Q & A With America’s Real Estate Professor: Investing in Real Estate
By Leonard Baron
Investing in Real Estate vs. Mutual Funds
Q. I’m deciding where to allocate my investment dollars, to a rental property or a mutual fund. What should I consider? Bob M., Philadelphia, PA.
A. I’m not a financial advisor, so you would need to talk to a financial advisor about how to allocate your investment funds between different assets (stocks, bonds, real estate, annuities, etc.) and the historical rates of return on each of those. What I can tell you is that direct investment in real estate is not like investing in a financial asset, and there are two main issues: rates of return and the management hassle of real estate.
- Rates of Return - All real estate is extremely high risk and things do go wrong and you can lose all of the money you invest in a property – similar to if you bought an individual stock and that stock went to zero. With that high real estate risk, you would think you would earn higher returns on property, but that is just not necessarily correct. Your investment returns could be anywhere from negative (5 percent) to positive (10 percent) depending on the particular property you buy and how well you manage it over time. Real estate can help you build significant wealth, but there is no easy money in real estate and it is hard to earn even a 4-6 percent positive return on your money. It might look like a great deal upfront, but then things do not go as well as planned and returns come out much lower than anticipated; which can happen with financial assets too!
- Management Hassle – Rarely would you have to get up in the middle of the night and drive to your financial advisor’s office to handle an issue with a stock or mutual fund you own. But with real estate, that could easily occur, possibly a few times per year. You can have a management company handle it, and that could work well, but it also might not work well and the management may fall back into your hands. Historically speaking, people who make fair money on individual property real estate investments do the hard work and handle the property management themselves, from renting and leasing the unit to fixing maintenance issues. So just beware that if you plan on doing real estate, you should talk to some other investors and gain a full understanding of the time and issues involved before you allocate your investment funds to a property thinking it’s easy money and everything will go well.
Tax Free Investing IRA Funds into Real Estate
Q. I have a fair amount of money in my IRA and am considering buying some real estate so I earn money tax free. How do the basics work with this? Jennifer C., Chattanooga, TN.
A. What you are talking about is a generally called a Self-Directed IRA. There are many account custodian companies that can assist you in setting this up. You would transfer your IRA funds to an account at that company, and they would buy investment real estate, that you select in that account. There are many issues, however, with this strategy. Make sure you retain your own separate lawyer or CPA to advise you on the process.
In general, you need to have enough cash in your IRA to buy the property for cash. Loans generally do not work in these, because they have to be non-recourse debt, so no traditional bank mortgages will work. Also, there are annual fees for account maintenance at the self-directed IRA company and possible LLC or other fees related to the management of the property. And you can’t deduct losses or depreciation, if any, against your regular income like you could on a regular real estate investment. Overall, they’re just not as simple as they sound and may or may not make sense depending on your financial and tax situation.
Always have a skilled professional tax advisor assist you in these complicated matters. They can be intricate, and if you violate one of the IRS rules, you could be in for some hefty tax penalties, and we don’t want that! Good luck!
Leonard Baron, MBA, is America’s Real Estate Professor® - his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate owners how to make smart and safe purchase decisions. He is a San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! More at ProfessorBaron.com.
Email Your Questions to: Leonard@ProfessorBaron.com
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