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Integrating Real Estate into your Retirement Plans

I have written a few blog posts on why I think real estate investments can be a good supplement to a retirement plan. But how can real estate investments be integrated into a retirement plan? To wrap up my discussion on real estate investing, I will provide a suggestion on how this might be done.

In my recent posts on real estate investments I have used the example of a $300,000 property to illustrate the importance of cash flow when investing in real estate. To buy a $300,000 investment property, an investor would need a 20% down payment or $60,000. For an older investor who has accumulated significant assets over the years, this size down payment may not be a problem. For the senior investor the investment becomes one of just analyzing the property’s cash flow. But for a younger investor the larger down payment may be a problem.

Many readers may have read my recent posts on real estate and, I am sure, have been thinking “I can never come up with that amount of money so I can never invest in real estate.” Well, if you are one of these people, this post is for you. If I were currently in my 30s and did not own a home or have the money for a large down payment for a real estate investment, this is the approach I would use.

Assuming my employment was stable and I had already set aside an emergency fund worth around six months of living expenses in a non-retirement account, I would start saving money every month to go toward the down payment for a real estate investment. This process could even take 5 or 6 years. But waiting this long to invest in real estate will not matter because, in my opinion, real estate prices are not going up anytime soon. However, saving for a down payment should be in addition to setting aside funds every month in your retirement accounts.

In an earlier post I talked about the first rule of real estate investing in which I discussed how your home is not an investment. But that does not mean your home cannot be an investment in the future when you are not living in it. If I were looking to buy my first home today, I would search for a home using the concepts I wrote about in my September 2011 posts. That is, I would do all the research and analysis of a home I planned to move into as if it were an investment. When you move into the property, it will not be an investment. But when you move out of it in the future, you can keep it and then rent it out to someone else. At that point the property will be an investment.

Why would I use this approach? This approach allows you to get around the large down payment problem. As a homeowner the down payment requirement is much lower. The days of zero down payments are gone, but, if you have good credit, you can get a Fannie Mae or Freddie Mac backed home loan with a 5% down payment. Another option is a Federal Housing Administration (FHA) loan which allows a 3.5% down payment. However the FHA has lower loan limits that vary in different areas of the country. There is another benefit to getting a homeowner loan versus an investor loan; the interest rate is lower. Currently a home owner can get a mortgage rate that is about 0.5% to 0.75% lower than an investor loan.

Although the lower down payment will likely create a higher monthly loan payment, I would still go through the same cash flow analysis as if it were an investment property as discussed in this post as you do not know when you may move out of the property and rent it out. It is possible you may experience a sudden job loss or job change requiring you to turn your home into a rental property earlier than planned.

After finding the right property that passes the investment property cash flow test, I would purchase the property and move into it making it my primary residence. At that point I would start the process over again. I would start saving money for another down payment outside my retirement account while continuing to stay informed about the local real estate market. In a few years, when I had enough money for another 5% down payment to purchase another home, I would search for another property that passes the investment property cash flow test. Once located, I would purchase the property, move into it, and convert the first property into an investment property. You can repeat this process as many times as time and money allows.

Let’s review an example to illustrate how this approach can help your retirement plan. This example is similar to my personal situation, so I know it is possible to do. Let’s assume, over 10 years, you have purchased three properties. You purchase your first property in year 0 at age 40, your second property in year 6 at age 46, and you purchase your third property, which is your current residence, in year 10 at age 50. All three properties were purchased for $300,000 in real terms (i.e., ignoring inflation).

Let’s fast forward another 10 years. It is now year 20 after you purchased your first property and you are now 60 years old and considering retirement. Your two investment properties have had a net positive cash flow; one for 10 years and one for 14 years (10 and 14 years is how long the first two properties have been rented out). In this scenario, we are not going to assess the net cash flow. I assume you have used the cash flow for property upgrades, stock investments, future down payments, or some other worthwhile endeavor. In this example we are only going to evaluate your real estate equity position. Even though after 20 years your properties have surely increased in value, we are, as in previous posts, going to ignore any property appreciation and only evaluate your equity position based on the purchase price and loan balance reduction.

