From the December 2005 issue of Investment Advisor • Subscribe!

December 1, 2005

Adding Property to the Mix

More investors are investing IRAs in real estate for real diversification

Purchasing real estate has long been a vehicle that investors use to help pad their retirement, but a growing trend among investors these days is to invest a portion of their retirement accounts, like IRAs, in real estate.

Joan Owens, VP of Investment Admin-istrative Services at Fiserv Investment Support Services, which considers itself one of the largest custodians of alternative assets like real estate, says the number of IRA accounts under Fiserv's administration jumped 18% this year over 2004, and the dollar value of the IRA holders' property investments over the same period has increased 30%. The 30% increase shows that IRA holders "are making bigger purchases of property" in their IRAs, she says.

The classic argument for investing a portion of one's IRA--or investment portfolio--in real estate is diversification. For instance, say you have a client who's rolling over a sizable retirement account from a previous employer into an IRA. It may make sense to invest a portion of the money in the stock market, some in real estate, and some in REITs, Owens says.

Robert Morrison, president of Huber Financial Group in Buffalo Grove, Illinois, says "almost all" of his firm's clients have exposure to real estate in both IRAs and taxable accounts, primarily in real estate mutual funds. Real estate is the best alternative asset to use nowadays, he says, because it has "a non-correlating relationship to equities." Because equities correlate so closely with one another, "finding an alternative asset class that creates real diversification has become tougher and tougher," Morrison says.

Real estate targeted funds, Morrison says, are the best bet these days because they spread out the client's risk of putting too much money in one particular segment of the real estate market. It's better to spread a client's risk across "geographic areas and in industries where you have residential and retail [properties], and industrial real estate investments [to] mitigate some of that risk," he says.

Depending on a client's risk level, Morrison says he counsels clients to invest from 5% to 10% of their portfolio, or IRA, in real estate. His firm won't take clients with less than $400,000 in assets, and "usually half of their investable assets are in IRA-type accounts," he says. He does caution clients today to consider how much leverage a fund has before investing in it. "A lot of real estate funds and REITs are highly leveraged right now, and while they've had fantastic returns in the last couple of years, as interest rates go up they have some risk embedded in them because they've leveraged a lot of their assets--meaning they've taken on a pretty big debt load."

Lou Stanasolovich, president of Legend Financial Advisors in Pittsburgh, refrains from investing his clients' money in real estate because he says more times than not, "it's the wrong kind of deal." Particularly now, he says, because "most real estate investments probably won't do that well going forward because we're at the top of the cycle because the low interest rates are now rising." He always steers his clients away from buying homes, especially now as he anticipates the burst of the housing bubble. The only investment that makes sense, he says, "is a commercial lease for a warehouse or manufacturing building where you have the lease locked in for a long period of time, like 10 years, and you know you're going to get a certain return on your money."

Morrison agrees, and says that a direct purchase of real estate should be a long-term investment. "People who are buying real estate now with the idea that they are going to flip the property in a year or two, may see the property either flatten out or lose value," he says. "That's a high risk, especially in big markets like New York, California, and Florida." There's also been a "huge run up" in clients that are interested in buying second homes and vacation homes. The key here is to hang on to it. "For most people, if they're buying personal use property as a long-term investment, even if the next five years are flat or down, it won't matter because they're still using the property," he says.

Owens with Fiserv adds that when buying real property investments in an IRA account, the advisor and the client should be aware of the IRS's prohibited transaction rules, which are referenced in IRC Section 4975 of the tax code. Of particular importance is one part of the code that pertains to disqualified persons. "An account holder needs to be aware that if they're interested in buying a property, they couldn't have owned it prior to that transaction," Owens says. "Or there are certain family members that they cannot purchase from or sell their IRA investments to." The rules also state that you can't buy insurance or collectibles in an IRA.

Another important note for advisors and their clients, outside of the IRS code, is to know that there are only a few trustees or custodians who deal with self-directed IRAs and alternative investments, Owen says. "Each custodian can have its own policies regarding this type of transaction," she warns. Advisors and their clients "need to know what those policies are, and talk to the custodians before they, for instance, buy a farm. One custodian may take it and another may not." When getting ready to do the transaction, one of the most important players in the transaction is the custodian, she says, so "you want to make sure they are ready to set up the account."

Some clients may also consider borrowing money from their IRA to invest in a property, which is known as leveraging. This can be risky, Owens says, and the advisor and client must ensure the bank will provide for a non-recourse loan. "Leveraging has been around, but not many banks will allow for non-recourse loans," she says. With a non-recourse loan, "the bank will only hold the property as collateral--they won't hold the IRA holder, or the IRA, liable for default if the payments aren't made," she adds. "The only recourse [the bank has] is to come in and take ownership of that property."

Stanasolovich also questions why a client would want to tie up the bulk of their net worth "in an investment property inside their IRA where it has long-term capital gains and possible deferral abilities in a 1031 exchange." He asks: "How easy is that to liquidate?"

Owens with Fiserv concedes that real estate isn't for everybody. "Advisors are positioning themselves as providing comprehensive solutions, and real estate is one asset class that can provide a partial solution," to diversifying a client's portfolio, she says. "Clients will need a pretty large portfolio for an advisor to say, 'let's take a piece of that and put it into a commercial real estate property where it would be a direct investment and not part of a REIT.'"

Fiserv recently hooked up with InvestorLoft.com to help the company provide an educational tool for advisors and investors that details the steps of purchasing real estate property outright, and within an IRA. The site also has a nationwide database of properties that are available. InvestorLoft.com is a "source to connect all of the professionals that are needed to execute this transaction--realtor on the buy side, and investors and advisors can go [to the site] to see what's available," Owens says.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.

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