By Jeff Fullerton
“I’m thinking about taking out a non-recourse loan to invest in some real estate.”
Financial advisors regularly hear these words from self-directed IRA clients who want to build wealth through the acquisition of tangible assets. A wisely curated rental property portfolio offers income potential in the form of short-term rental returns and long-term capital appreciation. Unlike paper investments, which are controlled by the actions of others, well-chosen properties offer investors direct control, making them far different from stocks, bonds and mutual funds.
Is it any wonder that real estate investing is such a hot topic?
Still, there's a downside to real estate investing: Property ownership realities can quickly spiral out of control, becoming pricey boondoggles.
Poor property management, unscreened and unreliable tenants, tough local and state eviction laws and statutes and seriously damaged properties can all dent cash flow. Add to that picture novice investors who are unaware of self-directed IRA or 401(k) investing rules that affect the tax-favored status of their retirement plans, and you have big issues. When properties and neighborhoods haven’t been vetted thoroughly, they can turn into money pits that leave investors reeling.
No one said investing was simple. Yet it doesn’t have to end in disaster for individuals with savvy financial advisors on their side.
Spotting Property Pitfalls
To avoid the potential dangers of poorly chosen properties for long-term investments, you and your clientele need to be cognizant of a few major red flags during the research phase of investing.
First, examine the property’s tenant record. Some places are harder to rent than others and a history with a lot of vacancies or high turnover signals danger. Lousy property management, high crime rates and proximity to busy traffic areas can all contribute to the problem.
A rental property’s ability to attract and retain high-quality tenants is paramount to its success as an investment engine — worthwhile real estate investments produce a stream of reliable income. Without a steady source of rent, investors must dip into their emergency funds, easily depleting them within a few months and leaving a gaping income hole.
A subpar rental record could also be caused by poor management which generally leads to poor cash flow. A history of poor management could translate to a blighted property that costs more to fix than investors can hope to recoup any time soon.
You’ll also want to scrutinize the surrounding area. If the surrounding properties have flat or decreasing values, think twice about investing in the neighborhood. If your client purchases real estate in a high-crime area, he will have to deal with weak tenant demand, poor or no appreciation and tons of unused space — hardly ideal.
5 Steps to a Wise Property Investment
Financial advisors have a duty to steer clients away from less-than-ideal properties and toward options that are bankable. Remember: Lenders want to see investments apt to produce positive cash flow and they’ll pass on loans if they notice red flags.
The process begins with key actions focused on ferreting out unacceptable real estate properties. Counsel your clients to take the following steps to ensure a worthwhile investment:
- Research neighborhood crime statistics.
Safety plays an enormous role in getting and keeping dependable tenants. Research crime rates and act accordingly. Rely on a trustworthy source — MyLocalCrime, for instance — offers up-to-date information on all local crimes committed in the area. The site offers an interactive map so you can see exactly where crimes happened, as well as the types that occurred. Ask yourself whether the crimes would stop you from renting there. If the answer is “yes,” take a pass.
- Obtain accurate data on rental rates and property costs.
Investors in real estate should be prepared to maintain their properties while still enjoying a stream of rental income. Data on a neighborhood’s average rental rates will help determine whether a property is worth the long-term investment. Determine a property’s operating expense percentage by dividing the monthly expenses by the monthly rent. The resulting figure should ideally fall between 37.5 and 45 percent. Otherwise, the property may not have enough cash flow to support debt and produce the income you expect.
- Pick the best possible property management company.
Your clients already have busy lives; do they really want to add another 24/7 job as landlord? Many property investors wish to avoid the hassles inherent in rent collection, tenant screening, property maintenance, contract management, etc., so they turn to property managers.
Good property management companies will take on all the unforgiving and unpleasant tasks inherent in working with tenants. Yes, their fees may amount to as much as 10 percent of each month’s rent, but peace of mind tends to usurp a modest income loss.
- Review neighborhood comps.
Research begets success. Find as much information as possible on comparable properties for sale and those that recently sold in the general area. Do some digging, and really invest some time in this step.
Make sure to avoid purchasing the finest property in the area, though. This is an investment, not a family home. The No. 1 mistake real estate investors can make is overpaying for a property — it simply doesn’t make sense to own the most expensive building on the block.
- Check surrounding schools’ reputations.
Excellent school districts are magnets for dependable tenants with families. Even if you aren’t familiar with a particular area, you can uncover data on test scores, graduation rates and student-teacher ratios on sites such as Schooldigger and GreatSchools.
Assisting clients as they navigate the realities of real estate investing takes time but can produce incredible returns. Like any investment vehicle, properties need to be scrutinized upfront and continuously monitored. Real estate can be a great recipe for wealth building; it just requires due diligence mixed with a dash of responsible fiscal mentoring.
Jeff Fullerton is the president at First Western Federal Savings Bank, specializing on customized lending on IRA non recourse loans.