Q: What’s the problem with residential real estate as a growth asset?
A: It grows slowly.
Q: How might an investor enhance that return?
Owner-occupied real estate has long been considered a “good investment” for the “average Joe” because it has enjoyed a supply/demand imbalance since World War II. Applying leverage to that asset with a home loan was considered wise compared to the utilitarian cost associated with rent. The National Association of REALTORs suggest that a fully-amortized loan acts as a “forced savings account”, building equity for people who are normally too undisciplined to save money.
How might investors plan for their retirement with residential real estate? Certainly, the Government stacks the deck in favor of churning real estate investments, through the tax code. That strategy however, is predicated upon larger purchases and larger debt; a great idea for a potentially booming market.
What if an “average Joe” wanted to take a conservative approach and move some IRA money into the the house for sale across the street? The widely-held notion that real estate wasn’t suitable for qualified retirement plans just isn’t true. Specific companies will act as a custodian (or trustee) for your individual retirement account so that real estate or alternative investments can be held as an investment. One bank will even make non-recourse mortgage loans to IRAs, so that the property can be leveraged.
Let’s use some “old math” to see if residential property makes sense as an asset for retirement funds:
- The purchase price will be $150,000 and the 25-year, fixed rate, no-recourse loan will be for $100,000.
- The PITI for that property will be approximately $1,000. Let’s assume monthly rent in the amount of $1,400 (and that rent increases commensurate with property tax increases).
- We’ll assume that the property is vacant one month out of each year and that annual rent is $15,400.
- We’ll knock off $1,400 for annual repairs.
After servicing the debt, this property provides for a net cash return of $2,000 annually or some 4% return of the $50,000 invested- not great but better than one gets in a money market fund.
What will the annual return roughly be if the property value doubles in…
- 20 years? (72/20)+4%= 7.6%
- 15 years? (72/15) +4%= 8.8%
- 10 years? (72/10)+4%= 11.2%
Leveraged real estate, in an IRA, might be suitable for investors, with a long-time horizon, who want a hands-on approach. Speculate as to how long that property might take to double and compare it to other investment choices already available.
NOTA BENE: IRA investments have a lot of rules, including prohibited transactions. Always check with your tax advisor prior to making changes to your account.