Principles of Wealth #31* 

There are several assets that have a higher historical ROI than stocks. By adding one or two of them to your portfolio, you can reduce your exposure to stock market risk while boosting your overall results. 

Income-oriented real estate (rental real estate) is one of those assets. The historical return on real estate stocks (REITs) is almost 11%. This is one point higher than the historical return on the stock market in general. But if you invest directly in rental properties, you can safely ratchet up the return in a way that you can’t do it with stocks. I’m talking about an ROI of 12% to 15%.

Let’s look at the math:

Scenario One: Let’s say you have $200,000 to invest and use it to buy a rental property generating rental income of $25,000 a year. (This is the range you’d be looking for.) After deducting expenses – taxes, utilities, repairs, maintenance, and so on – you’d expect a gross profit of about 60% of that or $15,000. And then let’s assume you have the property managed at a cost of $100 a month (8% of the rent). Your net income would be $13,800.

Scenario Two: You use that same $200,000 to cover a 33% down payment on a $600,000 property. Assuming the same ration of purchase price to rent, you could expect rental income of $75,000. Deducing the same percentage of expenses (40%), you’d be left with $45,000 before management fees and about $41,000 afterwards. Then you’d have to pay for the mortgage, which, at 5%, would run you about $20,000. Your net cash flow would be $25,000.

In the first scenario, you bought a $200,000 property and netted $13,800. That’s a return of about 7%.

In the second scenario, you used that same $200,000 to buy a $600,000 property, financing $400,000, and ended up with a net of $25,000, which is 12.5%.

And that, you may be interested to know, is about what I’ve averaged on my rental real estate investments over the past 30 years.

But that’s only part of the story. That return of 12.5% is what I get in the early years of renting out the property. As time goes by, the rent goes up while the mortgage goes down. Eventually, of course, there’s no mortgage at all. The rental fees have paid it off.

So the actual ROI on rental real estate, if you hold it for, say, 5 years, is going to be around 15%, and it will grow higher from there.

And remember, rental real estate is just one of several asset classes that will give you 12% to 15% returns safely. And these higher ROIs are – in my opinion –safer than investing in stocks or even REITs, because you know the property better and you have some control over what you charge and what you spend.

So getting back to the original point: Some asset classes, such as rental real estate, can give you ROIs that are 2 to 5 points higher than stocks with, in some cases, less risk. The prudent wealth builder will take advantage of these.

Here’s how you might do it. Let’s say you divide your investments into 3 buckets: An index fund giving you 10%. A Warren Buffett type portfolio giving you 12%. And rental real estate giving you 15%. Your average ROI would be 12.3%.

The difference between 10% and 12.3% may seem insignificant. But over a career of investing, it can make a huge difference.

A thousand dollars invested every year at 10% would give you $5 million in 40 years. The same investment earning 12.3% would give you more than $10 million – twice the return for an ROI that was better by just 2.3 points.

The takeaways:

* Over the long term, there is a huge difference between a 10% ROI, a 12% ROI, and a 15% ROI.

* Trying to get much-higher-than-average ROIs will almost certainly make you poorer.

* So shoot for 10% with stocks and add other asset classes to your mix where you can expect to get 12% to 15% safely.

* In this series of essays, I’m trying to make a book about wealth building that is based on the discoveries and observations I’ve made over the years: What wealth is, what it’s not, how it can be acquired, and how it is usually lost.