I am seeing more and more clients liquidate their retirement accounts and put them in self directed IRA’s. While this is one method of investing, it has its drawbacks, so I prefer just a straight real estate investment. Some of the drawbacks on self directed IRA’s are that you lose the depreciation tax deduction and it is not very liquid.
Lets do the math on a straight foreword real estate investment. Lets say that you purchase a home now for $150,000 and put 20% down giving you a total out of pocket investment of approximately $31,500 and a mortgage amount of $120,000. At todays super low rates, your mortgage payment would be $694, principal and interest plus $106 for taxes, $50 for insurance and $50 for HOA dues for a total payment of $900 per month. That home will likely rent for approximately $1050 to $1150 per month giving you a net operating profit of $150 to $250 per month. If we put away $100 of that for maintenance it leaves us with an average profit of approximately $100 per month or $1200 per year.
If we divide $1200 net profit by $150,000 total investment, our return on investment is a dismal 0.8 %. Not very appealing, but it really is not the entire picture. That net profit really should be applied only to the $31,500 that you actually invested assuming that the maintenance will over time cover all major expenses. That return yields a much better 3.8% (which is better than most people have done on a lot of investments over the past 7 years). However that is still not enough incentive for most people to run out and buy a home as an investment because there is some work involved in owning an investment property.
So let’s throw in the rest of the story. Now we will assume that the home appreciates at 5% per year (which is still the long term average in spite of the recent spikes and lows. Although our current 10 year average including the spike and crash is 8%) over 30 years. This would result in a sales price of $375,000 at that time (I know that seems like a lot but remember an average home used to cost $15,000). That results in a total return of $340,000 (remember your tenant has now paid the home off for you) on a $31,500 investment or a total return of 1079% over the 30 years or a net return per year of 36%.
Now this investment can either be taken as retirement in the form of on-going rent or in a lump sum and it would be taxable. Keep in mind that the rental amount are very likely to keep pace with inflation and other costs of living, so they will provide a fairly nice retirement on a little over a $30,000 investment.
Another benefit to owning the rental home is the fact that you can depreciate the home and have current tax savings to help you offset the relatively meager cash flow in the beginning. Keep in mind that when you depreciate an asset, you will have to recapture that depreciation as income when you sell the property. In our ongoing example, the depreciation would be the purchase price of the home ($150,000) minus the land value (lets say $25,000) because the land does not depreciate, divided by 27.5 years. This results in an annual depreciation amount of $4545. If you are in a 25% tax bracket, that will save you an additional $1136 per year in net taxes.
I am not saying that being a landlord is for everybody because it is not. We have all heard the stories of the landlords who walked into a house and it was stripped. If you are a person that cannot bring yourself to evict someone from a home, then this may not be the business for you to get in either. I am also not guaranteeing that home prices will continue to rise in the short or long term and I am not saying that any of this should be attempted without speaking to an accountant or professional financial advisor, because these scenarios also depend on your individual tax situation. I am urging people to think outside the box when it comes to a retirement plan (and if you are less than 35, this plan works especially well). We can’t steal homes for you. In most cases it is not a requirement that you buy your investment home significantly below market value, the math still works. We will promise your that we will work hard for you and get you the best deal we can at the time you purchase a home.