Last time, we talked about the pros and cons of the “yield shield” and the impassioned views on both sides of that debate.
But what if you sidestep that entirely and generate your dividend yield through rental real estate instead?
Unlike stock dividends, which can be cut by company management, rents are arguably way more stable. Plus, real estate can be leveraged with a mortgage to juice a higher capital return.
Separately, regardless of which strategy you use, how should retirees think about the “crossover” point beyond which sequence risk effectively disappears?
This week, in the final part of our 3-part series on asset allocation, we talk again with Karsten Jeske, CFA, about both these topics.
- How rental real estate can change your optimal asset allocation
- Whether a bond tent strategy is still relevant if you have rental real estate
- How to analyze the sequence risk crossover point after which you are guaranteed to outlive your savings
- How to visualize the relationship between “how much nest egg is left” vs. “how much retirement is left,” and how to know when you’re really “out of the woods”
Do you think rental real estate is a more effective “yield shield” vs. dividend stocks? Would you change your asset allocation with rental real estate? How will you know when you’ve crossed the sequence risk “crossover” point?
Let me know by leaving a comment!
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Links mentioned in this episode:
- ERN’s “When Can We Stop Worrying about Sequence Risk?”
- Asset allocation: Does the “yield shield” really protect against sequence of returns risk? (HYW069)
- Asset allocation: How to use a bond tent to reduce sequence of returns risk (HYW068)
- The shockingly un-simple math behind retirement safe withdrawal rates (Part 1) (HYW035)
- The shockingly un-simple math behind retirement safe withdrawal rates (Part 2) (HYW036)
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:22
Today’s episode is part three, the final part of a three-part series on asset allocation.
In part one of the series, we talked about glidepaths and bond tents in the years leading up to retirement and the first few years after retirement, as a way to mitigate sequence of returns risk.
In part two of the series, the last episode, we talked about a dividend investing strategy where you invest in high dividend-paying assets. This is commonly known in FIRE communities as the “yield shield.” And we talked about some of the tradeoffs of that strategy and the validity of it.
In this final part of the series, we’re going to be talking about an alternate dividend strategy where you combine rental real estate with your traditional stocks and bonds portfolio to see if that produces a better outcome in terms of mitigating sequence risk than the yield shield.
We also talk about the heuristics for how to evaluate the crossover point after which, as a retiree, you’ve essentially neutralized sequence risk and you’re virtually guaranteed not to outlive your savings for the rest of your life.
So, these are super important topics. It’s an action-packed agenda. Again, in this episode, as it was in the last two, I hope you enjoy it, and let’s get to the show!
I wanted to ask a bit of a related question, which is, how might rental real estate change things? If you have a rental property that produces the equivalent of 1%, 2%, 3%, whatever, of after-tax withdrawal income that essentially serves as the dividend portion of your portfolio, or that contributes one or two points to your annual withdrawal rate, then how might that alter your asset allocation and safe withdrawal strategy?
Does it make it more compelling to hold an all-stock portfolio? Does it potentially even make a glidepath strategy irrelevant, and in what conditions?
Karsten Jeske 03:10
If you believe that you hold a real estate portfolio where the dividend income is relatively stable, and also the principal of that portfolio is relatively stable, then you could argue that this is something that will aid you in your withdrawal exercise.
My wife and I definitely thought about buying our own rental properties. We’ve always pushed back because we have some other routes to do that. We invest in real estate through some private equity funds, so you basically just become a shareholder in an LLC.
I have absolutely no power. That money is totally out of my control, out of my hands. They can basically do whatever they want with it, so there’s definitely a trust issue there that you only want to do that with some trusted players.
So far, I’m happy with the returns. They invest in real estate. They do multifamily.
They have relatively stable rental income. There’s a little bit of a hiccup, obviously, right now because there are some properties where you have some rental delinquency. I don’t think that the delinquency rate is at any worrisome level, but it’s definitely higher than before.
Rental real estate potentially also suffers a little bit from this “all else equal fallacy.” It’s hard to model how your real estate income is going to behave over the business cycle.
If we have another bad recession, it’s hard to model that. And because it’s hard to model, let’s not model it at all. That’s obviously the fallacy that some people might commit there.
Definitely the danger is that you think that you have this very stable rental income that will hedge the sequence risk in your equity portfolio. But in keep in mind that your rental portfolio could also take a hit during a bad bear market.
The nice thing is that doing the background check on some of the private equity providers that we invest with, you ask them all, “For how long have you been doing this?” and “How did you do in 2007, 2008, and 2009?” and they actually have very good returns during that time.
