How is dividend growth investing like rental property investing?
It sounds like a joke, but I'm serious. What are the similarities?
I'll start with an example of rental property investing. I will ignore taxes, the time value of money, inflation, and market values, because these concerns do not affect the conclusion.
Suppose I purchase a unit of rental property for $100,000.00. Suppose the market rent for the unit happens to be $500.00 per month, and suppose I am unable to raise the rent over time.
After 200 months, I will have received my $100,000.00 back. I now have assets ($100,000.00 in cash plus rental property worth $100,000.00) and income ($500.00 per month).
If I sell the rental property, my assets do not change value ($200,000.00 in cash), but my income drops to zero.
Suppose I am able to raise the rent by 1% per year. It now takes only 186 months to receive my original investment back. What if I am able to raise the rent by more than 1% per year? Here is a table showing the effect of raising the rent each year by a different percentage:
rent increase %
number of months
decrease in number of months
Note how the change from 0% to 1% returns my original investment in 14 fewer months, but the change from 9% to 10% returns my original investment in only 4 fewer months.
Here is a chart showing the decreases:
You might expect that a linear change in rent increases (i.e. a 1% change from 2% to 3% is the same as a 1% change from 8% to 9%) would produce a linear change in the outcome, but it doesn't. Why is that?
Let's take a look at the amount of the rent, and how it changes over 10 years based on different percentages of raises:
rent increase %
rent after 10 years
increase in rent
Notice that raising the rent from 2% to 3% results in a rent increase of $62.46, but raising the rent from 9% to 10% results in a rent increase of $113.19. Again, a linear change in the input produces a non-linear change in the output. Why is that?
The answer to both questions is the same - compounding.
Suppose you raise the rent by 10% after one year from $500.00 to $550.00. When you raise the rent by 10% after a second year, it does not go up another $50.00, it goes up by 10% of $550.00, which is $55.00. You are applying a percentage increase to the result of another percentage increase. This is compounding. It's not clear who said, "Compounding is the eighth wonder of the world" (Einstein or Rothschild?), but it is true.
Now let's turn to dividend growth investing. Investing $100,000.00 in rental property is like investing $100,000.000 in companies that pay dividends. Some companies never raise their dividend, other companies raise their dividend by 1%, 2%, etc. each year. The fastest way to get your original $100,000.00 back is to invest in companies that raise their dividend every year; the larger the percentage increase, the sooner you get your money back.
"Dividend growth investing" means "growth of the dividend", which becomes "growth of income".
Many companies raise their dividend each year by more than the rate of inflation, which is a terrific way to avoid the long-term erosion of your purchasing power due to inflation.
Back to rental property investing.
What do you do when you receive your original $100,000.00 back?
Buy a second unit of rental property.
Suppose you are unable to raise either rent.
After 400 months, I will have received my second $100,000.00 back. I now have assets ($100,000.00 in cash plus rental property worth $200,000.00) and income ($1000.00 per month).
If I sell the rental property, my assets do not change value ($300,000.00 in cash), but my income drops to zero.
What do you do when you receive your second $100,000.00 back?
Buy a third unit of rental property.
Lather, rinse, repeat.
If you are lucky enough to be able to raise the rent on each property by 10% each year, then your original $100,000.00 in cash will become:
after this much time
number of units
10 years 4 months
20 years 8 months
41 years 4 months
You could start investing at age 20 with $100,000.00, and before you turn 62, you will be receiving more in income each year than your original investment!
Back to dividend growth investing.
In rental property investing, compounding means using received rents to purchase additional units of rental property. In dividend growth investing, compounding means using received dividends to purchase additional shares of dividend growth companies. (You could reinvest your dividends back into the company who produced them, or into a different company; the outcome is the same either way).
Some SA authors have called this a "second" level or compounding; the first level is when each company raises their dividends, and the second level is when dividends are reinvested into additional shares, which then raise their dividends, etc.
Anyone who is considering how to invest in order to produce a reliable stream of income (perhaps for retirement years) with built-in inflation protection, should consider dividend growth investing.