Surprisingly Simple Math to Early RE Retirement (Napkin Math)

[Cal C.]

I posted this in the member blogs last week, but wanted to get some more eyeballs on it.

As many of you know, Mister Money Mustache (MMM) wrote a blog post entitled The Shockingly Simple Math Behind Early Retirement that if nothing else gives stock investors a very simple rough estimate to how much money they will need to retire. It translates to basically 25 times expected annual spending. We can argue the issues with that article but whatever flaws it does or does not have it at least gives investors some idea as to their savings target.

There is also a surprisingly simple way to figure out how much real estate (or really, how many single family residences) you need to retire. Assumptions here are that you have paid off the real estate involved, your net operating income (rent-expenses except for mortgage-NOI) is at 50% of rent and rent will keep roughly in line with inflation.

To keep this even more simple we'll use a nice round rent amount, $1,000. Using the 50% rule of thumb, you can quickly see the NOI is $500. 12*$500=$6,000. So simply using that number as a building block quickly gives you a rough estimate of how many paid off single family residences you need to retire providing you know how much you're expected spending is going to be. For example, if your expected spending is $60,000 annually then you need ten mortgage free houses.

However, one of the flaws of the MMM article and the math laid out in the previous paragraph is the disregard for taxes. Taxes are a very important consideration with real estate because of the tax advantages of depreciation. In fact, your taxes may be cut nearly in half because of it. Here is an example: the basis on your rental property is $100,000. You set aside 20% for land value leaving you $80,000 to depreciate over 27.5 years. That gives you $2,909 in depreciation per property. If you have ten similar rental houses then that would effectively reduce your taxable income by $29,090. Assuming that you are paying 20% in combined state and federal income tax then that reduces your tax bill by more than $5,800.

Here is the back of the napkin math.

Rent/50%=ROI

(House cost-land)/27.5=Depreciation

NOI-Depreciation=Taxable Income per house

NOI-(taxable income*tax rate)=After tax income per house

Expected spending/After tax income per house=number of houses needed to retire

[Nathan Gesner]

Yes, this is a good point. It's not uncommon for napkin math to leave some things out which is why it's simple and can be done on a napkin. I would hope people are a little more thorough in planning their future.