Let’s say that you have $200,000 that you want to invest.
Up to this point, all of your investments are in the stock market, mostly through tax-advantaged retirement accounts like a 401(k).
However, you’ve recently started thinking about buying your first rental property.
You have an important question to sort through:
Should you buy your first rental property or just keep investing in the stock market?
This is a common dilemma for all real estate investors, not just people thinking about buying their first rental property. Personally, I’ve been thinking about this question quite a bit lately.
The way I see it?
Why not do both?
Why not build your overall investment portfolio to include both stocks and at least one rental property?
Today, we’ll explore why you may want to invest in the stock market and own rental properties.
If you’ve been on the fence about buying your first rental property, this post will help you think about why it may be a good idea.
Real estate is my favorite asset class.
It’s no secret that real estate is my favorite asset class. Without my four rental properties, my journey to financial freedom would look much different.
I’m confident that real estate will remain a powerful asset class moving forward.
That’s because no matter how much the world changes with AI, quantum computing or any other new technology, I know one thing will always be true:
People will always need a place to live.
At this point in my life, I know that I’ll never become a brilliant coder or software engineer solving the world’s hardest problems.
But, I can provide the geniuses a place to live.
That’s why I’m comfortable with the majority of my net worth being in real estate right now.
By investing in rental properties, I can make money in four different ways:
1. Rental property cash flow is king.
With cash flow, you can cover your immediate life expenses. For anybody hoping to reach financial freedom, it is essential to have income to pay for your present day life expenses.
For my money, cash flow from rental properties is the best way to pay for those immediate expenses.
If your present day expenses are already covered, you can use your cash flow to fund additional investments.
That might mean buying another rental property or investing in another asset class, like stocks.
2. Long-term wealth through appreciation.
Appreciation simply refers to the gradual increase in a property’s value over time.
While cash flow can provide for my immediate expenses, appreciation is all about the long-term benefits.
Like investing in stocks over the long run, real estate tends to go up in value. The key is to hold a property long enough to benefit from that appreciation.
To benefit from appreciation, all I really need to do is make my monthly mortgage payments, keep my property in decent condition, and let the market do the rest.
3. With rental properties, other people pay off my debt.
When I buy a rental property, I take out a mortgage and agree to pay the bank each month until that mortgage is paid off. At all times, I remain responsible for paying back that debt.
However, I do not pay that debt back with my own money.
Instead, I rent out the property to tenants. I do my best to provide my tenants with a nice place to live in exchange for monthly rent payments.
I then use those rent payments to pay back the loan.
As my loan balance shrinks, my equity in the property increases. Equity is just another way of saying ownership interest.
When my equity in a property increases, my net worth increases.
4. Real estate investors earn massive taxes benefits.
When you earn rental income, you must report this income on your tax return. Rental income is treated the same as ordinary income.
However, the major difference between rental income and W-2 income is that there are a number of completely legal ways to deduct certain expenses from your rental income.
Common rental property expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs. We’ll touch on a few of these deductions below.
With all of these available deductions, the end result is that most savvy real estate investors pay little, or nothing, in taxes on their rental income each year.
Yes, you read that right.
I’ll say it again, just to be clear:
Most savvy real estate investors legally pay nothing in taxes on their rental income each year.
Even though I love owning rental properties, I still invest in the stock market.
While there are certainly real estate investors out there who are 100% committed to real estate, I’m not one of them.
Even with my passion for rental property investing, I have a significant portion of my net worth in the stock market.
For one reason, I enjoy having some totally passive income streams. Compared to being a landlord, there is essentially zero work involved in being a passive stock investor.
For another reason, I see the value in having multiple, diverse streams of income to help protect me against life’s uncertainties.
Plus, like many of you, my investing journey began with my employer-sponsored 401(k) plan.
401(k) investing is easy and relatively straightforward. With automatic contributions from my paychecks, I don’t even need to think about funding my account.
As a W-2 employee since 2009, without even thinking about it, I’ve invested regularly in the stock market and enjoyed the benefits of compound interest.
As my career progressed and my family grew, I added investment accounts to my portfolio.
