Advantages of Real Estate in a Self-Directed IRA

A great way to take advantage of Real Estate in a self directed IRA is through Fractional Ownership.  Fractional ownership is a type of situation where multiple investors pool together their funds to make one larger purchase.  For Example:

Joe and 4 of his friends each invest $50,000 from their self directed IRAs to buy a $250,000 4-flat rental property.  Now Joe and his friends each own a 20% interest in a cash flow property.   By pooling together funds and buying properties for cash there is no dilution of returns.

Real Estate is a logical addition to many retirement portfolios for 4 key reasons.

1)       It is totally transparent.

• Real Estate is a tangible asset and is not subject to the same volatility or vagary many traditional Wall Street products are.

2)      It offers strong cash flow

• Many income properties are generating between an 8% and 10% annual cash return

3)      It can be acquired at bargain prices

• With many landlords needing to liquidate properties, today’s market offers great opportunity to acquire real estate at below-market prices

4)      It acts as a hedge against inflation

• With the fear of inflation looming over the economy, real estate has always acted as a hedge and performed well in times of high inflation

In today’s uncertain economic times, having a portion of your retirement invested in Real Estate will give you greater diversification and greater returns.

How Should You Invest For Retirement Today?

A lot of people are struggling with how to invest for their retirement.  I have had clients come to me and say that their retirement fund has been set back 10 years.  They don’t want to work an extra 5 years to re-fund their retirement and are looking for a better way of doing things.  I often explain to them how they can use a portion of their retirement funds to invest directly into real estate and bypass Wall Street by  using a self directed IRA.

The first concern my clients have is, “I checked with the company that services my IRA and they won’t let me buy real estate.  I can only hold stocks, bonds and mutual funds.”  Most of your typical brokerages will not let you hold Real Estate.  Real Estate is considered an “alternative asset” when it comes to retirement accounts.  There is a special “Self Directed IRA” which is designed to hold alternative assets; primarily real estate.  Not many brokerages offer these types of accounts because they can’t make commission off of anything which isn’t a typical Wall Street product.  There are several very good brokerages which offer Self-Directed IRAs for real estate.

Keep in mind that opening a Self-Directed IRA does not mean you have to close your current IRA.  You can transfer as much or as little as you want to your new account.  For Example, if you have $500,000 in a traditional IRA at XYZ brokerage and you want to invest  $150,000 in real estate, you can just leave the other $350,000 at XYZ brokerage and maintain your current assets.  However, if you rolled your entire IRA over to a Self-Directed IRA you can still own all the traditional assets you’d like.  A self directed IRA has all of the features of a traditional IRA with the added ability to hold alternative assets.

Everyone knows that the closer you get to retirement the less risk should be in your portfolio.  Depending on your current needs, you may be looking for long term appreciation or immediate cash flow from a rental property.  Working with a good Real Estate Broker and attorney you can clearly define your objective and find a property that meets your needs.  Owning cash-flow property in an IRA offers a great stream of revenue which often times can create better cash flow than an annuity or stock dividends.   Just like a traditional IRA, all appreciation and cash flow are tax deferred.   Always work closely with the company servicing your Self Directed IRA to ensure compliance during the transaction.  If the transaction does not comply with the self Directed IRA requirements it is possible you will lose the tax deferral as well as incur an early tax liability.  Due Diligence is the name of the game.

Why Real Estate Needs To Be a Part of Your Investment Portfolio in Today’s Market

Traditionally, a “diversified” portfolio has always included corporate stocks and bonds, bank instruments, cash equivalents and government debt.  In today’s changing and turbulent market an investor holding these assets is assuming a greater risk due to challenging fundamentals as well as mandated policies and precedents.

Let’s look at these investment products and see how they are affected by today’s financial climate.

Stocks:  In recent years the market has witnessed many companies, which were considered to be titans of their industry, brought to their knees by debt, mismanagement and cumbersome legislation.  Almost every sector of the economy has been hit.  Legislation is being passed regulating many of today’s industries.  Heads of companies have been unilaterally replaced and compensation and budgets overseen by forces outside of the companies.  These precedents have left a bitter taste in the mouth of many investors and have forced many to recognize the increased risk of any publicly traded company being negatively impacted by increased regulation and oversight.  Furthermore, there is greater pressure for companies to lower their dividends to either remain competitive or to cope with changing market forces.  This is an increased risk for those holding stocks for cash flow.  These precedents have created an element of risk which previously did not exist when investing in stocks.

