When investing for passive income and ultimate financial independence, two distinct asset routes tend to surface time and again: cash flowing rental property and dividend paying stocks. The following table illustrates a handful of options an investor can take when pursuing financial independence through these two asset classes.
Let's say we have $250,000 to invest using one of the five strategies:
An important distinction needs to be made between the asset classes: Rental property sends cash flow your way in the form of checks to the mailbox and dividend paying stocks send cash flow in the form of dividends. Everything else is capital gains appreciation. The stock investor will rely heavily on the ups and downs of their holdings' prices to achieve a cash flow.
Looking at or scenarios, we see that the Massive Leveraged rental property delivers a massive cash-on-cash return of 35.1%. This takes into account the amount the property will appreciate each year at 4%, rental income after all expenses, and phantom cash flow add-back after non-cash, depreciation tax savings have been taken into account. The key to this huge return is leverage. With a 20% down payment of $217,400 and 3% closing costs of $33,100, the total cash outlay is $250,500. From a pure rental cash flow perspective, an investor can expect $2,989 a month or $35,871 a year for a 14% cash on cash return. Of course, in this situation one has to be comfortable with nearly $800,000 in debt.
Turning to our unleveraged property, the investor purchases outright a property worth $242,000. Without the benefits of leverage, the investor receives a total cash-on-cash return of 12.8%. Honing in on just the rental income outside of the property appreciation or phantom cash flow add-backs, the investor will receive $19,360 a year or about an 8% return on the total investment and closing costs of $250,000.
Turning to stocks, if one is able to beat the market and generate Buffett-like returns of 15% a year, they can expect total annual cash flow of $37,500 on the $250,000 investment. Approximately 2% of this return comes from dividends and the other 13% comes from price appreciation. Again, this is a key distinction between rental property and stocks. The investor is counting on the price appreciation of their stock holdings to generate a substantial cash flow and must have the willingness to sell stocks to realize this cash flow. This comes with capital gains tax implications, an additional cost to this strategy. Ultimately though, the Buffett investor might realize returns of 15% while the leveraged property and unleveraged properties generate returns of 35.1% and 12.8% respectively.
The investor who wants more reliability in the cash flow in this strategy can enhance it with divdend payers. One can invest in stocks that meet the Buffett mold and pay a dividend yield of at least 4%. This will still lead to a total capital gains and divdend cash flow of $37,500, with the dividend payments now representing $10,000 annually. This is about half the amount of the rental cash flow from the unleveraged property.
Finally, one can simply turn to an index fund and rely on the appreciation of a broad basket of stocks to create cash flow. The historic long-term average return of the stock market is 11% or about $27,500 a year on the $250,000 investment. We can see that this 11% return is not too far off from the unleveraged properties return of 12.8%. Again, one has to be comfortable with the type of cash flow in this situation. It is not made up of rental checks being delivered in the mail. It is based on the prospects and subsequent stock price appreciation of large, U.S. companies.
Ultimately, it is hard to dispute the returns that arise from leveraged rental property. In a appreciation and cash flow apples-to-apples comparison, at a 35.1% return, the leveraged property beats the closest competitor by 20%. However, no investment is perfect without its risks. Should the property not rent, the leverage can turn the other way and greatly magnify the losses. Perhaps one can find a happy medium and invest in a property half the price while still using some leverage to their advantage. In our scenario this would cut the total returns down to about 16.2%.
In the world of stocks, one has to have great confidence in their Buffett skills-set, perhaps a stretch, and has to be comfortable with price appreciation as cash flow. On the flip-side, it is not easily possible to realize price appreciation as cash flow when it comes to rental property outside of equity loans.
Much of this comes down to two key factors: the investors comfort-level with debt and comfort-level with the stock market. Our unleveraged property does not deliver much greater returns than an index fund, which might make the hassle of purchasing and managing one not worth it. If one is comfortable with stocks and not comfortable with leverage, they should perhaps purchase index funds and aim for the long-term returns. However, the cash flow profile for a rental property is completely different than that of stocks with the monthly cash flow arriving in the form of rental checks. Perhaps the question should be, if all of your regular income sources from a job dried up tomorrow, which asset source could you reliably count on to pay the bills?