Besides my 401(k), my favorite investment accounts include a Roth IRA, 529 college savings accounts for my three kids, and a Health Savings Account.
In conjunction with my rental properties, I view each of these different investments as part of my overall strategy to reach financial independence.
Combined, I refer to these different investment and income streams as Parachute Money.
What is Parachute Money?
Parachute Money is one of my favorite concepts in all of personal finance.
Pretend your life is like flying on an airplane.
For whatever reason, you decide you need to get off this airplane. You decide to take control and make a change. You’re ready to jump.
All you need is a parachute.
You have a choice between the only two parachutes on the plane.
The first parachute has only one string (or line) connecting the canopy to the harness . You think to yourself, “This doesn’t seem very safe. What if that one string breaks? That would end very badly for me.”
Then, you look at the second parachute.
The second parachute has 10 strings. You say to yourself, “OK, this one looks much safer. If one string breaks, the parachute still has nine other strings to keep me safe. Even if something goes wrong with one or two strings, I would glide safely to the ground.”
It’s obvious which one of these parachutes to choose, right?
Why is having Parachute Money important?
The central idea of Parachute Money is to create multiple sources of income so you are not beholden to any one source.
Picture each source of income as a string on your parachute. The more strings on the parachute, the stronger it is.
With Parachute Money, if one of your sources of income dries up, you are more than covered with your other sources.
Likewise, the more sources of income you have, the stronger your personal finances are.
Parachute Money includes your primary job, any side hustles, any income generating assets, and your emergency savings account. It also includes the income of your significant other, if you share finances.
The key to Parachute Money: protect yourself with as many investment and income sources as you can.
That’s why I own stocks and own rental properties.
Should I buy a rental property or stick with the stock market?
Lately, I’ve been asking myself this very same question, “Should I look into buying a fifth rental property? Or, should I invest that money in the stock market?”
There are certainly lifestyle considerations that go into this question beyond just the strength of the investment on paper.
For example, owning rental properties means taking on a job. On the other hand, investing in the stock market is mostly passive.
If you’re not ready for the job of being a landlord, then you should stick with investing in stocks.
Setting lifestyle considerations aside, we all have limited dollars available to invest. And, we work hard for those dollars.
When we choose to put those hard-earned dollars to work for us, we want to make sure we’re getting a good return on our investment.
It’s hard enough deciding where to invest your money once you’ve decided on the asset class. Take real estate, for example.
Even if you know you want to buy a rental property in a specific area, there might be hundreds of potential properties available.
Picking the right property is not easy and requires some careful analysis.
How much more difficult does the decision become when you’re not even sure if you should invest in real estate or invest in the stock market?
That decision can start to feel overwhelming.
Deciding between various asset classes can feel overwhelming.
With so many investment choices out there, it can be difficult to choose where to invest your money. That’s why it’s useful to have a way to compare one type of asset class to another.
Then, you can consider investment opportunities in different assets classes and make informed choices on where to invest.
Fortunately, we can use two simple metrics to help with this analysis:
- Cash on Cash Return on Investment (CoCROI)
- Return on Investment (ROI)
Real estate investors have long used these two metrics to decide if a potential property is a good deal compared to investing in the stock market.
In our next post, we’ll take a close look at each of these metrics. We’ll learn how each of these metrics can help you compare a rental property investment to typical stock market returns.
Don’t worry if math is not your favorite thing.
These two numbers are easy to calculate with an online calculator. The key is to make sure you understand the underlying principles and variables that go into the calculations.
Are you comfortable investing in rental properties and the stock market?
I like to invest in rental properties and the stock market to protect myself from economic and life uncertainties.
I don’t want to be all-in on only one asset class.
So, I view my rental properties and my stock investments as parachute strings working together to protect me should my airplane start going down.
Because I’m comfortable investing in both rental properties and the stock market, I need a way to help choose between options across those asset classes.
In our next post, we’ll learn how to do just that.
Do you invest in the stock market and in rental properties?
Which asset class did you invest in first?
Is part of your reasoning for investing in both asset classes to add layers of protection to your overall finances?
Let us know in the comments below.
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