Corporate Bonds:  The bankruptcy of GM has set a horrific precedent.  The priority of debt was unilaterally changed, which resulted in significant and unwarranted losses for the bond holders.  Based upon this precedent, there is a greater risk in owning corporate bonds.  There is no longer any assurance that the priority of bond holders will not be unilaterally usurped by overzealous government interference.  This is an element or risk which did not previously exist when investing in bonds.

Bank Instruments and Cash:  In light of the failure of many banks over the past few years, the FDIC has raised their level of insurance to $250,000.  The government is currently watching hundreds of banks across the country for fear they are or will soon become insolvent.  As account holders of IndyMac and many other institutions experienced upon insolvency, any money on deposit over the FDIC limit was lost.   Furthermore, given the level the federal government is borrowing and spending, there is a greater chance of significant inflation which would devalue cash holdings.  There is also risk of being locked into a bank instrument, such as a C.D, at a rate below inflation.  These factors result in an element of risk which did not previously exist when holding cash on deposit or holding bank instruments.

Government Debt:  The federal government is currently indebted at an all time record high.  It is spending far more than it is taking in.  It is also projected that it will continue to increase its spending and will most likely see its revenues go down as a result of higher unemployment and lower tax revenue.  If the federal government were a company on the Nasdaq, it probably would have already been taken over and restructured.  Does that sound like a company you’d like to buy debt from?  While it is not realistic to say the government will unilaterally stop honoring its bonds, it is also not realistic to say that there is not an increased element of risk investing in government debt.

Based upon all of the recent changes and trends plaguing today’s financial products, a new investment strategy is needed which minimizes new fundamental risk and provides strong capital preservation and passive cash flow.  This strategy needs to be heavily weighted in products which are fully backed by hard assets.  There are only two investment products which can be combined to create such a strategy:  Precious Metals and Income Producing Real Estate.

Precious Metals:  Gold and other metals have always been an excellent hedge against inflation and perform well in times of economic uncertainty due to their tangibility and global demand.  Given the vagaries of the markets and potential risk of inflation, precious metals are a prudent investment in today’s financial climate.  Precious Metals are a superior alternative to cash holdings or low-interest bank instruments.

Income Producing Real Estate:  Income producing real estate is comprised of apartment buildings, office buildings, retail centers and industrial centers.  Contrary to what many have been hearing in the media, Income Producing Real Estate is one of the best investments available today for the following reasons:

• It is totally transparent.  You know exactly what you are buying.  Many of the financial products on Wall Street today are so complicated very few investors actually know what it is they are buying.  Real estate is 100% tangible and easy to understand.
• It offers strong cash flow.  Investors are routinely getting between 8% and 10% annual cash flow out of their income producing real estate.  This is a tremendous return given the investment is 100% secured by a hard asset – real estate.
• It offers strong appreciation potential.  Prime income producing real estate has always been in demand and has always seen good historic appreciation.  With what is happening on wall street you may see many investors turning back to real estate, driving appreciation up further.
• It can be acquired at bargain prices.  Since very few buyers can get sufficient financing today, investors with cash can drive the best deals.  Also, there is a price point between $1-5 Million where a property is too large for an individual investor to purchase (who otherwise cannot get financing) and too small to be on the radar of the larger institutional investors.  This has created a shortage of buyers for properties in this price point.  This lack of buyers combined with the strength of a cash offer makes today’s climate perfect for acquiring income producing real estate at bargain prices.
• It offers tax shelter through depreciation.  Since investment real estate can be depreciated, those who own it personally can offset their income and realize a tax benefit.  No other investment offers this benefit.
• It offers tax deferral through Self Directed IRAs and 1031 Exchanges.  Real estate can be held in a self directed IRA.  All cash flow can accumulate tax deferred, making the returns that much more significant.  Also, for real estate which is held personally, there is a 1031 Exchange which allows you to sell a property and roll the proceeds over into another similar investment without having to pay any tax at that time.  The taxes are deferred until you would cash out of the real estate down the road.
• Investors can participate passively with no debt.  There is a concept called Fractional Ownership where individual investors can purchase a fractional interest in a piece of income producing real estate.  They can do this personally or through a self directed IRA.  Instead of having to raise $3million to purchase a property, 30 investors would each invest $100,000 and own a 1/30^th interest in the building.  These Fractional Ownership products are designed to be 100% passive meaning there are professional managers responsible for the day to day operations of the building.  This allows you to diversify your portfolio with income producing real estate in a passive manner.  Also, since the investors own the property outright with no debt, the investment is inherently secure.

