When it comes to retirement planning, there’s keen interest in stocks, bonds and cash, but there’s another asset that has the potential to outperform them all in the long run, and that’s rental real estate. No, rental real estate isn’t for everyone, but if you understand what it is you’re getting into, the payoff can be generous.

Why invest in rental real estate now – isn’t the market bad?

rental real estateThere might be some hesitation about the idea of investing in rental real estate—the market remains weak in many locations. However, down markets are usually the perfect time to begin investing in any asset. With prices down at least 20% to 50% or more from the market top five years ago, much of the risk of owning property has been cleared out. But there are other reasons:

  1. Stocks are looking a bit wobbly in the face of a fire hose of bad news
  2. Interest bearing investments are paying close to nothing
  3. But those same low interest rates also mean low mortgage rates
  4. House prices have fallen significantly, creating bargains everywhere
  5. Lower property values can also mean lower property taxes
  6. The are more foreclosures than there have been in a human lifetime, creating even more buying opportunities
  7. Fewer people buying means a bigger pool of potential tenants

Rental real estate as a retirement investment

Whether it’s held in a retirement account or as a standalone investment outside, rental real estate can be a perfect addition to your overall retirement planning. First, the mortgages used to purchase rental property are self-extinguishing—all you have to do is make your monthly payments and in due time the loan will disappear. And with rentals, your tenants will pay that for you. Another advantage is price appreciation. Despite the recent decline in property values, the long term trend in real estate is up. With population growth and the general condition of at least gentle inflation, real estate is all but guaranteed to rise in value over time. The combination of a) mortgage amortization and 2) gradual property appreciation can be a winning combination for retirement planning. Both are a long term process, but that’s exactly what retirement planning is.

How to invest in rental real estate

You can invest in rental real estate either indirectly, through professionally managed trusts, or through direct ownership of the property itself. The easier way by far to hold real estate in a retirement account is through real estate investment trusts, also known as REITs. They trade like mutual funds, which not only means that you’ll be spared the job of actively managing property, but they also pay dividends and enable you to diversify across many properties. In addition, you can find REITs that invest in different sectors of the real estate market, such as shopping centers, office buildings or apartments. Of course, you may choose the direct route of owning rental property yourself. Your ability to diversify will be restricted if you do, but a well chosen, well located and expertly managed rental property can be one of the best investments imaginable. It’s complicated, but you can even hold real estate in your IRA or Roth IRA accountas long as it’s purchased with funds provided from the retirement account itself.

Buying rental real estate directly

If you decide to buy rental real estate directly, understand that you’ll be taking on all the responsibilities of a landlord. Once you buy the property, you’ll need to maintain it, find tenants, manage the property’s income and expenses, fix what’s broken and—eventually—find new tenants as you need to. If that prospect doesn’t scare you off, understand that the most critical aspect of success in rental real estate is buying the right property. There are a few things to keep in mind with that:

Location, location, location

You’ve probably heard this before—it’s referred to as “the three rules of real estate”, and for good reason. Any property purchased needs to be located in an area that’s likely to increase in value. That can mean that the property is either located in an area likely to experience steady overall growth, redevelopment (older areas) or is in an area likely to experience strong employment growth. Sometimes location can even be enhanced by building moratoriums, meaning that new housing stock won’t be coming on line which can push the values of existing properties higher.

Know the market

Any rental property you want to purchase should be located in an area you’re very familiar with. That means not just knowledge of the general environment, but also of the market trends in the area, including and especially the rental market. If you’re weak in this area, you can overcome it by getting to know a couple of local real estate appraisers. Never invest in an area you know nothing about.

Make sure the property is structurally sound

Broken windows or a bad paint job can easily be overcome, but a cracked foundation or location in a flood plain are different issues entirely. Be sure to have any property you’re considering thoroughly inspected by a home inspector and, if necessary, a structural engineer.

Buy below market

In a strong market this could be a problem, but with the market as it’s been recently the job is much easier. Properties have a value range, say $180,000 to $200,000, rather than a specific price. You want to buy at the lower end of that range—lower if possible. The less you pay for the property the less risk you’re taking on. Again, getting to know some local appraisers can make this job so much easier.

Rent income should cover the house payment, plus a few extras

At a minimum, the reasonably expected market rent should be sufficient to cover the mortgage payment, property taxes and insurance. It should also provide a cushion for routine repairs and maintenance, as well as an allowance for vacancies between tenants. The idea is to make the property self-sustaining, and to prevent you from subsidizing your tenants.

Be ready to get your hands dirty

If you own your own home, you already know that houses can be a lot of work, and this will be magnified by having tenants in the property. You can hire others to do the work for you, but this will lower your return on investment and may even cause you to lose money. You should be prepared to do at least basic repairs to your rental property as a way of saving money. Direct ownership of rental real estate is not a passive investment, but if you’re looking for an asset that will provide either a large nest egg at retirement (by selling the property) or a steady income (once the mortgage is paid off), this is one of the very best investments available.

Photo by Ian Muttoo via Flickr

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