Ready to retire? Curious as to how the money you’ve saved over the years will last forever? Depending on your situation, income property may be your answer. It starts with identifying goals; from a broad perspective, most retirees seek to 1.) protect the money from inflation, 2.) use the money to generate an income with little risk, and potentially 3.) leave money to heirs. Now, it’s up to you to decide if this is an appropriate retirement approach for you; if so, the following fundamentals can help to make your retirement years truly golden.
Before we really dig deep, let’s make sure this is for you. In essence, this strategy works for those who have accumulated a healthy sum of money, do not have a need for great liquidity, and who’s goals are somewhat similar to those above. If you require more than a 10% return on your money on an annual basis, than you may be more interested in a riskier, leveraged, hands on approach to real estate, or you may just be more interested in a different arena of retirement possibilities all together. Also, if you might need the majority of your money to be in cash form at some future date, this might not be for you. What we will discuss is a safe way to maximize return on your money, protect your cash from inflation, generate a stress free income source, and reduce speculation risk associated with investment securities such as preferred stock, bonds, mutual funds, and other speculative securities typically used to fund retirement. Rental property does not need to be a substitute for these investments and may only be a supplement to a well structured retirement plan. You must decide on your desired monthly income, and what pre-tax rate of return is adequate for you. Then, you may formulate a successful, well conceived investment strategy.
Real estate prices are a good indicator of how the dollar is valued in this country. Without going too deep, real estate market prices tend to increase and decrease along with inflation and deflation, respectively. This is primarily tied to the fact that the Federal Funds Rate (the interest rate at which bank’s borrow cash from one another) carries a heavy influence on the interest rate individuals are charged when mortgaging a home. So, rest assured that the dollar in the rental home will be a much better representation of overall dollar value in the U.S. than the dollar sitting aimlessly in the bank. To adequately protect your dollar from inflation, you must not mortgage the property because your cost of mortgage may also increase with inflation (defeating the purpose), and you must not overpay for the property. In checking the county’s tax assessors office for records of purchase regarding the property in question and surrounding properties, you ensure an appropriate grasp of market value in the particular area. Thus, you can mentally gauge what the property is worth and not over pay. Generally, most tangible assets will increase in dollar value along with inflation. Some retirees purchase low risk bonds or preferred stock that yield a fixed annual rate of interest, in order to protect cash from inflation by way of annual interest. While this may be true, the investments are subject to a more costly, interest rate risk. Because the interest you earn is fixed, you may not be able to resell for the same dollar value that you purchased the securities. Generally, as interest rates increase (the dollar gains value), the dollar value of your preferred stock or bond will actually decrease, losing value. This phenomena is best illustrated by example:
Assume you purchase a preferred security for $1,000, earning 5% annually ($50).
The next year, interest rates climb, and investors can earn 6% interest elsewhere as the demand for borrowed money increases. So, why would an investor purchase a security earning 5% for $1,000, when s/he can earn 6% on her/his money? The only way to resell the originally purchased security would be to do so at a lower price. The lower price would yield a 6% return on $50 annually. $50 is equal to 6% of $833.33 – the new price. So, as you can see, you lost nearly $170 in a period of increasing interest rates. Lastly, we didn’t get into what can happen to the value of your security if the company in question starts to slide (take a wild guess). I will note that increased interest rates are capable of putting downward pressure on house prices because mortgages are thereby acquired at higher rates; however, interest rates will typically increase as a result of increased demand for borrowed money – if people are borrowing, they are buying. So, it is only the desire to buy that puts the theoretical, erroneous downward pressure on home prices.
Now that your buck is shielded from the potentially devastating effects of interest rate fluctuation and inflation, let’s discuss how to earn income from your property – rent it out! Easier said than done, the ability to consistently rent out the property is largely a factor of where the property is located, who it appeals to, and the number of bedrooms/bathrooms. Exemplary of an ideal renters market is a college town, full of students. In said scenario, the demand for rental houses seldom declines as new students continually flow through, and for this reason, rental demand is somewhat shielded from recession. This is where deciding what monthly revenue and rate of return you desire comes into play. You must get an idea of what the average rent rate/room in the area is and average purchase cost per bedroom. Remember who your potential tenants are and choose the houses you buy accordingly.Let’s do this by example:
Let’s say you purchased a 4-bedroom, 3 bathroom home for $250,000. The real estate agent informs you that you should be able to rent the home out to students for $500/bedroom/month, totaling $2,000/month. This is a very reasonable, real scenario. The annual revenue is $24,000; property tax, insurance and maintenance costs total $5,500/year (consider these similar to transaction costs and management fees you would pay to a stock broker). Finally, we are left with $18,500 in profit. This is a 7.4% annual return on the investment after expenses (9.6% return before expenses).
This return is hard to match considering the small amount of risk associated with the principal investment. To get 9.6% on the market, you must subject your principal investment to a large amount of speculative risk; such a risk is not meant to be incurred during retirement. Common Sense: An investment security, at any time, could lose half its value. It is a rare occurrence that a rental home will suddenly drop in value by such a significant factor.
Let’s take this a step further and assume you have $1 million dollars you are willing to commit to such a project and you are able to find 3 other similar homes, producing $74,000 annually in post expense income. These numbers might not knock your socks off, but an investment that protects you from inflation and provides a such a powerful return with such a small amount of risk is most certainly worth exploring come retirement.
Now, you have seen how, if done properly, rental properties can provide retirees with a nice monthly income, protect principal cash investments from inflation, and minimize risks associated with retirement investments. Let’s talk about the heirs – the last of our retirement issues. If cash is tied up in these houses, the heirs are prone to prematurely liquidate in order to collect what cash is available. For this reason, it is wise to retain a number of liquid assets in retirement. Diversifying amongst the many different investment securities, real estate, and a bit of cash ensures that you are well equipped to handle any future encounters. Rental property is only a piece to the pie; while some pieces are bigger than others, never allow them to be alone. As a final note for those affected by estate taxes, make retain some type of asset that will cover the expenses of estate taxes; without such an asset, the heirs will be forced to lose value upon liquidation of the rental property. Life insurance is an extremely means to inexpensively cover estate taxes, and cash reserves or extremely liquid assets can do the job. Hopefully, these reflections give you a sense of how rental property can be manipulated into a fruitful provider during the years of retirement – good luck!
The Rent Lobster