Pros & Cons of Becoming a Real Estate Tycoon
Updated: Sep 16, 2020
Almost everyone loves the idea of owning income-generating rental real estate, especially in those early years of retirement. What's not to love? It can provide consistent income and you may even be able to enjoy it. Inherent benefits aside, it's vital to understand when taking on such an endeavor that one treats it like a business – because it is, in fact, a business. And like any business, it comes with responsibilities. Whether managing an income-generating property is the right decision for you will largely depend upon your financial situation, life objectives, and sometimes, even your personality.
It's a J.O.B.
When considering Rental Real Estate, the first thing to understand is that it will always take up a noteworthy amount of your time. This is regardless of if the property is managed directly by you or not. The question is how much time and how exactly that ongoing commitment affects your overall rate of return. You may decide to hire a service, but that expense should still be calculated in your overall net rate of return. I've met many people who claim a 10%+ rate of return on their investment, but after factoring the expenses and time they are devoting to the property, their real rate of return is more like 3% (or less). It’s important that an individual considering rental real estate, understand the relationship between their investment, the expense, and the actual amount of money that is going into their pocket. An investment that takes up a bunch of your time but only returns what you can likely attain through other less time-intensive vehicles isn't going to be the best. Of course, other factors, qualitative and quantitative, can still overshadow a lackluster return.
If the net net net rate of return of your property is reliably kicking off income north of 3-4%, (and keeping the property is not taking up a lot of your time) then you may really have something. However, if your net net net income is hovering around 2%, and the property is taking up a ton of your time, then there is probably a much easier way to make 2%.
Remember, when considering a piece of Real Estate, it should be a LONG term game plan. That is because to truly win the game on the investment, it will be essential to capture the inherent tax and estate planning benefits that potentially come into play closer to mortality.
Will You Be Destroyed by Tax?
I’ve met all kinds of highly intelligent people who have no clue how taxes work. Taxes are laddered, meaning they go up the more you make. You are not taxed at a certain rate (or bracket) across the board on every dollar. So as a general rule with any investment, you want to legally and ethically avoid taxation on those upper tiers. This is particularly true concerning unearned income (versus money taxed at the capital gains rate).
Working and owning property is an interesting dynamic. Many of the people I have met who are working but also own rental property have far too often not considered the tax ramifications tradeoff before buying the property. Doing something after careful consideration is ok; you are always allowed to break the rules once informed. The dynamic to understand is that rental income will be treated as income on your tax return and if working, your accountant will use depreciation to reduce your overall tax liability. From a tax perspective today this is a great thing. It limits how much of that income is going to be subject to taxation on those upper brackets. But hang on, you didn’t ‘get out’ of any tax, you deferred it using depreciation which in turn lowers your cost basis.
The tradeoffs of using depreciation for the short term is not always crystal clear initially to all people when they go off falling in love with an investment property. If, for example, the property ended up not being something you wanted to keep, but the accountant used an aggressive depreciation schedule - well, then that is how people run into tax issues and are dissuaded from selling off a lackluster investment. That basis may be so low down the road compared to the sales price that you owe much more than expected in tax. Also, be sure to remember that there are tiers to even the long term capital gains rate at a certain point. Additionally, AMT can come back to bite you in certain situations. If you considering real estate, are working, and make a good income, it is important you understand the ramifications of a decision beginning to end. Or at least as much that is humanly possible. Sometimes it's just a 'screaming deal.'
I have worked with highly paid professionals in the field of accounting who were overly aggressive with depreciation. That decision unfavorably shaped their retirement plan. Sometimes your expertise is not the issue, it’s the lack of tax flexibility and the lack of having a cohesive plan when making a decision in the first place.
The One Bedroom w/ an Ocean View
For some clients with the appetite, certainly, not all, the period of time just before retirement represents an ideal time to obtain a rental real estate property. In my experience just prior to, or just after, retirement is actually the ideal time qualitatively and quantitatively. There are a few reasons for this.