Let's say we have $250,000 to invest using one of the five strategies:
- Use this capital as a down payment on a mega-rental property worth approximately a million bucks.
- Purchase a rental property in its entirety using no leverage
- Test out our Buffett stock investing skills and attempt to acheive above-average market returns of say 15%
- Purchase our Buffett stocks but further enhance this strategy with dividend cash flow or
- Simply purchase an index fund and call it a day.
An important distinction needs to be made between the asset classes: Rental property sends cash flow your way in the form of checks to the mailbox and dividend paying stocks send cash flow in the form of dividends. Everything else is capital gains appreciation. The stock investor will rely heavily on the ups and downs of their holdings' prices to achieve a cash flow.
Looking at or scenarios, we see that the Massive Leveraged rental property delivers a massive cash-on-cash return of 35.1%. This takes into account the amount the property will appreciate each year at 4%, rental income after all expenses, and phantom cash flow add-back after non-cash, depreciation tax savings have been taken into account. The key to this huge return is leverage. With a 20% down payment of $217,400 and 3% closing costs of $33,100, the total cash outlay is $250,500. From a pure rental cash flow perspective, an investor can expect $2,989 a month or $35,871 a year for a 14% cash on cash return. Of course, in this situation one has to be comfortable with nearly $800,000 in debt.
Turning to our unleveraged property, the investor purchases outright a property worth $242,000. Without the benefits of leverage, the investor receives a total cash-on-cash return of 12.8%. Honing in on just the rental income outside of the property appreciation or phantom cash flow add-backs, the investor will receive $19,360 a year or about an 8% return on the total investment and closing costs of $250,000.
Turning to stocks, if one is able to beat the market and generate Buffett-like returns of 15% a year, they can expect total annual cash flow of $37,500 on the $250,000 investment. Approximately 2% of this return comes from dividends and the other 13% comes from price appreciation. Again, this is a key distinction between rental property and stocks. The investor is counting on the price appreciation of their stock holdings to generate a substantial cash flow and must have the willingness to sell stocks to realize this cash flow. This comes with capital gains tax implications, an additional cost to this strategy. Ultimately though, the Buffett investor might realize returns of 15% while the leveraged property and unleveraged properties generate returns of 35.1% and 12.8% respectively.
The investor who wants more reliability in the cash flow in this strategy can enhance it with divdend payers. One can invest in stocks that meet the Buffett mold and pay a dividend yield of at least 4%. This will still lead to a total capital gains and divdend cash flow of $37,500, with the dividend payments now representing $10,000 annually. This is about half the amount of the rental cash flow from the unleveraged property.
Finally, one can simply turn to an index fund and rely on the appreciation of a broad basket of stocks to create cash flow. The historic long-term average return of the stock market is 11% or about $27,500 a year on the $250,000 investment. We can see that this 11% return is not too far off from the unleveraged properties return of 12.8%. Again, one has to be comfortable with the type of cash flow in this situation. It is not made up of rental checks being delivered in the mail. It is based on the prospects and subsequent stock price appreciation of large, U.S. companies.
Ultimately, it is hard to dispute the returns that arise from leveraged rental property. In a appreciation and cash flow apples-to-apples comparison, at a 35.1% return, the leveraged property beats the closest competitor by 20%. However, no investment is perfect without its risks. Should the property not rent, the leverage can turn the other way and greatly magnify the losses. Perhaps one can find a happy medium and invest in a property half the price while still using some leverage to their advantage. In our scenario this would cut the total returns down to about 16.2%.
In the world of stocks, one has to have great confidence in their Buffett skills-set, perhaps a stretch, and has to be comfortable with price appreciation as cash flow. On the flip-side, it is not easily possible to realize price appreciation as cash flow when it comes to rental property outside of equity loans.
Much of this comes down to two key factors: the investors comfort-level with debt and comfort-level with the stock market. Our unleveraged property does not deliver much greater returns than an index fund, which might make the hassle of purchasing and managing one not worth it. If one is comfortable with stocks and not comfortable with leverage, they should perhaps purchase index funds and aim for the long-term returns. However, the cash flow profile for a rental property is completely different than that of stocks with the monthly cash flow arriving in the form of rental checks. Perhaps the question should be, if all of your regular income sources from a job dried up tomorrow, which asset source could you reliably count on to pay the bills?
