For many people, investment real estate makes up a large percentage of their net worth. Rental property has been a more consistent part of the financial picture for our clients than we ever assumed would be the case.
From a financial planning perspective, investment real estate provides nice benefits:
- If the mortgage is paid off, rental income becomes an important source of positive cash flow.
- Cost of ownership can be partially offset by tax benefits.
- Working on rental houses can be a rewarding task in its own right, as owners can see the relationship between their efforts and increases in either the rent or the value or sale price of the house.
There are downsides, however, to having too much real estate in your investment portfolio. Some of them include:
- Lack of liquidity. One of our clients who owns a lot of rental homes always says “there is a time to buy and a time to sell.” If you need to sell a house and you can’t find any buyers, or you can only sell it for less than you think that it is worth, the house may not have been a good investment. If your net worth is large enough that you will owe estate tax, your executor may have to sell some of your houses to pay the taxes due nine months after the date of death. This could force sales at prices that are much lower than the market.
- Unknown amounts of additional investment. Sometimes systems fail or renters damage the property in unexpected ways. This can force you to invest more in the house than you had expected.
- Difficulty with maintenance. Landlords may not be able to keep up with, or enjoy, maintenance forever. If a professional property manager becomes necessary, cash flow from the property decreases.
- Unknown exit strategies. When you tire of the burdens of ownership, or you die, do you have a plan for what to do with the property? Will you gift it to a son or daughter? Will you sell it?
We believe owners of investment real estate should consider these guidelines.
1. Keep real estate holdings under 50% of your investable assets. Having a combination of property and securities investments gives you the liquidity that you need to pay estate or other taxes that could become due if you die while still owning the rental real estate. It also allows you to sell when it is most advantageous.
2. Make sure you have the time and skills to manage the property. This helps reduce the risk of ownership and allows you to feel comfortable making decisions about upgrades.
3. Know who can help you. If you no longer want to climb on roofs or unclog toilets at 2 a.m., find a reputable property manager who can take over the day-to-day tasks of managing your investment.
4. Have an exit timeline. If you don’t want to work on your rental houses in retirement, then build a timeline with the steps that you will take to prepare it for sale and then give yourself a few years to sell it. This will allow you to maximize the price that you will receive for the property.
5. Know who’s next. If you are planning to gift the real estate to a son or daughter, make sure that they want this gift and that they are able and willing to keep the house up.
6. Pay yourself first. If you put significant time into the property, consider that an expense that needs to be compensated. What’s a reasonable wage for the work you do to maintain your rental properties? Only after including this consideration in your rent are you truly profiting from the experience. This is especially true when market appreciation is minimal. If you don’t receive an exceptional reward via price appreciation at the sale of the property, all your sweat equity may go uncompensated.
What is your exit strategy? Do you have a long-term plan for the role rentals play in your retirement income?
What challenges or rewards have rental properties brought to your financial picture?
~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP® — Tacoma, WA