Owning real estate can be a great diversifier, and is a respectable historical source of return (the last few years notwithstanding). But owning real estate is a particularly valuable investment in retirement. Specifically, real estate can do two things for you in retirement: It can give you a place to live, and it can help provide a steady stream of retirement income for you to live on.
Paying Off Your Home
For most people, the goal is to have their mortgage completely paid off by the time they reach retirement. If you can accomplish this, then your monthly cost of living will probably decrease significantly. That could be the difference between keeping your Social Security check every month or sending it off to your landlord.
If you plan to retire at age 65, then the latest age at which you can enter a 30 year mortgage, make all the payments as scheduled, and have the home paid off on time is age 35. The clock does not lie, and does not change for anyone.
For those who are purchasing their first home later in life, then, you will have to plan on reaching a decision point: You will either have to put off retirement, come up with your mortgage payment from somewhere even after retiring, or pay off your loan sooner.
“I’d be hesitant to pay off my mortgage too soon,” says Thomas Jensen, principal of Vaerdi Financial and a financial planner in Portland, Oregon. His concern: People need to hang on to their cash. Furthermore, mortgage interest is tax deductible – which makes mortgage debt less expensive than other forms of debt. In most cases, Jensen contends, it is better to pay off other debts and keep the mortgage in place, if possible.
Reverse Mortgages in Retirement
For many people, their home will represent their largest single store of wealth. If you’ve got home equity, and you’re over age 62, you can tap that equity for living expenses by taking out a reverse mortgage.
How Reverse Mortgages Work
You pledge your home as collateral to an insurance or investment company. In return, the insurance company will send you either a lump sum or a monthly check. Many retirees opt for a lifetime annuity. That is, the investment company will guarantee you a check each month or each year for the rest of your life, or the life of your spouse, whichever is longer. When the loan becomes due – ideally when you and your spouse have both passed on – your heirs can choose to give up the home, or to repay the investment company in cash plus interest.
Be careful before committing to a reverse mortgage: you could wind up painting your heirs into a corner. If they want to keep the family home, your heirs will need to come up with enough cash to pay off the reverse mortgage. If they can’t, they’ll have to sell the home. However, according to the Federal Housing Authority, if the home value is not enough to pay off the debt, your estate will not be liable for the difference; The FHA covers the shortfall instead. For more information, see the U.S. Department of Housing and Urban Development’s guide to reverse mortgages.
Look carefully at the fine print of any reverse mortgage, though – especially at the circumstances under which a reverse mortgage loan will become due. For example, many plans require the retiree to live in the home. If the retiree undergoes an extensive hospitalization or nursing home stay, that could trigger the loan, and you could potentially lose your home while in the nursing home.
Rental Real Estate in Retirement
Real estate rental income can provide another source of retirement income. If you own some property other than your personal residence, you could potentially rent that property out. Your rental income could provide a steady stream of retirement income for you. What’s more, unlike bond income, this rental income has the potential to increase over time. Moreover, you also have the potential for capital appreciation. Meaning your property’s value could go up. As we know now, there are no guarantees for any particular property. But the long-term appreciation rate for residential real estate, nationwide, has historically been about 3.4 percent, as measured by the Case-Shiller index, which measures the sales price of existing homes from 1987 to 2009. This increase was slightly greater than the rate of inflation, which was 2.9 percent for the same period.
Before you commit to directly owning a rental real estate portfolio, though, keep these points in mind:
- Rental income is not guaranteed. Your property can go vacant, tenants can have trouble paying, or damage or wear and tear can force the property to go unoccupied for a period of time. Have a plan for income if one or more of your properties doesn’t generate a rental income for several months.
- Unexpected repairs happen. Expect the unexpected. Keep a reserve fund to handle things like leaky roofs, burst pipes, and the like.
- Even if you have paid off the mortgage, you will still need to pay property taxes and, for some properties, maintenance and homeowners or condo association dues.
- Not all repairs are tax deductible. Only repairs you make to restore a property to acceptable operating condition so you can collect rent are fully deductible. Any capital improvements or upgrades must be deducted over the life of the property, under MACRS rules.
- Rental income is taxable – unless you own your rental property within a Roth IRA.
What About REITs?
Real Estate Investment Trusts are special companies that invest in real estate assets, and pass at least 90 percent of their rental income on to investors. As such, they can be excellent sources of income, according to Pete Mitchell, a financial advisor in Long Beach, California. Currently, they’re paying about 3 times the yield available on treasury bonds and CDs, and have historically yielded about twice the income available from the S&P 500, according to data from the National Association of Real Estate Investment Trusts.
If you’re in or nearing retirement, you may not want to take on the risk of owning an individual REIT. But you may consider a REIT mutual fund for a small part of your portfolio, to add a bit of sparkle to the income yields available from other investments, such as bonds, bond funds, stocks and annuities.