The recent volatility of the stock market may lead some retirement investors to consider investing directly in real estate to balance their portfolios in 2019. Real estate provides balance to retirement funds invested heavily in equities because property tends to move counter to stocks. Since property values rise over the years, real estate can also hedge against inflation, a critical requirement for any retirement investment.
Attractive as it may be, direct investment in real estate can be difficult for retirement investors because of the IRS’ restrictive rules governing individual retirement accounts (IRAs), including:
• When you use a self-directed IRA to invest in real estate, you must also operate it with money from within your IRA. You can’t use your own money to pay the tab when the furnace gives out.
• IRA rules penalize withdrawals made before reaching retirement. You must leave all the income from the property within the IRA or pay penalties and taxes.
Alternatively, there’s the 401(k). You can’t directly invest in real estate by using 401(k) money to buy a rental property, unless you’re self-employed and set up a self-directed 401(k). However, you might be able to loan yourself money from your 401(k) to buy a rental property, if your employer allows personal loans. You’d then repay your 401(k) loan using income from the property. It may be a risky strategy, because leaving or getting terminated from your job could cause your employer to demand immediate repayment of the loan.
If found in violation of any IRA rules, or if you couldn’t repay (or rollover) the 401(k) loan, you’d potentially owe not only income tax but also early withdrawal penalties. Fortunately, there are at least two other real estate investment options that overcome the challenges of directly investing retirement account funds in real estate.
Investing Retirement Funds In Private Mortgage Pools
Private mortgage funds, like the one in my firm, among a myriad of others, pool together loans made to hundreds or even thousands of house flippers to diversify the risk that an individual project, or a single local real estate market, will go south. Underwriting private loans is a complex process that requires a great deal of construction, finance and local real estate knowledge. That makes it important to carefully vet the skill of the manager running a fund before you invest.
Read the investment prospectus carefully to see exactly what the fund’s rules are for lending money. Check the backgrounds of the leadership team: Do they have the knowledge and experience required to make good lending decisions? Fund managers who have a track record of successful flipping or property development in the areas where they lend are apt to have good judgment about which projects are likely to be successful. Make sure properties in the fund’s portfolio are inspected regularly to identify projects that may be going awry and need to be put back on track.
A private lending firm that incorrectly evaluates the profit potential in renovation plans can find itself funding projects that don’t sell for the expected prices. That can lead borrowers to default on their loans. This makes it important to also evaluate what the lender does with nonpaying borrowers: Does it foreclose (which is a lengthy, costly process in many states), or does it work out a solution with the borrower to step in and complete the project in order to save the cost of foreclosure and maintain the project timeline?
As long-term, fixed-rate investments, private mortgage funds don’t offer the liquidity of stocks, or even bonds. Investors in private mortgage funds typically have to wait several months after submitting a redemption request before they can withdraw funds since the capital is invested in active loans that need to be sold and paid off. However, since most retirement account funds need to be invested for many years anyway, the requirement that you commit your funds to the pool for several years may not be a concern.
Investing Retirement Funds In REITs
Real estate investment trusts, or REITs, invest in a cross-section of real estate, including residential, retail, office, industrial and warehouse property, and even mortgage-backed securities. The REIT then pays earnings, capital gains or dividends to investors.
Because they’re publicly traded, REITs are as liquid as stocks and bonds, which is an advantage over direct investment in real estate. However, REIT share prices can experience some of the same volatility as equities. And, when rates rise, which the Fed has indicated may happen again in 2019, REIT values may decline. That happens because investors tend to move toward safer investments in rising rate environments, such as U.S. Treasuries.
REITs are required to distribute their profits, so you can expect to receive regular income payments. REIT dividends are taxable, making it wise to consult a tax professional before investing.
The types of property a REIT invests in can also create risk. A REIT that invests in a single class of real estate — for example, single-family rental properties — can see share prices fall when values for that type of property fall. One way to mitigate that risk is to invest in a REIT EFT, which in turn invests in multiple REITs. Since each of those REITs invests in a different mix of real estate, REIT EFTs avoid the risk that you’re exposed to when you invest in a REIT that invests a single property type.
Balance Is Key To Mitigating Volatility Risk
It’s not surprising that the recent ups and downs of the stock market have retirement investors questioning the wisdom of investing heavily in equities. As a counterweight to equities and a hedge against inflation, real estate can bring much-needed balance to retirement investment portfolios.
Given the difficulties of investing IRA funds directly in real estate, private loan pools, REITs and REIT ETFs may be the more attractive solution for investors seeking diversity in 2019.
- Originally posted on Forbes