Because if you were in the multifamily business during 2007, 2008, and 2009, and you were cautious enough to not buy at the peak and not being forced to sell at the bottom, if you could make it through it, you didn’t have any cash flow problems, because they’re also leveraged plays. They have some mortgage on these properties.
If they were cautious enough that they never had any cash flow problems where they had to sell an underwater asset because they couldn’t make the mortgage payments at the bottom of the market, they all made fantastic returns.
If you bought some multifamily properties before the global financial crisis, everything in the real estate sector definitely took a hit, if you just look at the price returns, including multifamily. But remember, the ground zero of the global financial crisis was the single-family market where people were flipping houses. They were leveraging up their own private residences up the wazoo.
And the people that lost their houses had to move somewhere. Where did they move? They moved to multifamily complexes.
It’s actually some of the worst effects of the rental market at that time. The multifamily sector was a little bit spared from that. Maybe not everywhere; probably in Las Vegas or Miami, they also took a hit.
But if you were reasonably diversified and you knew what you were doing, you could do relatively well, even in 2008 and 2009 in that market. That’s why we have, so far, stuck with that little niche of the rental real estate.
There are obviously also some drawbacks. I’m probably preparing for some of the cash flows to be a little bit lower over the next few years, just to hold back some income and put some cash reserves on the side to deal with delinquencies.
But I definitely think that it’s a good asset and it’s a good diversifier, because there is a correlation with the stock market. Everybody who ignores this is really treading into dangerous territory if you assume that in your safe withdrawal analysis, there’s absolutely zero correlation with the stock market.
But as long as it’s not 100% correlation, if it’s only, say, a 0.5 correlation with the stock market returns, I think it’s definitely a very good diversifying asset, especially if you look at what other assets do you have as a diversifier for stocks?
You have the bond market where treasuries pay less than 1% as of mid-December when we’re recording this. And you have a rental real estate that has an unleveraged operating income of something like 5%, 6%, 7% or so. And then you leverage that up a little bit. So, that definitely looks like a very attractive asset class.
Andrew Chen 09:40
Does it alter the glidepath strategy? Does it mean that I can be less conservative in my bond tent, for example?
Karsten Jeske 09:51
Yes, I would definitely support that. Because if half of your retirement expenses are coming in from your rental portfolio, and the other half from your other paper asset investment portfolio, and you have some confidence that that rental portfolio is appropriately diversified…
Imagine you have 10 rental properties, but they’re all in one city and they’re all relying on that local economy. I would probably be a little bit more careful.
But I think the way that we structure it, we have four different private equity funds where we invested, and I would like to invest in more as they come out. But each fund itself is also diversified over multiple properties, so it’s not just one property. It’s not like one of these crowd-funded platforms where you basically fund one specific property.
The minimum investment is a little bit higher: between $100,000 and $150,000. But then each one of the funds is also probably somewhere around 10 properties, and each property is anywhere between a 70- and a 200-unit property. I think one of them is over 500 doors.
So, there’s enough diversification across different tenants. There’s always some delinquency. There’s always somebody late with the rent, but you diversify it over enough units, and then each property is in a different location and some geographic diversification.
So, I definitely like that idea. But make no mistake: if something were to go bad, they will stop paying dividends. They will say, “We have to preserve the cash flow, and we stop paying dividends.”
Each individual fund itself, I would not invest so much money in there that I say, “I give you the money, but I really need the dividend income every quarter.” I’m risk-averse enough and I’m also realistic enough that I would not invest in one single fund so much money that I would get into a cash flow problem myself.
Even if there is a problem, I think eventually, if you look at the total internal rate of return over the entire length of the fund, it’s still going to be a very attractive return. But keep in mind that there’s this illiquidity.
You cannot sell the share. You cannot get more money out than what they pay you as dividends. It’s only when the final tally is all done, after maybe 10 years, when they wind down the entire fund, that’s when you know your final internal rate of return.
I have invested with some of these companies that have gone through multiple market cycles, and they showed me the IRRs that they generated. They definitely looked very attractive, even the ones that spanned the global financial crisis or the dot com crash. So, there’s definitely something about real estate.
Stock picking probably doesn’t work so well because there’s only about 5000 corporations in the U.S. that are really in one of the big indexes, maybe 500 that are reasonably liquid. And everybody is trying to do the same thing. Stock picking is pretty much arbitraged away in that sense, or largely arbitraged away.
But in the real estate sector, there’s definitely something about picking and the illiquidity, how broad the market is, how many small properties there are, where not everybody can do the same kind of analysis. There’s some off-market transactions.