• The first property has been owned for 20 years. The original 5% down payment on a $300,000 property means a 30-year $285,000 loan was obtained when purchased. After 20 years, the $285,000 loan has been reduced to $145,000. Your equity position in the first property is $155,000 ($300,000 – $145,000).
• The second property has been owned for 14 years. You again used a 5% down payment on a $300,000 property at purchase. After 14 years, the original $285,000 loan has been reduced to $202,000. Your equity position in the second property is $98,000 ($300,000 – $202,000).
• The third property, your current residence, has been owned for 10 years. At purchase another 5% down payment was placed on a $300,000 property. After 10 years, the original $285,000 loan has been reduced to $232,000. Your equity position in the third property is $68,000 ($300,000 – $232,000).

The two investment properties have a total equity position, assuming no capital appreciation, of $253,000. This equity was created with just an initial investment of about $36,000 (including closing costs). This equates to an average annual return of about 11.5% for each property. I should add that the equity build up via loan payoff is tax free when selling the property. This 11.5% return does not include any property appreciation or net cash flow provided by the properties. Not too bad in my opinion. But the best part of this scenario is all the options these two investment properties provide.

The equity in these two assets can be used in several ways. You could sell one or both the properties and invest the after tax equity in the financial markets if that makes economic sense using the process I discussed in this post. Another option is you could just keep the properties and use the cash flow as retirement income. This is what I am currently doing. There are two other ways you can use the equity in your rental properties. One I have already used and one I plan to use in the future. I will explain.

I went through the above described process 3 times and I also purchased a 4^th property as a vacation home. So I had 2 investment properties and 2 homes for my personal use.  In 2002 I was seeing many houses sell within hours of coming on the market with multiple bids on the same house. I became concerned that real estate was getting overvalued so I wanted to lighten up on my holdings. I decided to move into my vacation home and make it my primary residence. This allowed me to sell my previous residence tax free. I was fortunate that my previous residence had increased in value so much that the equity allowed me to pay off the loan on my vacation home and I still had significant cash left over. I used some of this excess cash to make some upgrades to the other two investment properties and the balance I invested in the stock market. This consolidation move made my financial position much stronger as I no longer had any debt including any mortgage debt on my primary residence. This allowed me to save retirement funds at an even faster rate than before resulting in my being able to retire earlier than planned.

The other option I will employ sometime in the near future involves moving to another area of the country. When I do, this is how I will use my remaining assets. I will sell one of the investment properties via an IRS “1031 tax-free exchange.” I will use these proceeds to purchase a property in the new area that I eventually plan to live in. I will rent this newly exchanged property for a year or two (required in a 1031 tax-free exchange). At that point I will sell my current home tax-free as it is my primary residence and move into the new property in the new location. As a note, I will not have avoided the tax on the investment property I sold to buy the new home via the exchange. I will have only delayed this tax until the new home is sold.

As you can see real estate investments can provide a lot of options down the road. The bottom line is that investment properties give you more income, more capital, and more choices when retirement arrives (including possibly an early retirement). You may have lower retirement financial assets by including investment real estate in your retirement plans. But real estate investing will very likely provide you a much higher overall net worth in addition to more diversified assets than if you had, at age 40, just bought one expensive home to live in and tried to save only through your retirement accounts. If your only path for building retirement assets is saving money from your earned income, unless you are among the top 10% of income earners, it will be very difficult to accumulate enough retirement assets. The law of leverage that real estate allows (discussed in this post) will cause your net worth to increase much faster than just trying to save money out of your earned income.

Because the real estate markets are getting back to normal valuations, and in some areas below normal valuations, the strategy described in this post is what I would do if I were currently in my 20s, 30s, or early 40s. If you are not sure how to get started in real estate, I would first read the lessons learned I listed in this post on my California real estate investing fiasco. The next step I would take is read several books on the subject. A couple good books on the subject are Investing in Real Estate by Gary Eldred and What Every Real Estate Investor Needs to Know About Cash Flow… And 36 Other Key Financial Measures by Frank Gallinelli. Both books cover all the real estate investment basics in detail as well as advanced topics.

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