Rental Properties Pay for Retirement

By Michael Douville - Real Estate Analyst

Recently a client came to me with a very common concern. Retirement was approaching, and income sources and monthly requirements would be changing - a plan was needed.

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Advances in health care have added many years to the average lifespan in the US, and retirement nest eggs need to last much, much longer than they did even just 10 years ago. If the average US male reaches the age of 60, he has a very good chance of living well into his 80's. The average woman in the US can expect to live beyond that, into her late 80's or 90's. As generations progress, there will even be a large and growing population of centenarians. Getting old stinks; getting old and being poor really stinks!

"Getting old stinks; getting old and being poor really stinks!"

Plenty of Asset Allocation Options

Good diversification of any portfolio is absolutely essential. A small payment to a financial planner can easily provide many excellent options. It is wonderful to have growth stocks provide capital gains, however, cash is what pays the cruise lines and buys the books and tuition at your children and grandchildren's private schools. Cash pays the electric bill, the cable and Internet service, puts gas in the car and food on the table. No two people have the same cash requirement, but everyone needs money to spend on a monthly basis, and by now I believe you must have realized Social Security will not meet your needs. Therefore, a portion of the individual's Retirement Funds needs to be in cash generating assets.

I bank with a very large national establishment. I keep above average balances in my checking account and savings account. My checking account is earning 0.5%; that is one-half of one percent. My savings account, which is gold or premium, receives 2.25% as of 08/18/2008. A 9-month CD can generate 2.96%, and various combinations up to 24 months at 3.49%, which is better. However, most people have a hard time lending their money at those rates.

"There are excellent people who can help with a higher yielding basket of securities and fixed investments, but my favorite asset class is residential rental real estate."

The average dividend for the S&P is 2.21%. SPDR's offer an excellent stock diversification opportunity, but again lack in the cash flow component we're looking for. A good financial planner or stock broker can help you find higher yielding securities, but as the yield goes up, the volatility and market risk increases as well. Fixed income investments offer a cash flow, however, often at the sacrifice of growth, and over time inflation will grind away your purchasing power. There are excellent people who can help with a higher yielding basket of securities and fixed investments, but my favorite asset class is residential rental real estate.

Why Rental Properties

As a separate asset class, real estate offers excellent diversification from securities and the volatility of Wall Street; by it's very nature, it is a long-term investment. Residential rental real estate is easy to own and easy to understand. Financing is readily available and the population demographics are powerful.

Residential rentals are extremely local in their characteristics and everyone can research a quality area near there home or office that offers great opportunity. It only takes a short time to become familiar enough with neighborhood amenities and values in the chosen "Universe of Homes," that one knows when a special situation like a foreclosure, job change, or another crisis has appeared offering a better than average purchase price. These situations need someone to rescue the property and relieve the problem. As a retirement component, one can afford to be patient and reap the rewards.

Nothing is Without Risk

Not every property is suitable for the purpose of a rental, nor is every neighborhood or subdivision. Careful thought and research is used when deciding on potential areas for investments. The obvious components are the desirability of the property as a rental and the rent revenue the property will potentially generate. Growth of both the rent and the appreciation of the unit are considered, and there are many regions of the country offering excellent potential.

Here in Maricopa County which is home to Phoenix, Scottsdale, Gilbert, and Peoria, the average rate of appreciation prior to 2003 was approximately 5%. Rent increased about 3-5% annually. The years 2004-2007 were extraordinary, and there has been a decline in prices as much as 20-40% partly as a result.

Many analysts, including myself, believe the bottom in housing has been reached with normalization occurring in the 2010 time range. In my opinion, opportunities for rent increases and capital gains are currently available. I will use a recent acquisition as an example.

The Case Study

My client needed a cash component within the total retirement package. Real estate is a tax advantaged vehicle, and is particularly effective outside of a "retirement account" such as an IRA or a Keogh. After counseling and deciding upon a strategy, we acquired a property for the real estate portion of the portfolio. This particular property was located within 5 minutes of the expressway looping metro Phoenix, allowing for terrific access to transportation. There were also excellent schools nearby and a regional shopping mall 10 minutes away. The building is over 1450 square feet: 3 bedrooms, 2 baths, a great room, a fenced backyard for children and pets, and the home had an attached 2 car garage. The area had enjoyed a steady 5% per year appreciation until 2004-2007, when the prices skyrocketed.

This particular model is located within a planned subdivision and has proven a popular floor plan built throughout the development. This model plan peaked at $318,000. My client purchased from an owner (it was not a foreclosure) for $225,000, thus reaping benefit by saving $93,000 off the peak sales price. The property was leased in 13 days at $1200/month to tenants with excellent credit. Computing the cost of rental: 13 days loss of rent (vacancy factor); imputing a $1,500 repair fund; adding a non-refundable cleaning deposit; plus the taxes and insurance - the unit generates about $9,400 per year in income, or after acquisition costs, offers a 4-4.15% cash return.

Rent is expected to increase 3-5%, adding to the cash flow. Unlike fixed income vehicles, the cash flow can GROW and shield the investor or retiree from the harsh effects of inflation. If the rent is increased by only $50/month, in 5 years, the rent revenue will have grown from $9,400/yr to over $12,000/yr; in 10 years, it will have increased about 60%, to almost $15,000 per year.

Unlike stock dividends, even in a bad year, rent revenues come in month after month. There is a potential for $93,000 in gains, and if a 5% appreciation rate is factored into the analysis, the capital gain could conservatively be over $55,000 within 5 years. A $225,000 property that appreciates at only 5% per year for 10 years will have grown to $366,501.29, all the while providing monthly cash flow totaling in excess of $120,000. That is a substantial return.

"I believe it is clear that a portion of one's retirement plan should include a strategy to accumulate residential rentals..."

Every retiree has different cash needs. However, I have a simple plan and a disciplined strategy to accumulate a portfolio of 10 properties. These ten properties will usually provide a lifetime of income. Further, real estate is a tax advantaged investment, and estate planners love the current capital gains treatment received by heirs - a stepped up basis. The estate will not only provide current income, but all the capital gains are forgiven at death, and the heirs receive the properties at current value, creating a huge legacy. In conclusion, I believe it is clear that a portion of one's retirement plan should include a strategy to accumulate residential rentals that should be held for a lifetime of benefits and diversification of assets.

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