Rental Income Retirement Strategy
Real estate investing can be divided into two broad categories—direct and indirect. Both of these include a number of potential opportunities, risks and drawbacks that deserve careful consideration. Because real estate investing can be complex, we recommend you learn the basics before diving in.
Direct Real Estate Investments
These involve purchasing a large enough stake in a property to have an active management role. For example, you could buy a multi-family investment property, either outright or with a mortgage. This would give you control and property management responsibilities, which can be expensive and time consuming.
You might make a direct real estate investment in rental properties to generate cash flow through passive income, sell property for a profit or both. But directly investing in real estate is not as easy as it may sound. Some key reminders:
- Generating income from rental properties requires collecting rent, which can be difficult. When tenants don’t pay rent, evicting them can be costly and time-consuming, and reduce investment returns. On the other hand, utilizing the services of a property manager also increases operating costs.
- Real estate investors who buy a property and sell it for a profit might require even more patience. Like every other asset class, real estate has ups and downs. When purchasing property near the peak of a real estate cycle, a property’s value can rise or drop below the equity originally invested. You might have to hold a real estate investment longer than planned to sell it for a profit.
- Investment property location likely influences its value. Some geographic areas have fared better than others have.
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Direct real estate investments can be problematic in plenty of other ways. At some point, you might face unexpected and significant expenses to keep a residential or commercial property in working order. A commercial property, such as an office building, might require a major repair after a natural disaster.
Real estate can be relatively illiquid, requiring time and paperwork to buy and sell. If you are forced to sell a property to pay a sudden, unexpected expense, you might do so at a loss.
An investment in direct real estate can also require a significant capital outlay. If you want to buy a $500,000 property and require a mortgage, you would need $100,000 for a 20% down payment. That figure doesn’t include closing costs and other expenses associated with the purchase.
Another consideration is risk. Many Americans hold the majority of their wealth in their homes. Like putting too many eggs in one basket, this leaves investors vulnerable to downturns.
Depending on an investor’s net worth, the down payment may be a small fraction of his or her total wealth. For some, it is a significant amount. Placing a substantial portion of your capital into a single investment may not be the best diversification approach. To pay for the mortgage, you'll need an income.
Finally, to accurately calculate returns on real estate investments, you need to account for interest, property tax, insurance costs and remodeling or maintenance costs. These costs can be substantial, and can lower your returns significantly. For these reasons, a rental income retirement strategy may not always be the best approach.
While investors have found success in direct real estate investment, because of the considerations mentioned, other investors seek to achieve their longer-term financial objectives through other means.
Indirect Real Estate Investments
These investments don’t provide the control of a direct investment. You typically don’t have a say in a property’s operations, but you are also absolved of associated responsibilities like upkeep and maintenance.
An example of an indirect real estate investment would be purchasing shares in a Real Estate Investment Trust (REIT), an entity that gathers capital to buy income-producing residential and commercial properties. Purchasing shares of a REIT entitles you to regular dividend income. In the US, this income isn’t taxed (at the corporation level) as long as the REIT pays out at least 90% of its profits in the form of dividends. Investors then pay taxes on these payments at their individual income levels.*
There are two types of REITs, publicly traded and non-traded. Publicly traded REITs are accessible to investors, as their shares trade in the stock market similar to corporate stock. Shares in these investment vehicles are reasonably liquid. Their prices update regularly and you can purchase them at almost any time.
Non-traded REITs don’t trade on exchanges. They also tend to be illiquid. These REITs can have significant lock-up periods. A lock-up period is a window of time when investors are not allowed to redeem or sell shares of a particular investment. If you invest in one and want your capital back, you may have to wait a while. Because of their illiquid nature, non-traded REITs frequently advertise higher returns than their publicly traded counterparts. To raise capital, non-traded REITs often rely on brokers who are incentivized by high commissions and advertise these investment vehicles as high-yielding securities. But should you buy into one of these investment vehicles and need to sell, you may have a hard time receiving your desired return.
If you invest in either a publicly traded or non-traded REIT you have no control over the properties in the REIT’s portfolio. Further, the properties these investment vehicles own may be concentrated in a specific geographic region or industry. And if you encounter significant unforeseen expenses, you may have a hard time getting the money you want from a non-traded REIT.
An Alternate Investment Strategy
Fortunately, there are other strategies you can use. For example, you could establish a diversified portfolio of stocks, bonds and other securities that provides exposure to real estate, when appropriate, through publicly traded REITs.
This investment approach can offer more liquidity, since it provides you the opportunity to buy and sell individual securities as you please. This strategy also provides effective diversification since you can own a wide range of assets instead of concentrating in one area of the market or a few properties. Another benefit of this investment strategy is flexibility, since you can choose which securities to purchase and which to avoid.
*The contents of this document should not be construed as tax advice. Please contact your tax professional.