## A simple method for valuing rental property as a component of your FIRE goal

20 June, 2021

Tracking net worth is fun but not particularly useful for FIRE. More relevant is the amount of money you have invested in (eventually) income-generating assets. If you have a house worth \$5M, that doesn't mean anything for your FIRE goals if you can't withdraw \$safe_withdrawal_percent from it. This difference between net worth and invested amount can widen significantly as, for example, local housing market conditions continue to defy any sense of reality.

The problem, then, becomes how to value your current rental property/properties, so that you can track your progress toward FIRE. This is the strategy I'm using now:

1. Calculate the theoretical value of the property based on the net income it would generate were it mortgage-free, and based on your safe withdrawal rate.
2. Subtract your home loan from the theoretical value. The result of this is the current value that you can put in your invested amount bucket.

Expanding on (1), let's say I've calculated that my property would generate \$10,000 of net profit per year when the home loan is paid off. We divide this number by my specified safe withdrawal rate to get the value that this property would represent, if it were part of a typical equities portfolio. So, \$10,000 / 0.04 = \$250,000.

This makes a bit more sense if we think about it as part of our overall strategy for retirement. Let's say that we are targeting a \$40,000 per year income, and we think a 4% safe withdrawal rate is appropriate. We will require \$40,000 / 0.04 = \$1,000,000 in invested assets to cover this. Going back to our rental property, we found that it's worth \$10,000 in income per year. The question is, how much is this property going to contribute to our retirement? That is, how do we measure the value of this property as a component of the \$1,000,000 that we need to retire?

Well, \$10,000 / \$40,000 = 25%, so when the house is paid off, it would represent about 25% of our retirement portfolio. In dollar terms, 25% of \$1,000,000 = \$250,000. Or, more directly, \$10,000 / 0.04 = \$250,000.

Expanding on (2), now, let's say I have an outstanding home loan of \$150,000 on this property. Subtracting the home loan from the theoretical value, \$250,000 – \$150,000, I now have \$100,000 that I can allocate to my invested amount bucket. Importantly, this number doesn't change if your housing market decides that your house is now worth \$800,000—that number is meaningless in the context of your goals.

The main benefit to this approach is that it allows us to track progress toward our goals as we continue to pay off our mortgage, and is not affected by wide swings in property market conditions.

Of course, there are some caveats:

1. It doesn't make much sense if you're planning to sell your property to fund your retirement. In that case, market valuation is important.
2. Your safe withdrawal rate has a strong impact on the theoretical value of the property. Using the example above, if you decided that a 3% safe withdrawal rate was more appropriate, the property would be worth \$10,000 / 0.03 = \$333,333. Of course, it would still be worth 25% of your overall number, since you still want \$40,000 annual income and you're still getting \$10,000 from your property. This difference, then, is a reflection of the difference in your target amount. Instead of aiming for \$1,000,000, you are now aiming for \$40,000 / 0.03 = \$1,333,333.
3. Tax. I'm using net profit to calculate the theoretical value, rather than gross. This should all work out as long as you're using a post-tax number for your annual target income. (That is, your \$40,000 per year is post-tax.)
4. I would ignore the value of my primary residence in any of these calculations—this is specific to rental income only.
5. Measured progress will be nonlinear, because of the amortisation of your home loan. Of course, this will tend to be true for everything else, due to compounding returns.

I know that this is a very naive approach, but it seems to strike a reasonable balance between complexity and accuracy. Any feedback would be really appreciated, so feel free to add a comment using the form below.