But what about real estate? Could real estate have a place in your retirement financial plan? It could, depending on the type of real estate investments and other factors unique to your particular situation.
Primary Residence: A “Use Asset”
Let’s start with your primary residence. I generally consider primary residences to be what I call a “use asset” instead of an investment asset. By this, I mean that your home is intended mainly to serve as a place for you to live, not as an investment that may generate a return.
This is not to say that your home isn’t a real asset that may increase in value over time. It certainly is and it certainly can. But your home is an illiquid asset — it isn’t like investment securities that can easily be bought and sold. And you have to live somewhere: Even if you sell your home and realize a nice profit, you’ll have to buy another home or pay rent to a landlord.
Therefore, I usually don’t include primary residences as part of my clients’ retirement financial plans. The only exception is if a client wants to plan for a potential cash shortfall later in their retirement years by taking out a reverse mortgage. In this instance, the primary residence can serve as kind of a “personal piggybank” by allowing the client to tap into the equity in the home without having to sell it and move.
Indirect and Direct Real Estate Investments
The two main types of real estate investments that I would typically include in a retirement financial plan are what I refer to as indirect and direct investments. Real estate investment trusts (or REITs) and mortgage REITs (or mREITs) are a good example of indirect real investments. When investing in a REIT, you are investing in a real estate project by purchasing a share of ownership in an office building, shopping center or apartment complex.
While indirect real estate investments can be part of a retirement financial plan, I don’t generally include them in my clients’ plans. The reason why is because they don’t add much diversification to a typical retirement portfolio. Most REITs are highly correlated with equities — in other words, they closely track the performance of major stock indices. So they can’t help diversify a portfolio that’s heavily weighted in stocks.
As the name implies, direct real estate investments are ownership of real property or a limited liability corporation (LLC) or limited liability partnership (LLP). Buying a home, apartment unit or complex or commercial building or storefront are the most common examples of direct real estate investment.
When managed properly, these kinds of investments may provide a steady stream of income that can supplement other retirement income sources like those listed above. Direct real estate investments can also provide an added degree of diversification to a retirement portfolio since they generally have a low correlation with stocks.
Considerations with Direct Real Estate Investments
One of the first things to think about when it comes to direct real estate investments is whether or not you want to be a landlord. If you own a rental home, apartment unit or storefront, you must be prepared to take care of all the maintenance and tenant issues that go with it. If there’s a burst pipe, broken HVAC or leaky roof, you must get it fixed. You’ll also have to deal with tenants who don’t pay or are late with their rent, including deciding if and when to evict them.
If you like the idea of direct real estate investing but aren’t crazy about being a landlord, you can hire a property management company to handle these details for you. In this case, make sure the investment still generates positive ROI when you factor in the cost of property management.
Fractional ownership, also known as real estate syndication, is another potential option. These are kind of like a hybrid between indirect and direct real estate investing: They let you buy a fractional ownership interest in commercial property, like a shopping center, apartment complex or medical office building. This way, you don’t have to be a landlord or hire a property management company.
Taxes are another major consideration with direct real estate investing. Unlike securities gains, which may be taxed at favorable capital gains tax rates, income generated from direct real estate investments is taxed at ordinary income tax rates, which are higher than capital gains rates for most investors. Depreciation may help ease the tax burden of direct real estate investing somewhat.
The tax implications of real estate investing can get complicated so speak with a professional tax advisor for more details.
Right for You?
In the right circumstances and with the right investments, real estate could play a role in your retirement financial plan. If you’d be interested in learning more about building a comprehensive plan and how real estate might fit, schedule a call with us today.