Welcome to this blog on Real Estate Investing. If you have not had a chance to read my series on Investing, I encourage you to do so.
When it comes to investing, where do you see yourself at retirement? What do you think will be your primary needs? It’s important to factor in the amount of time it will take and what it will produce when you’re trying to choose the right investments and prepare for your retirement. Therefore, it’s best to match your investment strategy with your goals.
As you build your investment portfolio, diversification should be an essential part of your strategy and a clear way to protect your investments. I believe real estate is one of the best retirement vehicles. It is the way I prefer to invest, so I would like to share with you some benefits I see in investing in Real Estate.
PASSIVE VERSUS ACTIVE
Real estate is one of the areas you can be as passive or active as you want. If you’re more of a passive investor, it’s relatively easy today to hire a good property manager who will oversee the asset on your behalf. Be sure to select a manager who approaches the role from an owner’s perspective. Before hiring them, it’s important to do interviews and check references.
I have found that 80% of the role is covering basic management responsibilities such as taking care of expenses, maintaining properties, pre-qualifying tenants etc. The 20% balance is where you get the most value as an owner. I would recommend hiring an individual or company who has personal ownership experience. If they own real estate themselves, they will likely have a better understanding of how to add value and bring this skill to the role.
A BUILT IN INFLATION GUARD
Real estate has a long-standing history of keeping up with and exceeding inflation – an important factor to consider when investing for the long run. If your investment only produces an after-tax return that is consistent with inflation, you haven’t increased your buying power at all. Your asset may have gone up, but you haven’t increased your buying power. Real estate though has generally always exceeded the inflation factor and as an additional bonus is – when there is real inflation, rents generally follow. Therefore, real estate produces a good inflation hedge.
REFINANCE TAX FREE
Although real estate is generally complicated from a tax standpoint, it does have several advantages. For example, depreciation is built in and shelters a good portion, (if not all), of your income stream and defers the tax until you sell the property. At that time, the income you received over the years will be taxed at the lower capital gains tax rates. This is something you can’t do in the majority of other investments. Another benefit is you can pull out equity by refinancing the property. The refinance proceeds are not usually taxed until you sell the property.
An additional strategy instead of a traditional sale is to complete a 1031 tax-deferred exchange, reinvest the proceeds, and keep your dollars earning – as opposed to selling and paying tax. If you do a tax-deferred, 100% of your investment is still earning a return instead of just the after-tax portion.
As you consider investment vehicles, pay attention to the tax component as well; don’t only look for an attractive return.
DEBT AMORTIZES DOWN
As you invest in real estate, the property itself will generate enough income to cover the mortgage payment as well as generate cash flow for you. As you make the mortgage payments, it’s self-liquidating the debt – so the property investment is paying back the debt. As the property appreciates and your loan amortizes down, your equity continues to grow.
In the long term, the benefit of amortization is something one tends to forget about, but once you step back and see the full picture, you see you have an asset that’s appreciating while your equity is quietly growing through amortization. By the time you retire, you own these assets free and clear, generating a solid annual income. It’s a nice way to retire.
STRESS TESTING
In every investment, there are assumptions made. The best thing to do is to do a stress test of the assumptions you’ve made. Adjust some of the assumptions and see how the forecasted return changes. Create models and run different possible scenarios. If our stress testing results in a lower return than we are comfortable with, we generally won’t invest in the deal.
In real estate, it’s often your income forecast that’s the big variable. Expenses can fluctuate, but generally they’re a bit more predictable. Income, on the other hand, can sometimes miss the mark, and this could be related to higher vacancies or slower growth than expected. One must also consider the exit cap rate – what assumptions are being made if for example, the plan is to sell in 5 years? Is the promoter increasing the cap rate realistically or are they being optimistic? I have seen many deals where the projected exit cap rate is lower than the market rates today – and that is a red flag. If through stress testing, the return is still reasonable then I’ll do the deal. However, don’t be afraid to walk away from a deal if the IRR significantly drops with just 2 or 3 variable changes.
Stress tests are valuable as they highlight areas you don’t typically get to see and the more you invest the more critical it becomes.
ACTION STEPS
As you diversify, I encourage you to put a ceiling on the percentage of capital you invest in each asset class. I will concede that my portfolio is heavy with real estate because it is the asset class where I have the most experience. This is why it’s important for me to track and stay on top of my investments in an Asset Return Report. Take a look at the report by following this link; it is best understood by following the Investment Forecast/Review Report as well which can be viewed here.
If you haven’t already, I encourage you to develop a similar report. Set up your parameters and as you make new investments log the information in and continuously track them over time. You can read more details about what goes into an Asset Return Report in my blog Developing a Sound Investment Strategy.
I would like to hear your thoughts on what I’ve shared today. Please let me know by putting them in the comments section. Your feedback could also help another reader.
