Rentals (commercial or residential) are a great way to accumulate wealth, snag some tax advantages, get some diversification from the crazy stock markets. But once a person clicks over into retirement phase – are those rentals (along with the tenants and toilets) really the best? For steady income in retirement can you do better by selling that rental and using other financial instruments?
The first thing we need to do is calculate an honest version of the house’s yield using something known as net operating income or NOI. The NOI is a calculation used to analyze the profitability of an income-generating real estate investment. The NOI is equal to revenue from the property minus all reasonably necessary operating expenses for the house. NOI does not include mortgage or debt payments, that’s not an ‘operating expense’ of the rental.
Using a hypothetic rental house (in my area), with a value of $430,000 and rent of $1,800/month. If you subtract
- insurance of $950,
- taxes (in my area of Colorado) of $1,950, and
- reserve 3% for repairs and
- 3% for vacancy for a total of $108 per month
So total operating expenses for our example are $349 a month, which nets our gross rent down to $1,451 per month or $17,412 annual. If you are using a property manager at a normal 10% your NOI drops to $15,252 per year.
The key word above is ‘honest’ – landlords’ kid themselves that ‘this house is never vacant’. Or ‘I’ll do all the upkeep myself.’ If my factors above prove too conservative, so much the better – but the NOI needs to be an honest reflection of the real costs.
This NOI of $17,412 represents 4.05% yield compared to the market value; or 3.55% if you are using a property manager. But can an income seeker do better?
Although it may seem like a foolproof source of income, rental properties may not the best path to create income for your retirement. Not to mention ‘tenants and toilets’ right off, but rentals do need attention. A ‘snowbird’ routine of extended multi-month travel may not lend itself well to collecting rent and generally keeping an eye on your asset. Commercial properties can be more hands off with triple-net rent and longer lease terms – but they have more risk of (long) vacancy at turn-over and expensive repairs (think flat roofs, large HVAC units, etc.).
Again, you can add a property manager to ‘handle all of the hassles’ but this will dimmish your (net) yields by 12 to 15%, AND your repairs will be ‘handled’ at retail costs by your managers – they are busy and have no energy for shopping your fixes/repairs to get great value.
So what choices do we have?
One is a Delaware Statutory Trust or DST. This is a security purchased in a brokerage account that as of this writing is able to accept 1031 exchange real estate dollars (i.e. no capital gains tax or depreciation recapture is paid when you sell the rent home and ‘buy in’) into a certain pool of apartments, Walgreens stores, or old folks homes – that then will pay you monthly dividends that will feel a lot like rent. The yields are in the 4’s perhaps low 5% – but they have very low liquidity, so your money is not accessible to you generally for several years. This needs to be a long term decision.
Moreover, the four-color brochures won’t make much mention of the risks inherent with their batch of real estate, that being the dividends are not in any way guaranteed. So when Covid came round, the Marriott DST’s quit paying dividends, because the hotels weren’t able to operate and kick out rent payments to that DST. If your strip center focused DST gets gutted by Amazon, your net dividends will sink. DST’s are still real estate remember.
The ’A’ word.
If you haven’t looked at modern annuities lately … then you probably don’t know what the latest generation can do for you. Yes they lack liquidity or full access to your account value in the early years – but so does your rental, the DST’s above or REITs, etc. etc.
- principal safe,
- growth tied to stock index, often double-digit credits when the markets do well,
- income guaranteed for life in the 6 to 7.5% range (a key benefit).
The key here is to get the right product that is good at kicking out income … you then compare that to how you feel your rentals will be performing (NOI).
Those letters stand for Charitable Remainder Unit Trust. This is not a new idea, but a little-known idea. Here you ‘donate’ your appreciated real estate to a special trust that does two things – it pays you/spouse income (in the 5 to 6% range generally) for as long as you live; then it gives the ‘remainder’ to a charity of your choosing. This charity can be a church, humane society, or school; but it can also be a family foundation, organized and run by your family for charitable work.
Why do this? One if you have a charitable bent and want to benefit some group or cause – and two taxes benefits dude! The benefits are pretty awesome.
First you get an upfront Income tax deduction of 30 to 50% of the value of the property you shifted into this trust. So, a $1 million strip center yields an income tax deduction of $300,000 to say $450,000. This deduction (check for IRS rule changes that occur from time to time) can be used over 6 years against earned and passive income. Next the income being kicked out of the trust is not 100% income taxed – there are provisions with the IRS as to how ‘charitable’ the trust is written that can result in only part to that income flow recognized on your return.
Lastly, you paid no capital gain tax and no recapture.
The disadvantage is you skewed the legacy away from family towards the charity you choose. So the family won’t be inheriting that strip center at your death.
I won’t discuss REIT’s here as there is no way I know of moving real estate equity into a REIT on a tax favored basis. So why sell real estate then go buy REIT’s with the net cash? The numbers rarely work in your favor.
Moreover, they have been through some tough times lately with regulators clamping down on how the accounting is done, repricing of the assets from year to year, and other practices that were perceived to be a little scamy. And they don’t walk on water, many REIT’s that owned Marriott (type) hotels quit paying dividends during Covid. Many old folks homes REITs are hating life just now and not paying dividends AND tanking in valuations.
In conclusion, rental properties can be an excellent addition to your investment savings while you work, but as you approach retirement, rental properties are just not as efficient kicking out income as several other strategies; and not convenient for many in that phase of life.