Up until perhaps Covid-19, the traditional plan for retirement was:
Over the course of a 40-50 year career (or careers) you would save enough and invest well enough that when you did stop working (full-time), and retired, you would then start using those savings and investments in your retirement so as not to run out of money before you run out of time.
Crucially, you will plan all this not run out of money before you run out of time.
That traditional retirement plan comes with a number of complications, and among those complications:
- You have to choose a withdrawal rate–meaning what percentage of your nest egg to spend each year on living expenses (so as not to run out and still be enjoying retirement).
2. You have to worry about timing risk–meaning the risk of a market crash early in your retirement at a time when you are no longer bringing in work income, but now using your investments to fund your life-style, and therefore drawing down your net worth over time.
3. You have inflation risk…Will inflation rear up and effectively erode your investment and/or savings as the cost of living rises?
So, why consider rental properties and/or two-family properties for investment?
First, in normal times–and these times are certainly not normal, rental properties generate ongoing income. If occupied (and not in a pandemic) rental properties keep paying you every single month, indefinitely. Rather than shrinking, your net worth actually grows over time as your properties appreciate while your tenants pay off your mortgage(s).
Second, concerns about inflation are in the news…Will your investment returns adjust for inflation?
For example, when you buy bonds, you will lose money to inflation–as interest rates rise (due to inflationary pressure), bond prices go down. Even if you do not sell the bonds, if you were to buy a bond paying 3 percent interest and over the next year, inflation rises at 2 percent. You end up with a real return on investment of only 1 percent. Meanwhile, the value of your bonds has declined as well.
Rents and indeed home prices, in contrast, over the long-term rise to keep pace with inflation. In fact, rents actually drive inflation and often surpass it, which is happening to some degree right now.
However, it is important, I think, to point out that a home is different than a rental property. A rental property is going to be valued very much based on gross rental revenues, operating costs, property taxes, and related. It’s not a home. It’s an investment.
If you were to buy a rental property now, in today’s dollars, you then are able to adjust the rent to tomorrow’s dollars. And the year after and the years to come, you are in a position to continue to raise rents over the years to keep pace with or exceed inflation. Meanwhile, very importantly, your equity in the property continues to increase as your mortgage is paid down.
Third, rental cash flow is usually predictable. When you buy stocks, you hope for the best based on historical performance and company management, but you certainly do not know what returns you’ll earn.
With rental properties, you know exactly what kind of returns to expect. You can calculate rental cash flow with very good accuracy—you know the purchase price, you know the market rent, and you can have a pretty good idea what the long-term average of all expenses will be.
Should you consider a 2-family property–living in one part and renting the other, mortgage companies will usually consider as much as 85% of the appraised rental value for that 2nd unit as your income in calculating your mortgage qualifications. So, that added rental income is added to your other income in calculating your qualifications for the loan.
Fourth, there are tax advantages.
To score tax breaks with stocks or bonds, you typically have to invest in a tax-sheltered account like an IRA, 401(k), 529 (college savings) plan or Health Savings Account (HAS).
But rentals come with “built-in” tax advantages. Every conceivable expense is deductible:
-legal costs and
-many closing costs.
You can’t deduct all those expenses in one year, but you can spread them over several years’–typically the life of the loan.
Depreciation of the rental property is calculated over a life span of 27.5 years (using the cost basis of the property). This includes the entire cost to buy the property. When you go to sell the property, the most you will owe in taxes is the long-term capital gains tax rate.
However, you can even defer those capital gain taxes using a 1031 Exchange.
You can further avoid paying taxes–at least deferring them, using a 1031 Exchange. In real estate, a 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred. Such an exchange can only be made with like-kind properties and IRS rules limit use with vacation properties. There are also tax implications and strict time frames that may be problematic, so this is best done with a professional, but the benefits are there.
Fifth, real estate investments add to diversification of your investment portfolio. Rental properties help you diversify both your income and your asset allocation. Instead of simply relying on stocks and bonds, you spread your eggs into the third basket of real estate, and over the long term, a significantly less volatile market than stock or even bond markets.
As you plan your financial independence and retirement, don’t ignore rental properties! They bring unique retirement advantages to your portfolio mix.
We can discuss this in detail and help you identify good investment opportunities to consider.