As your clients near retirement and the picture of their resources become clearer, they will be looking at what they have accumulated to help fund the rest of their lives. Many can count on some combination of retirement, pension, fixed, and other accounts to contribute to their income stream. Many of those in retirement also hold residential real estate investments, and they expect those properties to fund some part of this need. The trouble for the client, and the opportunity for you, is that investment real estate is generally, unconsciously held to a lower standard of contribution than other asset classes.
Real estate investments lack accountability
Let’s use the example of return rates. Retirees generally expect a range of annual returns from assets that can span 4 to 8 percent. That can be measured, and retirees read about these return rates every day. The classic stocks and bonds and mutual funds cannot avoid being held accountable to performance.
On the other hand, very few retirees know exactly what their return rate is on their rental unit. They have a sense of cash flow, making a few hundred dollars a month, or higher amounts for a rental without debt. All this looks good. But what the investor ignores is the real cost of ownership, as well as the larger cost of the periodic capital repairs of $30,000 to $50,000 or more that is never debited against performance. Sure, it’s expensed in the tax return. But when all expenses are counted against all cash flows, the real return of the real estate investment is generally one-half or less of the indices. This is absolutely true for many retirees’ rental properties.
Why smart investors make dumb real estate investments
So why are so many retirees happy with low-performing real estate assets?
- Ignorance is bliss. Even the smartest of real estate investors are blinded by the emotion of this asset class. A West Coast investor owns $15 million worth of investment real estate equity that generates $300,000 per year in cash flow. For most people, $300,000 in cash flow is terrific. But simple math tells you that this represents a 2 percent return on equity — less than a savings account, and with all the risk of unhappy tenants. The worst part is that $300,000 did not take into account the time and cost of the owner and their crew sweeping through the rentals to make repairs. In comparison, investors in mutual funds have experienced a better return rate over time, and they don’t have to replace the toilet of a fund it owns.
- The illusion of safety. With the exception of science fiction movies and certain areas near the Mississippi River, property does not simply disappear. People can see their investment. They can touch it. There is a sense of pride of ownership. Ego plays a role in all this. Retirees see their rental as a safe bet, something that cannot be taken away from them. The irony of this sense of security is that few rental properties are held in some type of asset-protecting entity (e.g., S-Corp, LLC, etc.) that places the retiree and all assets owned subject to claim.
- Bad advice. An investor asked his accountant about a property the investor owned, wondering if the property, with no debt and $20,000 in cash flow, was a good investment. The accountant called the investment property a “cash cow,” saying the investor would be crazy to sell it. His real estate agent confirmed that the investment was good. They focused on the cash flow, and not the $1 million in equity (there’s that 2 percent rate of return again) generating that cash flow. Advisors are well intended, but they typically do not have the tools or experience to properly evaluate real estate investments. For the investor, hearing from a CPA that his investment was a cash cow was like receiving the Good Housekeeping seal of approval.
In the land of the blind, the one-eyed man is king
Right now, you have more insight than most investors, real estate agents, and other advisors about the lost opportunity of real estate investments. Imagine being able to give your clients insight on a decision that could double or triple their income from a real estate investment. An investment generating $20,000 each year can potentially grow to anywhere from $40,000 to $60,000, and multiple properties that generate $50,000 can reach more than $100,000 each year. All that needs to happen is for a client to reposition their asset to better real estate or even a different asset class and perhaps a better allocation. If the client’s objective is income, then the client and advisor should be on the same page. Here is what you can do to help clients make the most of these assets:
- Ask if your clients have rental properties. Many do; your ears may not have been focused in the past on this asset class. While you are at it, get an understanding from your client of the cash flow rate from their real estate that they expect will help fund their goals. You will revisit this later.
- Ask for information to review performance, such as a Schedule E and the current market value of the property. Find a quantitative real estate agent to work with you to create an analysis on a tool called the annual property operating data analysis. CCIM.com is a good source to help you find a professional in your local market. Make sure that all expenses are included in the analysis, to include long-term maintenance reserves.
With the analysis in hand, discuss with your client how their real estate holdings match their needs. Discuss alternatives to reposition their investments to meet or surpass their income needs, including tax-free, tax-deferred, and taxable options.
Going through this process, putting aside emotion, and accounting for all expenses have helped families dramatically improve their retirement position. Yes, this process still works in today’s market, even with the decline in real estate market value. It takes a long time to recover from a bad real estate investment. And too far into it, an investor will never recover from a bad decision.
Rich Arzaga is the founder and CEO of Cornerstone Wealth Management Inc. He can be reached at 925-824-2880 or email@example.com.