With all of the factors plaguing corporate stocks and bonds, bank instruments, cash equivalents and government debt, a new strategy of alternative investment is required to preserve and grow your wealth in this market.  The two assets which are paramount to this are Precious Metals and Income Producing Real Estate.

The dirty little secret about real estate taxes and how they work

The mechanics behind real estate taxes are a mystery to many and I hope to offer some clarification.

Real Estate taxes, believe it or not, are not strictly calculated on what your house is worth.  I know, it’s crazy.  Follow me on this one.

Real estate taxes are somewhat unique in the way they are calculated.  We all are used to paying many types of taxes.  The two most common taxes are sales tax and income tax.  These are fairly easy to calculate because they are just a percentage of what you bought or a percentage of your adjusted gross income.  If sales tax is 9%, you know you will pay $9 in tax on your $100 purchase.

Real estate taxes are a different animal.  Your real estate taxes go to the county government which then distributes the money to the school districts, townships and etc.  While the state government makes its money on sales tax and the federal government makes its money on income tax, the county makes its money on real estate tax. 

Every year the local taxing bodies put together budgets for their annual operations and then the County  divides up that amount among all the properties.  Let’s assume the County needs to raise $6,750,000 this year.  If there are 1,000 properties in the County it would be easy to say each property will need to pay $6,750.  however, some properties are worth more than others so it wouldn’t be fair to charge each property a flat amount.

This is where property assessments come in.  The county needs to figure out what every property is worth to make sure that it pays its fair share of the taxes.  The county assessor (or township assessor, depending on which county you live in) will assess your property at 1/3 of market value.  Assessments are broken into two parts, value of the land and value of the structure.  So if your house is worth $300,000 (which is the value of your land plus your structure) your assessed value would be $100,000.  Now that every parcel has an assessed value, the county adds them all together to figure out what all the property in the county is worth.  In Portfolio County, which is a very small, imaginary county, the total assessed value of all the property is $100,000,000. (Keep in mind that the total assessed value is 1/3 of market value, so the total market value of the property is $300,000,000.)  After exhaustive board meetings, Portfolio County determines that it needs to raise $6,750,000 in real estate taxes to meet its budgets.  Portfolio County then comes up with a multiplier to get the money it needs out of all the real estate.  The multiplier is calculated by taking the amount of money needed, $6,750,000, and dividing it by the total assessed value of the real estate in the County, $100,000,000.  This leaves us with a multiplier of .0675 or 6.75%. 

Now any parcel can have its real estate taxes calculated.  A large property with an assessed value of $250,000 will pay $16,875 (6.75%) whereas a home with a $40,000 assessed value will only pay $2,700. 

Now we get to the heart of the matter.  How can my assessed value stay the same or go down while my tax bill goes up?!  I’m glad you asked!  Let’s look at an example:

In 2006, Joe’s house in Portfolio County had an assessed value of $125,000 and he paid $8,437.50 in real estate taxes.  In 2007, Portfolio County had a lot of road work they had to do and needed more money for their budget.  Instead of needing the $6,750,000 they did in 2006, they needed $9,000,000 in 2007.  So what the county did was increased the multiplier to raise enough tax revenue.  The new multiplier for 2007 was now .09 or 9%.  So even thought Joe’s 2007 assessed value stayed the same at $125,000, it was multiplied by 9%, resulting in an $11,250 tax bill, a $2,812.50 increase from 2006.

Even assuming Joe challenged his assessed value and was able to get it reduced to $100,000 in 2007, at the 9% multiplier, he still would have paid $9,000 in real estate taxes, an increase from 2006.