Andrew Chen 14:12
There’s more possibility for alpha.
Karsten Jeske 14:14
There’s more possibility for alpha. For example, I’ve heard one person tell me that if you’re looking for a rental property, the MLS is a non-start. Everything that comes out on the MLS as a rental property is bid up so high that you don’t have trouble making a lot of money.
You need to get your hands dirty and try to find a property off market. And the funny thing is he said that he knows people who are very good at finding properties off market.
After they do that, they don’t even want to buy the property and fix it up and rent it out. They get a finder’s fee, and then they sell it to somebody. This is how specialized the market has already gotten in the rental space.
So, you can’t go off the MLS. If you go off the MLS, probably rental yield is going to be crummy. You have to find the property yourself.
Or you have to pay a finder’s fee to somebody who finds a property for you off market, where they put flyers into people’s mailboxes and say, “We want to buy your house,” where they operate on the off-chance. Very macabre.
They go through the death notices in the newspapers, and then they go to these properties. How sad is that? There’s a death in the family, and then there are 17 people in front of your house, and you get flyers.
“If you want to sell your uncle’s house or your grandpa’s house, we’re going to give you cash really quick. No need to fix up the house.” How sad is that?
Andrew Chen 16:08
Yeah. There’s software now that helps you do that.
Karsten Jeske 16:13
It’s very sad and very macabre, which is probably one of the reasons why I don’t want to get into that kind of the business. Because the private equity funds that we work with, they do the same thing. They don’t buy stuff off the MLS.
Andrew Chen 16:30
Yeah. I imagine the properties aren’t even listed there.
Karsten Jeske 16:31
They also do off-market transactions, or they find a plot of land where nobody ever was able to develop anything, and they found a way to do that. So these guys, they’re some very smart people.
And of course, you have to pay them a management fee. I think they take something like 1% or 2% off your investment as management fee every year.
But the nice thing about the private equity route is that even with that 1% or 2%, they’re not going to get rich off of that. They have a huge incentive to manage this well, pay out the dividends and the rental income to the investors, and then there’s a certain order of who gets paid first from what. The investors get paid first before the managers get paid.
And then same thing with the capital gains. There’s a certain tranche. The first x%, the investor gets 80%; the manager gets 20%.
And if you go above a certain tranche, then it’s 50/50 in terms of the capital gains. These guys have a huge incentive to do really well, find good deals, because they get very rich off of that final split where they get half the capital gains.
The investors already get paid very richly. This is how these people have boats and vacation homes. They got it off of that 50% split in the end.
Andrew Chen 18:04
I just want to ask one more question. I know we’re running really late on time here.
But I wanted to ask about the crossover point of how one can analyze when sequence risk disappears. And what I wanted to ask is, if we think about early retirement, basically it’s up to two 30-year retirements back to back, and the crossover point being where the retiree is virtually guaranteed not to outlive their savings.
What dependable heuristics can we use to analyze? For example, can we assert things like if you still have x% of your portfolio remaining and you’re already y% of the way through your expected retirement, or even life span, then you’re virtually guaranteed to outlive your savings.
And in particular, what I wanted to know is: is there a way that the retiree can visualize the plotted curve of the relationship between that x and y?
So they can analyze questions like, “Given that I’m 10% through retirement, what does my portfolio need to be to be out of the woods?” or “Given that I only have 80% of my original starting portfolio left, how far along my retirement horizon do I need to be to be out of the woods?”
Is there a way that folks can visualize these relationships?
Karsten Jeske 19:13
Yeah. I think I wrote a blog post about that. The blog post is called “When can we stop worrying about sequence risk?”
Basically, what you could do is you could look at what are the failsafe withdrawal rates, looking at five years horizon, 10 years horizon, 15 years horizon. If you want to do more granular than that, you can do that too, but I think I did it in five-year steps.
Imagine you want to withdraw x every year. How much money do I need at different stages during my retirement to, at least in historical simulations, never run out money?
Even if 17 years into retirement, you have a certain amount of x, you withdraw y, what has to be the multiple between x and y, so that even if we have another Great Depression, you will never run out of money over the next 17 years? That’s the question you ask.
You could plot that. I think I did that in one of the charts. It’s basically a function that starts relatively flat.
If you go from 30 years to 28 years, you pretty much need exactly the same amount as before, maybe a little bit less. Then, as you get closer and closer to between 15 and 10 years, that’s when it starts really bending down, and then you need absolutely much less than 25x or 30x.
