Real Estate is a popular investment for IRA’s. This is probably because of the high growth/income potential and the fact that people understand it better than, say, oil and gas leases (with the possible exception being those who live in Houston). There are many ways to add real estate to your self-directed IRA, and I will discuss a few of them here, as well as showing how these investments are valued and a few reminders about things to watch out for.
This is just an introduction. There are other factors to be aware of that are beyond the scope of this article. I am only trying to give you an overview and give you enough information to spark your creativity and broaden your horizons. Do not do anything without consulting your IRA custodian and, if necessary, a real estate lawyer.
The most popular way to do this is to invest in a Real Estate Investment Trust (REIT), This is the most done-for-you solution, but also the one that gives you the lowest return. We will set that one aside for now and concentrate on some others that require a bit more work on your part but offer a greater potential return.
Purchase of Single Family/Multi-family Housing
Probably the most straightforward way to invest in real estate is by buying the housing itself. Remember, though, that you can’t invest in any home that will be used by a disqualified person. Also, you cannot personally guarantee a loan taken out to buy, renovate, repair, or do anything else to an IRA investment. So, this means that any loan you take out for this purpose must be non-recourse.
The objective behind this investment would include both monthly income and longer-term appreciation.
As far as valuation goes, any 2-,3-, or 4-family house is treated the same as a single-family residence (SFR). To value them, you would find recent sales of comparable homes in the area and modify the sales prices as necessary to fit your target property. The process is the same as if you were buying a new residence.
A multi-family residence (MFR) consisting of 5 or more units is considered a commercial property and is valued based on the area “cap rate” (or “capitalization rate”). The cap rate is the rate of return you would receive if you paid all cash for a property…in other words, it is the net income before debt service. It is just cash expenses, not depreciation. This is also called “cash on cash return”.
For example, if you have a 5-family building with apartments each renting for $1,000/mo, your gross income would be 60,000 per year. If your expenses are $35,000/year then your net income would be $25,000. If the cap rate in that area is 10%, the market value of the building would be $250,000 (25,000/.10). If the average cap rate in the area is 8%, the market value of the building would be $312,500 (25,000/.08). Therefore, as the market cap rate declines, the market value of the building increases.
Cap rates vary across the country. In areas where real estate values are higher, notably NY and CA, the market cap rate is lower. They are relatively stable, and tend to run from 4.5% to about 8% across the US.
So, when you are looking at a property, if the cap rate for the building you are looking at is higher than the market cap rate for the area then you have a good deal. To find the cap rate for a given area, just ask a commercial real estate agent or you can find it online, just google “cap rate (city, state)”.
A few things to look out for…
- Make sure to use the actual occupancy when calculating the market value of a building. A seller may try to use pro forma numbers, but if the building is not fully occupied this would be misleading. Always get the current rent roll and P&L.
- There are different cap rates for different classes of property. The better buildings in better areas carry lower cap rates and the “war zone” buildings carry higher cap rates. So, always make sure you know the area where the building is located.
- Make sure the owner has not made promises to the tenants regarding upgrades/rent reductions in the future for which you would be liable.
- Always get an inspection and certified appraisal, and make sure the seller has clear title.
Lending to a Property Owner
There are investors who want to buy or fix up an investment property but don’t have the funds to do so (or who would rather not tie up their cash). There are a number of reasons why they may be looking for a private lender, as opposed to a bank…maybe they already have too many mortgages on other properties, maybe they need the money quickly in an emergency, or maybe they just don’t like banks. In any event, they would rather deal with a private lender. You could step in and lend them the money and get an attractive return without the risk of property ownership.
One thing you have to beware of…never respond to a newspaper ad looking for investors. It is illegal for you to lend money to a stranger if you are not licensed. The laws in this regard are not that strict…you can know the person casually (maybe you met him at church or the PTA). I must repeat here, though, that I am not a lawyer, so am not trying to give legal advice. Just be aware that there are restrictions on the way people can solicit investors and vice versa. You cannot just place an ad in the newspaper saying that you have money to lend unless you are licensed.
If you want to go this route the same due diligence applies as though you were buying the building itself. You have to make sure you go in with your eyes opened. You also have to look at the person you are planning to lend to. What happens if that person is killed or disabled? How are you protected?
There are alternatives to a straight loan agreement. You may not need the income, especially if you are years away from retirement. Maybe some type of equity/share arrangement would work better…or a combination of equity and income. You might ask for a 50% interest in the building, or a 10% ownership in the building and 50% of the monthly income. Maybe with a minimum return guaranteed. In this way you might be able to get a higher return than with just a straight interest rate.
If you do decide to fund someone else’s investment, you have to keep these points in mind:
- Make sure that the property is professionally managed and that there is insurance in place
- Have an established exit strategy. When and how are you going to receive your principal? Maybe a balloon payment or an agreement to sell the property in a certain number of years. You don’t want to reach retirement and have no access to your funds!
- Check the borrower out thoroughly…credit report, criminal record…even if you think you know someone you should check this stuff out…
There is a saying in private money circles… “Show me the return OF my money before you talk about the return ON my money.” Always be sure your investment is protected and you know when you can expect to receive your investment back from the borrower.
You may be better off finding a private loan company that is looking for lenders. These companies have systems in place to protect your investment. They do the due diligence and then present the opportunity to you. They have the experience to save you from the pitfalls involved in lending to others. This is a great alternative for those who are inexperienced and those would rather not get their hands dirty, but still get a good return on their money.
Purchase a Mortgage
This is similar to the structured settlement that we discussed in the last article. Sometimes people sell a property and decide to take back a mortgage rather than requiring the buyer to go to a bank for a mortgage. They may do this for any of a number of reasons…they would rather get a stream of income instead of a lump sum, they need to do it to get the property sold at the price they want, etc.
However, a couple of years down the road their circumstances may change and they may decide they want all of the money immediately. You can purchase the mortgage from them and then you will receive the payments every month. This can be structured to give you a significantly higher return than you could get from a corporate or government bond (or a bank CD).
In this case, though, you are being paid by an individual instead of a company or government entity, and it is backed by real estate. For purposes of this discussion I am assuming that you checked out both the property and the borrower and are satisfied that (1) the borrower can be expected to pay on time, and (2) the property is worth enough that if you have to foreclose you will be able to get your principal back.
We will assume that the property was sold a couple of years ago at $300,000, and the seller took back a mortgage of $290,000 at 6% interest for 15 years (180 payments). The borrower has made 27 payments so far. I checked an amortization schedule and after 27 payments the principal value is $281,677, and the payment amount is $1,738.70.
So (according to the amortization schedule), the present value of the remaining 153 payments is $281, 677 at an interest rate of 6%. But, you want a higher return, say 10%. The easiest way to calculate the amount you would have to pay to get that return is to plug the present value formula into Excel:
PV(rate, # pmts, pmt amt) which is PV (.0083,153,1738.70) The .0083 is the interest rate on a monthly basis (10%/12)
And the result is $150,337.72. So, to get a return of 10% per year you would purchase the mortgage for $150, 337.72.
You could do other things, as well. You could purchase just a portion of the payments; say the first 5 years (60 payments). To do that, you would use the same PV formula but would put “60” in the no. of pmts. This would work if the seller only needed a portion of their money right now.
This would work for any string of payments. If someone sold a business and is collecting payments the same idea would work. You can take this concept and apply it to your own situation. Use your imagination…
These are the most common ways to incorporate real estate into an IRA. In the next article, I will introduce a few others. In the meantime, try to think of ways that the above could work for you…
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