The main factor which drives how much you will pay in real estate taxes is HOW MUCH MONEY THE COUNTY NEEDS TO RAISE, not how much your house is worth or its assessed value.  If everyone had their assessed value reduced by 50%, their taxes would stay the same since the county still needs the same amount of money.  All the county would do is double its multiplier.  Long story short, real estate taxes are driven by how much money the county needs to raise, not necessarily your assessed value.

Even though challenging assessed value will not ensure that you pay lower real estate taxes, it will certainly result in you paying less than you otherwise would have had you not challenged them at all.

Why Good Deals Go Bad. Debt.

I read a very interesting article by Alby Gallun of Crain’s Chicago Business entitled “General Growth Blames Credit Crisis, Not Shopping Slowdown.” The full article can be found here.

General Growth is a Chicago based company which owns large shopping malls. Some of their flagship properties are Water Tower Place, Oak Brook shopping center and Northbrook Court.

This Thursday, General Growth filed for bankruptcy. Most hearing this news would think, “Well of course, with the economy the way it is, mall owners must not be collecting rent.” Surprisingly, collecting rent hasn’t been General Growth’s problem. Its problem is “its inability to refinance billions of dollars in loans, some of which are already in default. After several months of speculation, the company filed for Chapter 11 bankruptcy protection Thursday.”

Let’s recap. Company owns lots of great properties and is collecting rents. On the surface, everything seems good. But let’s dig a little deeper into their problems.

“The reasons for this (bankruptcy) are unrelated to the performance of the shopping center industry generally,” General Growth CEO Adam Metz wrote in an affidavit filed in U.S. Bankruptcy Court in New York. “Instead, the problem is that virtually every source of commercial real estate financing has dried up, leaving a vastly inadequate supply of credit to meet the demand created by current and upcoming maturities.”

The article also states that “The company’s loan troubles stem from a debt-fueled acquisition spree earlier this decade, capped by its $7.2 billion buyout of Rouse Co. in 2004.”

What General Growth did is borrow money with a quick maturity. The financing they got in 2004 to buy Rouse Co. has come due. In 2004, General Growth figured they would have no problem refinancing this debt. Well, enter 2008 and the credit crisis and any possibility of refinancing $7.2 billion is out the window. Now general growth is between a rock and a hard place. They are in default on this large loan and can’t refinance. They can’t really sell any off their properties because it is unlikely any buyer could get financing. This has left General Growth with the option of bankruptcy.

How many people would think that buying good properties which generate good revenue could still end up in failure? This is the danger that leveraged acquisitions pose. In my opinion, General Growth made 2 fatal mistakes.

1) They assumed that there would always be ample capital available in the credit markets. Those who assume that tomorrow will always be better than today will not be well positioned in the event of a market downturn.

2) They structured highly leveraged acquisitions in the height of the market when prices were high. A company of this magnitude should know that the time to acquire new properties is in a market downturn. Had General Growth preserved their capital and slowed growth earlier in the decade they could have positioned themselves to make significant acquisitions in this down market and avoided the entire situation they are now in.

When trying to figure out why General Growth expanded so much in 2004 it helps to look at Kripsy Kreme. Why did they end up with so many stores before they went under? Because someone was paid a bonus for every store they opened and they flew around the country in their corporate jet opening stores, whether it was in the best interest of the company and its shareholders or not, because they were getting paid to do it. The same mentality applies in large REITs such as General Growth. As an investor, especially in this market, increasing attention needs to be paid to these kinds of internal motivations to new acquisitions. No matter what type of investment you are making, you need to do your due diligence.

What can an investor take away from the mistakes General Growth made?
The best lesson to be learned is to be cautious of debt. Not just the amount of debt, but its term. The reason General Growth got into trouble was not because they were overleveraged but because they had debt they couldn’t refinance. Don’t put yourself in that situation. Short term debt seem great when you get them but if you can’t pay it off or refinance it, it can put you under and cost you significant equity.

As is true with anything, you always learn through mistakes. It is my philosophy that by studying other companies and other investors, I can learn from their mistakes and avoid them myself.

Slow and steady wins the race. Going too fast and being too aggressive can cost you in the long run. Always consider the worst case scenario and do what you can to protect against it. If you take an all-or-nothing position, you run the risk of ending up with nothing.

