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Is Real Estate the Key to Financial Independence?

A leading voice in the FIRE movement discusses her journey to financial success.

Paula Pant, host of the popular Afford Anything podcast and prominent figure in the "Financial Independence, Retire Early” movement, outlined FIRE principles and tips for financial security without the high salary on Morningstar’s The Long View podcast.

Here are a few excerpts on passive income, her views on Gen Z’s money mindset, and the best ways to balance a portfolio from Pant’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Real Estate and Equity  

Benz: I wanted to switch over to discuss a little bit more about your FIRE journey. A big part of it has related to purchasing rental properties. And I guess the question is, who's cut out for this type of endeavor and who's not? It seems like that this whole thing of passive income through real estate is a big piece of FIRE, at least for some FIRE proponents. Can you talk about that?

Pant: Sure. I think that in any type of portfolio building your contributions are going to be the single biggest determinant of the success of your portfolio. So, you need to be making big contributions consistently over a long period of time, over at least a decade or more. And so, whatever type of asset you find yourself enthusiastic about is likely going to be the best one for you, not necessarily because it's mathematically best, but because it provides that level of enthusiasm, motivation, engagement that's going to keep your head in the game, and it's going to have the behavioral consequences that will inspire additional contributions.

And so, to each person who wants to pursue financial independence or who generally wants to build a healthier portfolio, one of the first questions I would ask that person is, hey, if you had a bunch of magazines laying in front of you or a bunch of different tablets with different websites open, which one would you pick up? Would you pick up the article about cryptocurrency? Or would you pick up the article about real estate? Or would you pick up the article about index fund investing or individual stock picking? I mean, what excites you? And once you first answer that question of what type of investing do I find exciting, then you can build your parameters, this goes back to the risk management conversation earlier, then you can build your parameters over what percentage of my portfolio do I want this fun investing to occupy? But first defining what you find is fun, you know, that can be the lead in to inspiring a person to make more contributions than they otherwise would have.

This happens, by the way, often when--when the market declines, I often get questions from listeners to my podcast, who will say, hey, you know what, I know that I'm not supposed to time the market. I know I'm supposed to just keep everything automated. But check this out. There's a big market decline. I'm really, really excited about the prospect of picking up stocks that are on sale. So, how do I square the circle? How do I drive the idea of not market timing with my enthusiasm around buying the dip? And my response to that is, hey, if your enthusiasm around buying the dip spurs you to make more contributions than you otherwise would have--so, in other words, you're still making your normal contributions, and they are happening in the normal way that you've already set up. But you have this additional money that you otherwise would have spent on beer and ice cream, that you are now spending on buying the dip, because you're really excited about what's happening in the markets, that's great. And that's an example of choosing some asset or some event that spurs the extra contributions that adds fuel to the fire and gets you to that financial independence faster.

What Is the Right Ratio for Liquid Investments?  

Ptak: More broadly, what sort of ratio of liquid investment assets like stocks, bonds, and mutual funds relative to real estate investments is a reasonable target? How can people ensure that they're striking a healthy balance?

Pant: I don't think there's a one size fits all formula for everyone. I would say that when we talk about the percentage of your portfolio that would be dedicated to real estate investments, that question itself is split into how much of that is principal or equity that's on your balance sheet versus how much of that is debt or leverage.

So, when you zoom out of that and go to the overall question of how much of my portfolio should I hold in stocks, bonds, index funds versus in real estate? That question, when you have the real estate that you hold yourself, you're not a REIT, but real estate that you directly own, that question is inseparable from the second order question of and what is the ratio of equity to debt that I hold?

So, if--and again, I don't think there's a certain magic number, but I'll tell you my own journey. I tend to be pretty conservative when it comes to mortgage debt. And I wanted to contain my entire portfolio to have no more than as an aggregate a 50% debt to equity ratio. So, across all rental properties that I owned, I made sure that I always had $1 of equity for every dollar of debt. And over time, I actually paid that off. And now, all seven of my units are free and clear. There are many people who would say mathematically, that's a mistake, because certainly I could get a very low fixed rate mortgage and arbitrage the difference. I 100%. understand the math behind that argument. And to your question, that same person could equally argue like, hey, now that you have these properties paid off, when you look at your aggregate portfolio, given the fact that you've paid off these properties, the ratio of equity that you hold in these seven units compared to the value of the investments that are in brokerage accounts, that seems to--you seem to be very, very heavily tilted towards real estate. Yeah, absolutely, absolutely.

