Helping boomers keep real estate in perspective
Given the red hot ardor for property that has been showered on real estate markets nationwide, financial advisors say it’s necessary to bring a dose of reality to baby boomers’ dreams and they are offering practical guidance to do just that.
There are a number of steps that an advisor needs to take to help a client make a wise decision, says Diane Pearson, a certified financial planner with Legend Financial, Pittsburgh.
While doing a review, one point should be to examine a client’s cash flow needs, says Pearson. For instance, an advisor needs to help a boomer client determine whether to focus on paying down a mortgage or investing the money elsewhere, she says. And to do this, both short- and long-term considerations need to be factored in, Pearson continues.
In the case of younger boomers, a planner needs to help clients decide whether to take out a piggyback loan to avoid paying private mortgage insurance, according to Pearson. A piggyback loan involves borrowing the amount needed for the down payment.
For younger boomers, this could help them make a purchase without depleting emergency funds, she says, but a planner must help clients to evaluate such a choice carefully.
A basic question you need to ask a client is ‘how much house can you afford to buy?’ says Michael Kitces, a certified financial planner and director of financial planning with Pinnacle Advisory Group, Columbia, Md.
The advice will differ depending on whether the property is a home, a residential or commercial investment property, he adds.
For a property that is going to be a client’s home, an owner can view it two ways: as a home that is also an investment or as an investment that one happens to live in, according to Kitces. However, he adds that “virtually none” of his clients look at their home in the latter way.
So, as a planner, he says he covers points including: the security it provides, whether it fits family needs and, if there are children, whether it is in a good school district.
If the property a client is considering is an investment property, it raises another set of questions, Kitces says. Among the issues an advisor must review with a client, he says, is whether a reasonable rent is attainable, what vacancy rates will be, the amount of property appreciation, and tax and insurance expenses.
In addition, he adds, one should look at the passive income the property will generate and whether it will be offset by passive losses from other investments.
And, he says a major question that needs to be reviewed with clients is whether there is positive or negative cash flow. That is determined by looking at all the “dollars you are paying out of your pocket” including maintenance costs, mortgage interest and property management costs.
It also includes reviewing “other intangibles” with a client such as what happens if a renter does not make payments and the client becomes a creditor, Kitces says.
The questions a planner must raise regarding financing include whether to pay in cash, whether the client qualifies for a mortgage and, if the client does, what kind of mortgage should be selected.
If you plan to hold a property for five years, then you don’t need a 30-year fixed mortgage, Kitces says. Boomers are more likely to want to pay off a mortgage than younger clients, Kitces says.
A general point that should be discussed, he adds, is that “it is not a foregone conclusion that real estate will appreciate every year.” There is the potential for the real estate market to drop, as it has in the past, Kitces says, and consequently that possibility should be discussed with a client.
Particularly if a property is heavily leveraged, Kitces says the client should know that “leverage swings both ways.”
“There have been a couple of really spectacular years of returns” and clients may assume that will continue, he notes. But, he cautions that an investment needs to be made with “an eye looking forward and not backward.”
The first thing you need to be certain the client understands is that real estate investments can have their own set of risks and that it is also important to have a solid portfolio of traditional investments, says John Gay, a certified financial planner with Frisco Financial Planning, Frisco, Texas.
Issues that should be examined with a client, Gay says, are: whether the property is really a good value, and whether it is going to be held for the long-term or whether a client is going to flip it after a few years.
Positive cash flow is very important if the property is purchased as an investment, Gay says.
Vacancy rates and items such as repairs that may become necessary, utility expenses and other costs also are important, he continues. These questions are relevant for investment properties but also are important when a residence is purchased because it is both a home and an investment, says Gay.
An advisor’s discussion with a client over the type of mortgage depends on the timeline for holding the property, according to Gay. If the timeline is short, an adjustable rate mortgage can be considered, but a fixed rate mortgage may be more appropriate for longer time horizons, he adds. Full financing of a property may help avoid private mortgage insurance which is a “good thing,” he says. But he says he likes to encourage clients to have at least a 10% stake in a property.
If a client wants to invest in raw land, Gay recommends that an expert in that area of real estate be contacted because it “is pretty risky if you don’t know what you are doing.”
A basic question you need to ask a client is ‘how much house can you afford to buy?’
‘Leverage swings both ways’
Real Estate Checklist
üIs cash flow positive?
üIs avoiding private mortgage insurance worth full financing?
üDon’t assume real estate will continue to appreciate at the recent scorching pace.
üWhat if a tenant falls behind on rent?
üWhat is a client’s time horizon?