The first reason is time. In a lot of cases you are (or should be) winding down the rat race. You start to have more time and you certainly should have the enthusiasm to prepare for your retirement. If not, then I’m pretty sure if you have a significant other in the household, they will be very willing to reduce their work to begin the hunt for the dream vacation home or a rental goldmine. The point is, the timing is often perfectly suited to people’s lifestyles and objectives. Often times college is paid, the kids are all grown, starting new families of their own, and it’s an empty nest. It’s really the ideal time period for one of the last big enjoyable purchases - just before the long steady ride out into retirement. I genuinely enjoy watching people go through this process.
The second reason is tax. There is usually a unique period of time that exists between the normal retirement age of 65 and 72 (before social security kicks in and RMDs start to come due). I call this the “tax valley” where there is an opportunity to be strategic in how income is distributed (and taxed) and when to actually start taking income from things such as pensions and social security. This is often the period of time where it makes the most sense to de-risk by selling off brokerage assets, employee stock grants, effecting Roth conversions, downsizing, and purchases supplemental real estate. Its also the time many want to travel (and possibly not even own a residence for a while). I’ve seen it play out many unique and inspiring ways, but logically the pattern is that there is a significant dip in income. That is an opportunity you can plan around.
Just prior, or just after retirement is a great time to visit a few properties on the market. It can just be a fun experience if changes in real estate are desired and financially appropriate. You never know, your timing might be perfect to snap up that ‘screaming deal.'
Go for the Step-Up in Basis
To me the ‘Holy Grail’ of rental Real Estate investing (and investing in general) has got to be the ‘step-up in basis’ to fair market value at the time of death. I imagine, financially speaking, there is not much more of a fulfilling financial feeling than being able to use a property for 40 years and then at death bequeathing it to a loved one at the property’s fair market value, wiping away the taxable gain. And on top of that, make money on the deal in the process. There are not too many legal and ethical ways to get out of tax, but that is a pretty good one and it’s available to any property owner.
The step-up in basis to the fair market value at the time of death is probably the biggest financial benefit to the American property owner. But it is a LOOONG term strategy and that is why I say to a client... “Just make sure you want to keep it, and prove it’s a good investment with math before you buy it.”
Not All Properties Are Created Equal
COVID-19 may change this, but a rental property where I live in San Francisco I’d say can be pretty reliable. Yes, it has its own long-standing issues for investors such as rent control. But at least historically people have a desire to visit and live in San Francisco. And that's the point. You want to understand how changes in the economy can affect your property over the long haul and how income could potentially fluctuate. Some places it may truly be ‘recession-proof’ and trying to find those opportunities that provide reasonable stability. That should be the endgame. It is a situation I have seen be the main support mechanism for a great many retirees. Some of them would say it’s their version of an annuity, but better. Better in that it’s an asset you still own and can even potentially use as a residence (i.e. the backyard rental or apartment complex). The insurance company issuing the annuities know this to be true, who do you think owns all those hotels in downtown San Francisco? The fact is Real Estate, if in the right location, and under the right set of circumstances can be a very reliable and stable income source.
However, a Real Estate investment can also be strongly correlated to the economy and even the stock market. A property in a location where people may lose their jobs or other unforeseen widespread economic catastrophes can have a long-lasting effect on the property’s income reliability. We are seeing that now with people losing their jobs and the state law preventing the landlord from evicting tenants for failure to pay rent. This is an important consideration when making this decision to buy. All you need is to be aware of the risk, not rely too heavily on one source of income, and have a backup plan to weather the potential storm, and ideally even an actionable ‘exit strategy.’
The last time I counted there were up to 11 sources of retirement income, I don't meet too many people who say they only want one or two. We want and should have as many sources of income as is financially beneficial. Right now, there just are just not too many viable sources. To me, I cannot deny it makes a strong case.
Proper financial planning should diversify your income sources and in an age where much of our money is in fact directly correlated to the stock market, having other sources of income is an essential part of planning.
Conclusion & COVID-19
As I've said in previous articles… What happened to the retiree income options? Is it really just as simple as ditching new money into bonds and taking more risk with stock dividends? Currently, projected rates of return for traditional income-generating vehicles are stagnant. At best, when planning we can assume conservatively 1-2% before more risk is required and in turn venturing into the truly unknowable. I suppose I'm just a bit underwhelmed by the options for my hard-working retirees - who did everything right. So that's why for the foreseeable future I'm recommending clients with or without the appetite for rental income to consider if they have what it takes to be real estate moguls - and if the financial mosaic calls for it.