Let Real Estate Help Pay for Retirement
Rental housing certainly promises a potentially better return than savings accounts and other fixed-income assets, and an alternative for those weary, or wary, of the stock market.
Investors, however, need to do their homework and thoroughly think through the decision to buy a second home, which may be less lucrative than it might seem at first blush and, like any investment, is not without risk.
"Buying a second home for income is not for everyone. It's the epitome of 'undiversified.' There are many risks and to the uneducated investor, it's probably best to avoid the lure of high returns," said certified financial planner Rick Kahler, president of Kahler Financial Group in Rapid City, S.D.
If the goal is supplementing cash flow, the house should be "free and clear" of any mortgage — unless the investors plan to eventually live there themselves — as there is rarely any cash flow from a mortgaged home, according to Kahler, who has been buying investment properties himself for 30 years.
"If one is to take the plunge, be sure to get some education in the business of buying and renting houses. Yes, it is a business. There is nothing passive about managing real estate," he said. "I have seen more disasters of people who have gone into the rental business without proper preparation."
Financial planners and real estate agents are seeing, at least anecdotally, notable interest in real estate now, given low fixed-income yields and a decline in housing prices as much as 50 percent from pre-recession peaks in some areas. A feeling that the economy is stabilizing may be giving buyers a push as well.
Mortgage applications for second homes and investment properties, however, have held fairly steady for the past four years at 6 percent and 5.5 percent, respectively, according to Mike Fratantoni, vice president of research at the Mortgage Bankers Association and executive director of MBA's Research Institute for Housing America.
He noted, though, that those statistics relate only to mortgage applications and may not fully reflect what's happening in the market, since a quarter of existing home sales are paid with cash.
Home prices nationally are down some 20 percent from their peaks and are starting to rise now, so for those considering buying a second home, he said, this might be a good time, especially since "mortgage rates are about as low as they've ever been."
Certified financial planner Greg Plechner, principal and wealth manager at Modera Wealth Management in Westwood, N.J., has seen more client interest lately in investing in rental property. (Read more: Structuring you portfolio.)
"I think that there are good values to be found. That's not to say that we're at the bottom of the housing market," but clients see rental property as an attractive source of investment yield, given the low rates of return on safe bonds, certificates of deposit and cash, Plechner said.
The broad market is offering investors a chance to buy low and sell high, he said, noting that stocks and bonds have risen dramatically since 2007, while one could argue that real estate remains on sale.
Financial planners warn, however, that many investors don't take into account the expenses, burdens and potential pitfalls of owning investment real estate.
While Kahler and some of his clients own investment properties, he said he generally discourages people from buying them. Investors won't get income from a mortgaged investment property, especially, a single-family home, he said; people should figure that expenses will eat up 50 percent of the rent.
The scenario may be different for those who plan to move into that second home someday, or to use the house for six months a year. In that case, Kahler said, "to buy that home and rent it out is a great thing to do because obviously the tenant is paying the mortgage for you."
As for expenses, investment homeowners may need to replace the water heater, roof, gutters and underground oil tank, repaint the house and resurface the driveway. They'll have a second set of utility, tax and insurance bills. (Read More: Is Your House Underinsured?)
"An investment property has as many demands as your residence does," Plechner said, adding that renters won't take as good care of it as the owner would.
Investors will either have to hire a property management company to respond to tenants' calls, or will have to devote significant time acting as landlord and handling problems themselves.
Investors also need to be careful about not overestimating rental income. When people run the numbers, they often figure the home will be occupied all the time, but there may be many months without tenants, Kahler and Plechner noted. People expecting a 6 percent to 8 percent yield may really see only 4 percent, Plechner said.
Kahler estimates that real estate comprises half of his own net worth. He just paid off his real estate investments in August, meeting his goal of being clear of the mortgages in the year he turned 57½.
In Kahler's part of the country, typical rental income is about 6 percent of the property's value, but expenses can cut that yield to 3 percent.
"You've got to do the numbers and say, 'Does this make sense?'" Kahler said.
A real estate investment trust, on the other hand, can provide investors with a 6.5 percent yield, without all the expenses and personal time involved in a single investment property.
"For most people," Kahler said, "they would be better off buying a REIT than they would be a specific home."
— Dinah Wisenberg Brin