Take The High Ground | Why real estate should be a part of your retirement portfolio

Real estate is in the news a lot lately. For the past few years it seemed you couldn’t open a newspaper without reading about the meteoric rise of real estate values, and now all of a sudden we’re bombarded with news of the imploding credit markets and real estate on the edge of the abyss. With all the talk of impending doom these days I am getting a lot of calls from people asking if now is really a good time to invest in real estate, especially in their retirement accounts. My answer is a resounding YES! It is always a good time to invest in long-term real estate. In fact, real estate is an essential part of any well diversified retirement portfolio and not an “alternative” asset. The real estate-enhanced portfolio will always be safer than the one concentrated entirely in publicly traded equities. Now let’s look at a few of the reasons why.

First, real estate is a non-correlated asset. This means that real estate values are not subject to the wild gyrations of the broad stock market. In fact real estate frequently goes up in value while the stock market is dropping. From 2000 to 2006 the S&P 500 is off almost 300 points while real estate has skyrocketed.

Cycles in the real estate market are long, generally around ten years, and while there are bursts of appreciation any declines in value tend to be short-lived and, more importantly, very local in nature. Take housing for example, which seems to be getting the most attention these days. Since 1979 nominal housing prices across the U.S. have increased every year, without fail! The U.S. housing market has survived inflation, stagnation, recession, double digit interest rates, unemployment, energy crises, war, terrorist attacks, and stock market booms and busts. Of course there are local markets that have suffered but, apart from for a few exceptions, they all rebounded nicely.

Real estate investments are relatively illiquid in nature, and it is this very nature that provides your retirement portfolio an additional margin of safety. Real estate transactions are highly complex, information flows are inefficient, and each real estate asset has unique characteristics that make it extremely hard to compare with others. (For example, no two buildings can occupy the same location, and we all know the old adage; Location, Location, Location.) Unlike stocks, it is not subject to the emotional mood swings of investors. Investors do have their mood swings to be sure, but there is no broad market panic selling or day trading with real estate, and no ticker symbols or analyst reports on every building we see. This country is filled with extremely wealthy real estate investors who made their fortunes owning properties, not flipping them!

Real estate provides additional diversification, safety, and tremendous long-term appreciation potential. When included in your self directed IRA the benefits are even greater.

• Cash flow and appreciation is tax deferred or tax free. (Depending on the type of retirement account it’s held in.)
• Real estate held inside a self directed IRA is generally exempt from creditors’ claims.
• Investments can be leveraged under certain conditions, significantly increasing returns.
• There isn no need to pursue a complicated and risky 1031 exchange.

Of course it is critical that you properly structure and manage the real estate inside your self directed IRA, or you could jeopardize the tax deferred/tax free nature of your entire IRA account. Engaging in a prohibited transaction is a sure way to trigger this very unfortunate result.

One argument I occasionally hear against real estate in a self directed IRA (too often from accountants) is that you lose some tax deductions associated with real estate. Since the retirement account doesn’t pay tax on current income then there is no deduction for mortgage interest, but for the retirement investor this is an erroneous argument. If you’re investing for retirement you want appreciating assets. You’re not paying income tax inside a self directed IRA and are deferring or eliminating capital gains. Under these circumstances I would happily forgo the mortgage interest tax deduction for a 20%+ total annual return.

So yes, real estate should be a part of every well structured retirement portfolio through the use of self directed IRAs. Now the question is what type of real estate to invest in? Rental houses? Office buildings? Land? Trust deeds? In upcoming discussions I will discuss various real estate asset classes and the why, how, and when of investing in each.