But that's all part of overall risk management. So, in my own case, knowing that I have no mortgages on any of my properties, means that I have reduced the level of risk that I'm exposed to. And that knowledge allows me to tilt the investments in my brokerage account more heavily towards equities. Personally, I have an all-equity portfolio. I have a barbell allocation. So, I also have a heavy cash allocation. But I haven't all-equities portfolio. And part of the reason that I'm psychologically feel confident about doing that I don't panic whenever there's a dip is because I know that in these other elements of my portfolio, I have safety. I know that in the real estate element of my portfolio, I'm not carrying any debt. And I know also that I have a heavy cash allocation.

And so, broadly, what I'm saying is that managing risk in one area of your portfolio, even if it seems a little too conservative for your age, or your timeline, that de-risking in one element of your portfolio can help you add additional risk and other elements of your portfolio. And if you think of my entire career, my business, the fact that I run my own business as essentially another element of my portfolio, having a low level of risk in real estate and a heavy cash allocation, those conservative anchors in my portfolio, allow me to have not only heavy equities exposure, but also to accept the risks of being a small business owner. And so, going back to your original question, which is, what's the ideal balance? I think that the ideal balance needs to be contextualized in terms of not just what's the equity to real estate split, equities to real estate split, but also, what is the overall risk composition of not just your investable assets, but also your career, your business, all of the ways in which you grow your wealth and make money including the income side of that equation.

YOLO vs. FIRE

Benz: I wanted to ask a little bit about your equity exposure. It sounds like you're an index investing enthusiast. Have you always been? It seems like for a lot of people, they end up being index fund true believers, but they only do so sort of after they've stubbed their toe with some other equity strategy. How did you land there?

Pant: My very first investments were in actively managed mutual fund. I opened up an actively managed mutual fund that had a 0.6% expense ratio, which doesn't sound too high. But in the FIRE community, people would--people who are listening to this would be dropping their coffee mug right now in shock and abject horror. So, yes, I started with actively managed mutual funds. And the more that I read, and specifically I started reading advice from--I read a couple of books from Jack Bogle. I started reading some Bogleheads books and forums and advice, the more I became an index fund enthusiast.

And in the FIRE community generally, that tends to be the dominant ethos. In fact, the author, Morgan Housel, said it very well, when he said, right now, especially when you look at young people, when you look at millennials, and Gen Z, the tendency seems to be either FIRE or YOLO. So, you've got the segment of the younger generation that tends to be index fund enthusiasts. We are interested in FIRE; we're interested in financial independence. That's sort of one subset of people who are interested in money management. And then, the other subset is like the YOLO crypto crowd of risk everything. And of course, I'm describing this as an oversimplification, and I'm describing two ends of the extreme. But I think, especially in the last year, year and a half, we've really seen that we've seen people in millennials and Gen Z, who are creating TikTok around crypto, we call we call it CripTok, and they're promoting some very, in my opinion, risky like go all in level of ideas.

And, by contrast, you also have the segment of people online, who take that very index fund-centric approach. I think that the fact that such distinct camps exist in the world of money management is probably analogous to how in the world of nutrition, you've got some people who are keto, some people who are paleo, some people who are vegan. You've got all of these people who are interested in the same goal, but they have different philosophies about how to get there. And people who are vegan, would have many criticisms of people who are paleo and vice versa. I think that's what's so interesting about this genre is that once you get into it, every person who starts to study money management at the individual level, has to ask themselves, all right, which group do I want to be in? Do I want to be vegan or paleo or keto, or – I'm trying to think of other examples of nutrition--do I want to be YOLO, or do I want to be FIRE? Or do I want to be some other type of crowd?

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.