In the previous post, we discussed Safe Withdrawal Rate (SWR) of our portfolio and how to pick parameters to make sure that we have enough money to keep up with our needs throughout our retirement. The concept of SWR can be extended to any type of portfolio, but the flexibility of the portfolio in terms of varying SWR differs based on our portfolio composition.
Let’s say my portfolio consists only of real estate, considered an illiquid asset. I have two rental homes with total asset value of $550,000 generating $4600 as rent cheques per month, a situation that’s reasonably less fluctuating than stock market. Mind you, there is no such thing as guaranteed returns, as many things can go wrong while holding valuable real estate that affect the periodical rent cheques. Less than 100% occupancy rates, delinquent tenants, major repairs and damages are some of the reasons affecting your cash flow. Many of the costs might have to borne by the landlord completely if insurance doesn’t exist or doesn’t cover. But as I said above, real estate offers a relatively stable income stream compared to non-real estate investment instruments.
Now the downside of this portfolio is, you guessed it, it is stable. You can raise rents, but not be able to raise 10% – 20% to match the market returns or index it to the inflation. If you are in parts of the world with rent regulation/rent control, there is a ceiling as to how much you can raise the rent. More importantly, you cannot withdraw more for sudden expenses, unless you sell your real estate, take the money you require and buy another real estate with left over money#1. In most of the cases, the resulting rent cheque will be lower than the previous one. And when you do this, your cash flow for the subsequent periods will be diminished and you have to reduce your retirement lifestyle FOREVER. Note that there could be scenarios where the real estate might have appreciated in value and/or you might be able to generate the same rental value but for general cases let’s assume: lower cost of rental = lower value in rental cheque.
So a couple of “bad’ years in expenses during your retirement years ( medical expenses, unexpected travel etc.) can seriously diminish your average yearly cash flow.#2 My point here is not to show real estate portfolio in a bad light; in fact, real estate it is one the best asset class to hold. I merely want to state that how rigid your SWR becomes in a pure illiquid portfolio. In fact, a decent dose of real estate in your portfolio would add the much needed stability to your yearly cash flow, kind of giving you “minimum guaranteed returns” on top of which you can design your yearly expenses.
Based on the above observation, we can define SWR rigidity as “the degree to which SWR can be modified year-on-year as per withdrawal needs.”
SWR Rigidity = Amount of illiquid assets/Amount of total assets
SWR rigidity is directly proportional to the ratio of illiquid assets in your portfolio and inversely proportional to the volatility of your yearly cash flow. So, more illquid the portfolio, more rigid the SWR and less volatile the yearly cash flow.
#1 I am not even factoring broker fees, other sundry transaction costs and applicable taxes.
#2 You can still do plenty of things here, sell the assets and use the cash directly or getting a reverse mortgage.
The Bronze Alchemist 