From the moment we start working, we, as a society are taught to prepare for retirement. You may have been told to put 10% of all your income into a savings account, contribute to your 401K, open an IRA, or invest with a financial firm who can manage your portfolio. While these are great traditional plans, many individuals often overlook one avenue that could set them up for retirement, one with benefits that alternative saving plans may not afford them – What I am referring to is using real estate as a retirement plan. This includes acquiring real estate assets and using the income from the real estate to pay for retirement. In this article, my goal is to introduce you to the idea of real estate investing as a retirement plan by outlining the benefits and pitfalls of this strategy.
The Benefits
- Use Debt to Build Equity: Investing in real estate is one strategy in which you can use another’s rent to improve your equity position. By leveraging debt, an investor can put down the down-payment and then continue to build equity without having to put in more capital. The tenant will pay down the mortgage, and by the time retirement comes, the debt will be paid off, and the investor can now collect 100% of the income from the property for spending, excluding maintenance and management costs.
- Stability for Retirement Income: Investing in stocks is a common way for Americans to pursue the wealth they need for retirement; however, this can come with the high risks associated with market volatility. Real estate, on the other hand, if selected appropriately, can provide an investor a different and diversified type certainty in their retirement future. The key here is to invest in growing or developed markets to ensure future tenancy and income. For example, acquiring a property on a hard corner so that if a tenant leaves, you can find a new one quickly.
- Home Security: Real estate can also provide home security in the case that you or your family run into economic challenges. This is specific to investing in multi-family real estate. By owning an asset with multiple units, you can be prepared for a situation in which a family member needs a place to live; a multi-family unit can provide housing for the family and put you in a position to support them. This can be important when thinking about the needs of your own children and the realities of economic hardships. You also need to check on local and national rent regulations as they have been limiting how and if landlords can use their own properties as a primary or familial residence.
- Future Value-Add Opportunity: Some real estate deals offer future opportunity for growth. Maybe they have a vacancy or need to be remodeled – Whatever the situation, these “value-add” assets are those that need a bit of work but which can become sources of increased cash flow. These investments are great for investors looking for properties for retirement because over time, investors can improve the asset, and if they improve the real estate, their cash flow will increase. However, if that investor decides to just leave the asset as-is, they will still have cash flow – it is a win-win situation (However, even for this strategy, a strong location is still a must).
- Appreciation and Depreciation: This is a simple and straightforward benefit. Over time, quality real estate generally appreciates, which means that the value of the real estate will increase with time, even if there is no tenant in place. In addition, as an investor, you can depreciate the real estate for tax purposes, meaning that as time goes by, you will pay less in taxes for the asset.
The list goes on regarding the benefits of real estate investing, but the aforementioned are the most essential to understanding real estate investing as a retirement plan.
The Pitfalls
It is important to remember that all investing has risks (THERE ARE NO GUARANTEES), and in real estate there are some pitfalls that investors need to be wary of when developing their investment strategy.
- Potential Vacancy: The income from a real estate property comes from the tenant paying rent; therefore, if there is no tenant, there is no income. So, when investing in real estate, it is imperative that you be prepared for vacancies. Unplanned vacancies can have a detrimental impact on your portfolios bottom lines, so be sure to follow these rules of thumb to avoid as much damage as possible from a vacancy: Invest in a growing or developed location, and use low leverage when putting debt on the asset.
- Balloon Payments: A balloon payment can hurt an investor years after they acquire a property; the balloon payment is a large payment due at the end of an amortized loan. As an investor, it is important to remember when this payment is due and to be prepared to either pay the remaining debt or to refinance, but keep in mind, there are times when lending is frozen and refinancing may not be a viable option.
- Inflation Gaps: Often, real estate investing is recognized as an inflation hedge. Since the property value increases over time as a result of appreciation, and the lease structure for tenants generally includes increases in rent, then real estate can be a hedge against inflation. However, if the due diligence is not conducted on the front end during the acquisition, then investors can potentially lose return due to inflation – their expenses and return can be lower than their expected calculations. This can result in decreased cash flow.
- Expectations: Metrics and various metrics are used often to compare investments but it is impossible to know everything. Often events, micro and macro, cause these metrics to fall apart. The Internal Rate of Return metric is commonly used and can be severely effected because it depends on sales price and cash flows coming in on time. Be flexible and considerate of possible negative challenges.
Preparing for the Future
Leaning about the asset types and investment strategies of other investors can provide you insight on how to develop a strategy to prepare for retirement. If done correctly, by building a diversified portfolio of assets, you can be prepared for a comfortable retirement with a stable revenue stream; in fact, you can build security that can even be passed down to your kids.
Read one of our favorite article on The Family Investment Mindset.
