Stocks are soaring but for many investors, real estate is king. Twenty-eight percent of investors say real estate is the best place to invest money they won’t need for the next 10 years, according to Bankrate. Stocks came in third on the list, after cash.
Real estate may attract even more investors when interest rates rise, prompting bond prices to fall. Stocks in sectors that pay significant dividends, such as utilities, may also dip.
The primary appeal of real estate is its low correlation to other asset classes, says Gary Anetsberger, CEO of Millennium Trust Co. in Oak Brook, Illinois. As an income-producing investment, real estate tends to perform differently than fixed-income investments when rates increase. Apart from the 2008 financial crisis, “real estate markets typically do not move in sync with the stock market,” he says.
[See: The 10 Best Ways to Buy Real Estate.]
Real estate’s usefulness as an inflationary hedge is also an advantage. Ryan Coon, co-founder and CEO of Rentalutions, an online property management platform for landlords, says that real estate is an asset that “rises with the tide.” As inflation pushes the prices of goods and services higher, rental rates can be raised accordingly.
Diversification is another plus. A portfolio that’s concentrated in stocks and bonds may be more susceptible to volatility in the markets. Adding a rental property into the mix spreads out your risk exposure, providing some insulation against downturns.
From a retirement perspective, real estate offers yet another incentive in the form of an additional income stream. Like any other investment, however, there are pros and cons. Before adding a rental property to your retirement investment strategy, here’s what you need to know.
Risk versus return. Real estate isn’t a perfect or risk-free investment. Paul Durso, president of Durso Capital Management in Charlotte, North Carolina, says two of the biggest risks are buying the wrong property and choosing the wrong tenants. You can avoid those mistakes with a little due diligence.
That begins with understanding a property’s return potential. Durso suggests using rental rates for comparable properties in the area as a starting point. Specifically, you should hone in on what the average rent is per square foot and then use that to estimate how much you can charge per month, based on the size of the property.
To fully understand your return potential, however, you need to dig a little deeper, says Michael Foguth, founder of Foguth Financial Group in Brighton, Michigan. “If you’re considering owning a rental property in retirement, you need to be aware of taxes, as well as what type of maintenance or future upgrades the property may need,” he says.
An important concept to be familiar with is net income or the amount of money a rental property generates annually after operating expenses are deducted. It’s how much income you receive from the property after accounting for vacancies, property taxes, insurance, repairs, maintenance or property management fees.
For retirees, owning a rental property can be a double-edged sword, Foguth says. You have the benefit of a steady income from an asset that may appreciate over time but also all the costs of repairs if something goes wrong. There’s also the possibility of not finding a tenant right away. “If nobody rents it for a period of time, you’ll be losing money each month the home sits empty.”
Checking the demographics of the the rental property’s location can help you gauge vacancy risks. “Look at how many people are moving in versus moving out,” Durso says, because an area with a growing population may be more likely to yield a broader group of would-be tenants.
[See: 10 Skills the Best Investors Have.]
Where the money is coming from. Before you can begin collecting an income from a rental property, you have to buy it first. Anetsberger says the upfront costs of investing in real estate can be significant if you’re financing a property or making upgrades and repairs to get it rental-ready. Rising interest rates can make mortgages more expensive, with even a minor difference in rates potentially affecting a rental’s profitability long term.
Taking on a loan may not be an option if you’re heading into retirement with a mortgage on your primary residence. You have to consider the logistics of qualifying for another home loan and your ability to make those payments in case of a vacancy.
Drawing on your liquid savings to avoid taking out a mortgage may not be the best choice if it depletes your cash reserves. Without a savings buffer, you may have to take on debt to cover major repairs or legal fees to evict a delinquent tenant. That, in turn, can diminish returns on your investment.
Anetsberger says there is a third possibility for investors who have a self-directed individual retirement account. Self-directed IRAs are managed by a trustee, but you’re in control of your investment choices. He says you can leverage your retirement assets through a self-directed IRA to cover the cost of buying a rental property, without withdrawing from your account.
In this scenario, you’re not taking anything away from your retirement assets so you avoid having to pay taxes or a penalty. You can use your IRA to buy, sell or flip real estate properties without losing your IRA’s tax-deferred status. The downside, however, is that buying real estate through a self-directed IRA can be complex, as there are certain rules the IRS requires you to follow.
The alternatives to playing landlord. Owning a rental property is a big responsibility, one that may run counter to your desired retirement lifestyle. Investing in a real estate investment trust or through a real estate crowdfunding platform can add real estate to your portfolio without requiring you to play landlord.
Anetsberger says that pooled investments, such as REITs or crowdfunding, offer two distinct advantages — diversification and low investment minimums. Instead of a five- or six-figure investment, it’s possible to invest in REITs or crowdfunded real estate with as little as $1,000. Plus, you can diversify with investments in both residential and commercial properties.
[See: The 10 Best REIT ETFs on the Market.]
Adding real estate to your portfolio sooner rather than later gives you more time to reap the rewards, but it’s never too late. “If you’re young and in your 30s or even in your 50s, you could end up seeing the benefits of investing in real estate,” Durso says.
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