I think that’s a good exercise. I did that exercise.
And then, for example, if you start with a retirement of 60 years, going from 60 years to 55 to 50 years, there’s really very little movement in that number.
Again, it depends on how you define sequence risk. If you say, “Look, I have a certain budget,” and if my portfolio does much better than what I feared, and I still have the same budget, this is a little bit our situation because we retired in 2018, we did a relatively conservative withdrawal amount at that time, and our portfolio has grown substantially since 2018 until now.
In fact, even at the bottom of the 2020 bear market, we still had more money, more net worth than when we retired. This is why I was not too worried about that particular market drop. But now, I would say that we are totally safe from sequence of return risk, because if we budget the same budget as before, we have so much more money, which, at the time of retirement, was already conservative.
Basically, what you could do is you could check: what is your current safe withdrawal rate? You look at what is your budget divided by your current portfolio, and has that ever failed in historical simulations? We are so far away even from the Great Depression that I could completely discard sequence of returns.
And this was one of the conclusions from that blog post. If you are rational, you could say that because our portfolio is up by 50% (our net worth has grown by 50%), should we now increase our withdrawals by 50%?
So you renormalize our retirement, where you say, “Imagine I had just left work yesterday, and now I start retirement, and I look at today’s portfolio. How much of a safe withdrawal rate should I apply to that?” And of course, that would give me a higher retirement budget.
If I do that and I ratchet up my living standards, now I have basically reinitiated sequence risk again, because now, instead of a 50-year horizon, I have a 48-year horizon. But again, between 50 and 48, that’s not that big of a difference.
So, now I have sequence risk again. In that sense, you will never run out of sequence risk until you’re basically one month before you die. Then you have no longer sequence risk, which is a bit of a sad and defeatist conclusion in that sense.
But keep in mind, the reason why sequence risk will be always with you is that there will always be sequence risk. Even today, we have sequence risk in the following sense:
We have the risk of probably never running out of money, but of course, we face the sequence risk between if we have a good sequence of return, we will die with some absolutely astronomical pile of money, or if we have bad sequence risk, we will probably still preserve our capital.
In a good outcome over the next 50 years, we could grow our portfolio to way into the double digit millions, versus in a not so good, we just preserve our capital and we only die high net worth. And in a really good sequence of return, we’re going to die as not just high net worth, but probably in the ultra-high net worth category.
In that sense, there is still a sequence risk. Of course, it’s a sequence risk between astronomical portfolio versus still multimillion portfolio. So, in that sense, you never run out of sequence risk.
But if you think about when do you no longer have to worry about running out of money, that’s a different calculation. Then, even two years into retirement, you can say, “We’ll never run out of money now.”
Andrew Chen 25:44
That’s an interesting point.
Send me the link to that blog post. I’ll definitely link to that in the show notes as well. I think that will be really useful.
And I think what I’m taking away is there is this relationship, which folks can read more about in your blog post, but also, if your budget, all you need to survive, is already so low of a withdrawal rate compared to your portfolio, then that sequence risk, at least for purposes as defined by not running out of money before you die, might be very short.
It might disappear within a couple of years, or it might have never even existed at all. It just really depends on the size of your portfolio. If your budget withdrawals were only 1% or 2% of your portfolio, you effectively have eliminated sequence risk even from the very beginning.
Karsten Jeske 26:38
Andrew Chen 26:39
Karsten, this has been super insightful, as always. I’ve loved our conversation. I’m probably going to break this up into multiple episodes because there’s so much meat here.
Where can folks find out more about you, your work, what you’re up to?
Karsten Jeske 26:53
Same as last time. I blog at earlyretirementnow.com, and this is where I’m most active.
People sometimes send me messages on Twitter or Facebook, and then I find them about a month later. So it’s always better to, if you want to reach out to me, go via my blog.
We’re enjoying early retirement here. We have a seven-year-old daughter. We do the homeschooling/doing the Zoom meetings with her teacher every day, but you still have to monitor that.
So we’re busy with that. And then I’m busy with a few other projects here and there, but enjoying our early retirement. It’s a very quiet and relaxed time.
So, if you want to reach out to me, you know where to find me: earlyretirementnow.com.
Andrew Chen 27:44
I will definitely link to that, the blog post, the cash flow model that we talked about, in the show notes. And I look forward to sharing this with everybody.
Thank you so much again for taking the time to chat with me. It’s been real fun, as it always is.
Karsten Jeske 27:55
You bet. It’s always good to talk to you.
Andrew Chen 27:58
Take care. Bye!
Karsten Jeske 27:59