had to do was switch from owning to renting.
But that’s not all.
Another thing I noticed when I left my 9 to 5, is that your costs actually go DOWN (by around 25%) once you stop working. Not a lot of people realize this, but retired people can actually live on WAY less.
Because when you stop working, you no longer need daily transportation, fancy work clothes, or expensive dry cleaning services.
And you have lots and lots of free time to make delicious, healthy meals, so you no longer have to choose between grabbing a Big Mac or greasy Panda Express takeout in between urgent work meetings (I never really got what’s the point of marking meetings “urgent” if they are ALL marked urgent?)
And because you’re no longer fighting other Corporate drones for vacation packages, you can travel for 50% -70% less money. (I used to spend $6000 on a 2-week vacation package in London. Once we stopped working, going to UK only cost us $2500/ for 2 people for 2 weeks. And that was the MOST expensive part of our Round-the-World trip).
I can go on and on about the wonders of not being forced to work a 9 to 5 job, but that’s an article for another day.
Anyway, because their work-related costs are now gone, Selena and Rick will only need $62,202($82,936 * 75%) per year to live.
Using the 4% rule, they’ll need to build a $1.56 Million portfolio ($62,202*25).
Sounds like a lot? Well, it is…but totally achievable with the magic of investment gains and compounding.
If they invest the 67K they save each year ($150, 000 take home pay – $82, 936) at an average market return of 6%, it’ll only take 15 years to generate a $1.56 Million portfolio!
Shocking isn’t it? That’s the advantage of being a Millennial. We have time on our side, so our money snowballs with the power of compounding.
But wait. There’s more.
Renting also will also give Selena more free time. She no longer has to worry about the extra paperwork, lawyer fees, and maintenance headaches that owners have to deal with.
Now Selena can use that extra time to pursue her dreams, and start working towards a side income.
And by the time she retires, if her and Rick can generate $15,000/year each from freelance writing and coding (and again, from my experience, this is easily achievable because this is how much I earned doing exactly this), she can lower her passive income requirements from $64,432.52/year, to $34,432.17 ($64,432.517 – $30,000 combined freelance income).
And that’s another amazing thing about becoming Financially Independent. Normally you wouldn’t even consider quitting your stressful job for a flexible, fulfilling job you love that only pays $15,000/year.
But with the passive income from your Portfolio boosting your income, there’s no reason why you can’t.
So now, Selena will only need $860,804.25 ($34,432.17 * 25) to retire. By investing $67K/year at 6% return, that’s only 10 years away!
“So, just by renting instead of buying, and not changing your lifestyle. You could quit your job in 10 years instead of 30! How awesome is that?”
For the first time ever, Selena is speechless. She’s staring at me like I’m a brand new Hermes Birkin.
And Rick’s beaming—like I just SOLD all of Selena’s Hermes Birkins.
“Okay, so where did you see the $1990/month rental again?” They both ask me at the same time.
photo credit and license: photo by Ching Ching Tsui @Flickr (https://creativecommons.org/licenses/by/2.0/)
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