True, it's not the asset that first comes to mind. But income property "can be an important bridge to retirement for those without quite enough to retire in the traditional sense," says Jeff Camarda, a real estate investor and CEO of Jacksonville, Fla.-based Camarda Wealth Advisory Group.
Because real estate is such an inefficient market, it's possible to find awesome bargains with very high returns on investment, Camarda says. And if you can manage the property yourself, you can collect more income. If you purchase the right property at the right price and on the right terms, he says, a rental property can produce significantly more income than traditional passive investments.
- Rental real estate can be a good source of retirement income.
- The relative inefficiency of the real estate market can produce bargains that offer strong returns.
- If you need to borrow to buy a rental property, do so before you retire.
- Choosing a good location is more important than finding the cheapest property.
- You should look to earn about 8% per year on your investment, after costs.
How Much Money Do You Need?
If you plan to finance your purchase with a mortgage, you'll need to take action before you retire, says associate real-estate broker Janice Leis, who serves the premier residential areas of Philadelphia and South Florida.
Mortgage lending guidelines typically require applicants to be employed and have at least two years of steady employment history in the same occupation. Lenders also require a substantial downpayment, typically 30% or more, if the buyer won't be occupying the property, says John Walters of the LeWalt Consulting Groupe in St. Petersburg, Florida.
If you don't have the cash to make such a large down payment, consider using your IRA funds. All equity growth and income from rental receipts will grow inside your IRA tax-deferred, Walters says. Purchasing the property with funds inside a Roth IRA, on which you've already paid taxes, means all your earnings and equity can grow tax-free. (For more, see "Using Your IRA to Buy Real Estate.")
Remember Recurring Expenses
After you've figured out how you're going to buy the property, you need to think about how you're going to cover recurring expenses. Owning residential income property is like owning a principal residence in that there are variable expenses outside the mortgage, says Rob Albertson, a residential real-estate agent with Realty Austin in Austin, Texas. There are maintenance costs for minor items (like leaky faucets) and major items (like a new roof).
Don't forget about the costs associated with marketing and the loss of income during periods of vacancy and tenant change-over. Albertson says to factor no higher than a 92% occupancy rate into your calculations, even in a hot rental market. Be conservative in your estimates of expenses and income.
Tax Benefits and Liabilities
There are also tax benefits and liabilities to consider. Walters notes that one of the chief benefits associated with rental property is the ability to claim a depreciation deduction on your federal income tax return.
Depreciation reduces the value of your property each year to approximate wear and tear; it also lowers your tax bill each year you claim it. However, it also lowers your cost basis, which means you could pay more taxes if you sell the property at a profit.
First and foremost, discuss the financial feasibility of your plans with a CPA, a real-estate attorney, and an insurance agent to see how much everything will cost, Leis says.
Choose a Location
Buying cheap won't help you earn a return on your investment if you can't find renters who want to lease the property, notes Jenny Usaj, managing broker and owner of Usaj Realty in Denver, Colorado.
"While the price will be higher in better areas, the time marketing the property will decrease as well as the time it might sit vacant," she says. If you are unsure where to find rentals, start near downtown or near a college campus. Rental residences often follow employment opportunities.
It's also important to look around the neighborhood and purchase a property that reflects the area's current demographic, Usaj says. "Is the area populated with single adults or families? Will a one-bedroom or three-bedroom residence be more appealing to the renters nearby? Again, be careful not to jump at the best bargain on the market. Make sure the property will appeal to the lifestyle of the area."
What Will You Earn?
"You want to earn at least 8% from the capital invested in the rental, net of all expenses," says John Graves, managing principal of an independent RIA, editor of the Retirement Journal and author of The 7% Solution: You CAN Afford a Comfortable Retirement. Expenses include the mortgage, taxes, insurance, maintenance, a 10% property management fee, and a 10% vacancy-rate allowance.
If you invest $100,000 in the property, you want to earn a net income of $8,000 a year, he says. The reasoning behind the 8% is that it compensates you for the risk and relative illiquidity of your investment. If you or your spouse can work on the property by doing repairs and maintenance or managing the property, your costs will decline and your income will ultimately increase, he says.
Investment-property owners could run into a number of problems, including renters who fail to pay, excessive maintenance costs, and difficulty finding tenants, says Cameron Novak, a real-estate broker and owner of the Homefinding Center in Corona, California.
Working with a reputable real estate agent with references to find your investment property is also important, he says. Many municipalities impose stringent inspection regulations and fees on landlords who want to turn owner-occupied properties into rentals, says John Braun, a real-estate attorney with Young Goodman Brown in Minneapolis and a seasoned real estate investor.
Potential investors should look into these issues before committing to a purchase. They should also be aware that homestead exemptions don't apply to investment properties, which can mean higher property-tax bills.
Rental property is not entirely a passive investment. "Owning residential income property is not a hands-free affair," Albertson says. "If you don't want to manage the property, or can't, as in you live out of town, you will be looking at 8% to 10% of your gross rents going to a management company to cover rent collection and repair requests."
In addition, would-be landlords should evaluate their own temperaments before jumping into property ownership, as the job involves dealing with a variety of personalities.
Finally, selecting the right tenant is key. Thorough screening is crucial, says Albertson. "This is the person you are entrusting with your retirement asset, so you'd better be sure you are not setting yourself up for disaster or numerous headaches."