Maximize your Depreciation Deduction

Most investors utilize the following simple form of depreciation. Jack buys a house for $200,000. The lot is worth $80,000 and the structure is worth $120,000. Jack treats his Depreciation Cost Basis (“DCB”) as the value of the structure, $120,000. He depreciates this cost basis over 27.5 years, resulting in about $4,350 per year to be deducted. Jack is glad that this can help offset some of his rehab expenses.

For his next real estate investment Jack was advised by Portfolio Real Estate Brokerage to calculate his depreciation employing the following techniques:

1) Jack included his closing costs on acquisition excluding any prepaid interest/insurance to his DCB
2) Jack also added his Rehab costs to the DCB
3) Jack was also able to take accelerated depreciation on appropriate items.
He depreciated Appliances and Carpeting over 5 years
He depreciated Landscaping and Paving over 15 years

Now, revisiting the above example, Jack had $2,500 in closing costs and $3,500 in rehab. Using the advice he received from Portfolio Jack was able to add another $6,000 to his 27.5 year DCB, increasing it to $126,000. Additionally, he put $4,000 into new carpet and appliances which he depreciated over 5 years. Jack put in new paving and landscaping at $6,000 which he depreciated over 15 years. Jack’s Depreciation Situation now looks like this:

$126,000 depreciated over 27.5 years = $4,580 per year

$4,000 Appliances and carpet over 5 years = $800 per year

$6,000 pavement/landscaping over 15 years = $400 per year

By properly utilizing Depreciation, Jack was able to go from a potential depreciation deduction of $4,350 per year to a potential depreciation deduction of $5,780, an improvement of $1,430 per year for the first five years.

Whether you are investing in residential or commercial properties, Portfolio Real Estate Brokerage has the sophisticated investment tools you need!

**Please consult a tax advisor before making any decisions on depreciation**

Contact Matthew with Comments/Questions at
Matthew@MyPortfolioRealEstate.com

Those who say Foreclosed Inventory is Stabilizing may be dead wrong.

I came across a very interesting article from the San Francisco Chronicle by Carolyn Said. The title of the article is “Banks aren’t selling many foreclosed homes.” In this article Rick Sharga, Vice President of RealtyTrac, a foreclosure tracking company, was quoted as saying “We believe there are in the neighborhood of 600,000 properties nationwide that banks have repossessed but not put on the market.”

The article further went on to say:
In a recent study, RealtyTrac compared its database of bank-repossessed homes to MLS listings of for-sale homes in four states, including California. It found a significant disparity – only 30 percent of the foreclosures were listed for sale in the Multiple Listing Service. The remainder is known in the industry as “shadow inventory.”

The full article from the San Francisco Chronicle can be found here.

This article is an eye-opener. The banks own so much property that if they were to put it all on the market, supply would so severely outweigh demand that values would plummet even lower than they are now.

This information has significant ramifications. Many people say that once the foreclosures stop that the fire-sale prices will go away and the market will return to some type of reasonable balance. While that is true, it has a flawed assumption. That assumption is that once the foreclosures stop that prices will begin to rebuild. What will trigger a market correction is a successful liquidation of the bank’s inventory of homes. Let me explain. Assuming the banks don’t want any greater market saturation of REO properties, their “shadow inventory” will continue to grow until the foreclosure wave dies out. Once that happens, the banks will continue to pump the market with REO properties. If the foreclosures die off mid 2010, it could still take the banks another 3 years to get rid of their shadow inventory. This constant stream of reo properties could keep prices stagnant, even for several more years. This means that the years of appreciation may be a little further off than the media would like us to think.

What does this mean for investors? This means that it isn’t too late! There will be a steady stream of quality properties at attractive prices coming on market regularly for the indeterminable future. This also means that investors need to be careful. What happens if there is another blowup in the financial markets and the banks are crying insolvent again and the Federal Government has no more money for bailouts? The banks may be FORCED to liquidate their phantom inventory at whatever prices they can get. As I see it now, albeit unlikely, the banks have the ability to flood the market with cheap properties, sending values plummeting even further. While I am optimistic this won’t happen, it reiterates the need to invest cautiously and invest with the facts.

My First Entry

I have started my official Real Estate Blog and will be uploading quality content soon. Stay Tuned.