The Challenges of Real Estate Investing

Last week, I discussed some of the advantages of investing in direct real estate for retirement. Of course, there are downsides to it too. Here are some of the challenges would-be real estate investors will face:

You have to have a good credit score and debt/income ratio. Take steps now to improve and protect your credit score and to pay down your debt. Otherwise, you’ll get a higher mortgage rate or may not even be able to qualify for a mortgage at all. If you have the cash, you can purchase real estate without a mortgage but you lose the benefits of leverage.

You need a hefty down payment. A 20% down payment will help you avoid having to pay for PMI (private mortgage insurance) but a 25-30% down payment is often needed to qualify for the best rates on an investment property. If you don’t have that, start saving now. Keep in mind that you’ll also need savings for emergencies after the purchase, including maintenance costs and covering the mortgage during vacancies.

The process can be time consuming and frustrating. Buying direct real estate isn’t as easy as buying a mutual fund. You’ll likely have to spend a lot of time researching and looking at properties and probably won’t get your first, second, or even third choice. (In my case, third time was the charm as I lost my first two to other buyers at the last minute.) Even once you get a signed contract, expect lots of phone calls, emails, and paperwork to complete the transaction.

You’ll need to manage the property or hire someone else to. The first method makes it a business and part-time job. The second is an additional expense that can cut into your returns. I chose the latter as I still had better cash flow after deducting the property management fees than if I invested locally and managed it myself (which would also cost valuable time). Pick your poison.

Rental income isn’t tax efficient. While there are lots of tax breaks from owning direct real estate, the rental income is subject to your ordinary income tax rate, which is higher than the tax on qualified stock dividends. One way to avoid this is to invest more for appreciation while you’re working and in a high tax bracket. Another is to purchase real estate in a self-directed IRA, which can grow to be tax-deferred or tax-free.

Your money is tied up. You can’t generally sell real estate as fast as you can with a stock or mutual fund. However, you can take out a line of credit to borrow against any equity you have. In any case, be sure to have sufficient cash and other investments that you can have quick access to.

There are additional risks. Maintenance costs and vacancies could be higher or rent lower than anticipated. If you decide to sell it, there’s the risk that the sales price could go down as we saw with the decline in real estate prices a few years ago. In that case, leverage can work against you as you can end up not just losing your down payment but also possibly being stuck with an underwater property.

Not dissuaded? Next week, I’ll talk about how I chose my property and what to look for.

 

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