During a prior article discussing retirement income, I mentioned REITs (real estate investment trusts) as a possible source of income. During the past 25 plus years of assisting clients with their investments and taxes, I have had a number of clients tout the benefits of creating rental income from the direct ownership of rental homes. However, generally about two to four years after the conversation on the benefits of direct ownership, I usually hear about the bad tenant or all of the repairs they are having to make.
The use of real estate to create an income stream is a wonderful idea and excellent source of income. There are three primary ways this can be done; properties can be owned directly, through a REIT, or a partnership. While success stories can be shared about each type of ownership, the method best for retirees is a REIT in my opinion.
While direct ownership of real estate can be very profitable and rewarding, it comes with its own set of demands and risks. While I have never been a landlord of residential real estate, I have advised and prepared the tax returns for many over the years who have. Since the benefits of owning real estate and using residences to create income are widely known and often touted in seminars and television programs, I would like to share the demands as well as risks of direct ownership.
First, adding additional real estate always increases the exposure for law suits in the event an accident occurs on the property. Unless the property is segregated into a limited liability company, steps should be taken to insure the property and perhaps add or increase the umbrella liability coverage. Diversification of properties is also difficult to do with direct ownership. Even when loans are used to complete the purchase, most investors are still limited to two or three properties. While using loans to increase the number of properties purchased or just to acquire the first unit, it adds a required fixed monthly payment that may not always be met with rental income.
Just how handy are you? Owning rental property is one sure way to find out just how good of a “Mr. Fix-it” you can be. With every call to a repair person reducing rental profit, most individuals turn to fixing many of the repairs themselves. This works well until the call for a repair comes right in the middle of a Vol’s game or a social event with the spouse. Only when time is available and this type of work is either desirable or enjoyable does this add to the quality of retirement rather than take away from it. But as time goes on, the number of repairs handled by the owner always diminishes due to age, health, and ability, thus forcing the use of professionals.
Rarely is an investor awarded with all exceptional tenants. I am certain the tenant horror stories are numerous and real. One bad tenant can wipe out several years of profit when major repairs have to be completed on the properties. Whether the damage was done by kids, pets, or friends, someone still has to write the check and it is usually the property owner.
Rather than purchasing residential real estate and becoming a property manager, adding select REITs to the portfolio may be a desirable solution. While an investment in a REIT is rarely leveraged, many of the demands of direct ownership disappear when REITs are selected. Before going on, let me warn, not all REITs are equal; thus, homework must be done prior to investing.
Most REITs invest in commercial real estate although there are residential apartment programs. Like any real estate investment, the REIT is not very liquid, thus they are not suitable as the sole solution. Most recommend limiting the REIT investment to twenty percent (20 percent) or less of the investment portfolio. The amount of leverage or loans the REIT is using is a critical consideration as is the type of leases when selecting a REIT for investment. A REIT with moderate loan to value ratios may be reasonable if the leases used are triple net. This means the tenant is responsible for all costs (repairs, maintenance, utilities, taxes, and insurance), thus the REIT only has to meet the mortgage payment and the remaining cash is available for distribution as dividends. Thus REITs can create the income stream without the calls to fix the toilet!
For assistance with insurance, estate planning, and managing investments, contact me at Quality Financial Concepts or one of the other Certified Financial Planners in our area. To continue a personal quest for education, you can also view our learning center on our website, www.goqfc.com. There you will find articles on a variety of topics, on-line seminars, calculators, as well as a host of other free tools.