Upon opening your IRA statement for the month of October 2008, chances are that you have seen your retirement nest egg take a beating of over 27% in one month. You have heard on CNBC and other media outlets that we are currently in a crisis, which analysts describe as worst than the “Great Depression.” The stock market at its current condition is worse than the crash of 1987 (aka “Black Monday”). The United States Secretary of Treasury, Henry Paulson, along with several government bodies have tried to rescue the ailing stock market with multiple remedies, but these efforts have resulted in little change. So what should millions of retirement plan participants do with their nest eggs to alleviate the anguish and take control of their investments?
Before we go any further on the subject of how to take control of your investments, we should review some basic information regarding “individual retirement accounts” established by the government. Investing in retirement for yourself was introduced to the general public in 1974 by the United States government. The purpose of the plan was to allow individuals to supplement their retirement and not just rely on social security. Retirement hopefuls were able to put their IRA’s and 401k’s in investments such as mutual funds, stocks, and bonds. These investments seemed to offer a good range of investment choices with a good range of risk versus tolerance, and also offered diversification to spread out the risk of investing. However, how much does the average person really know about investing in these types of securities?
Most IRA participants know little about how to invest in these securities, because investing in the market is not an exact science. You can study the company’s balance sheet, predict what its potential expected earnings will be, and then come up with a stock price multiple that someone may be willing to pay for in the future. I do not believe that there is more than 10% of individuals who participants in their IRA can come up with this estimate, and even if they can, there is no guarantee that the company will perform to expectation and someone will buy that stock in the future for a higher return. That is why most individuals who save for retirement using an IRA or 401k do so by investing in mutual funds that relies on fund managers to manage the portfolio, and hopefully these fund managers will outperform and get a higher return than individuals can do for themselves. But even these fund managers who are experts can fail. On October 10, 2008, the stock industrial Dow Jones market took a 3000 point swing to the negative to a low of 8,300. That is a drop of about 5,700 points from the Dow Jones high of 14,000 during the previous year on October 10, 2007. Hedge Funds are closing left and right, due to investors asking for the investment back before suffering more loses. If expert fund managers cannot offer a good return to investors, how are individual investors who are saving for their own retirement able to do any better?
One of Warren Buffet’s fundamental investment philosophies is to invest in businesses you understand. Most individuals who are saving for retirement, that are invested in stocks and bonds, do not really understand the business behind the stock ticker symbol. AAPL which is the stock ticker for Apple corporations, and then there is TITN which is the stock ticker for Titan Machinery, INC. Apple we know sales computers, mp3 players called IPod, and cell phones. Titan Machinery, INC makes machines for construction and agricultural areas. Yes, most people may understand the business of Apple, but how many understand the business of TITN (Titan Machinery). To take more control over their retirements, I suggest people take Warren Buffet’s advice and invest in business they do know and understand. They can do so by using a self directed IRA, which allows individuals to invest in a wide range of different investment vehicles. Some of the options that retirement participants can take advantage of in a “self directed IRA” are: accounts receivables, building bonds, contracts for sale, gold bullion, real estate, and of course stocks. Of the choices available in a self directed IRA, real estate is the choice I believe most investors will understand, and that is exactly what they should be investing in their retirement account.
To understand how to invest in real estate using your IRA, we need to understand what a Self Directed IRA is. In 1975, as part of the Employee Retirement Income Security Act of 1974 (ERISA) and the creation of IRAs, self-directed IRAs were permitted. The term “self directed” simply means you, the individual, have complete control over selecting and directing your own IRA. Most individuals do not know that the ERISA only limits investments in two types of vehicle life insurance policies and collectibles (paintings, cars, etc.). So why is it that 95% of the IRA’s are invested in mutual funds, stocks, and bonds? Most IRA holders have their accounts with a custodian, which are generally banks or stock brokers (i.e., Fidelity, Morgan Stanley, Bank of America, etc.), and they only allow IRA holders to buy and sell products that these institutions can make a profit on. These custodians make their money on commissions and portfolio management files, either charging a commission for each trade or collecting a percentage fee for the value of the account each year. The traditional custodians have no interest in telling you that you can invest in other types of assets, because there is nothing to profit from. When you ask these institutions if you can invest in real estate directly, their reply will be “no” or it is not allowed under their management. However we have REIT’s (real estate investment trust) that you can invest in, but you run into the same problems as mention before. These REIT’s offer you no control over the type of real estate you want to purchase, and is still run’d by fund managers that give you an annual prospectus that the size of a dictionary.
In order to invest in real estate with your IRA, you will have to have your account with a custodian that will allow you to do so, such as:
o Pensco Trust Company
o The Entrust Group, Inc
o Fiserv ISS
o Sterling Trust Company
These types of custodians allow you to have check book control over your IRA account and invest in anything you deem worthy as an investment, and as long as the fit into the IRS and ERISA guidelines. They generally make their money on the portfolio account value by charging a small percentage fee. Real estate as an investment is possible in a self directed IRA under the right custodian, because these types of custodians offer you flexibility.
Why is real estate such an ideal investment for the common IRA retirement hopeful? Well if we are employing Warren Buffet’s method of investing in a business we understand, then real estate is an ideal choice as most of us have had direct experience in the real estate industry. Most people living in the United States require housing as a basic need and have continuously strived for the American dream of home ownership. As more immigrants move to the United States and youths move away from their parental home, they will require a shelter over their heads. Real estate has the advantage of providing a steady income, which can help give a good yielding return year after year. For example, if a single family resident home that costs $100,000 to own while rent in the area was averaging $700 a month, this would yield an 8.4% return in cash flow ever year. Real estate also has the opportunity of appreciation and the national average of homes increase in value at an average of 4% a year according to the US Census Bureau. This means that if we took the same $100k home, the value of the home will be worth $122,100 in 5 years and along with your annual cash flow of $8,400 by the fifth year, your cash on cash return would be 38% of the initial $100,000 investment. The example we used shows how real estate can offer a great rate of return, but how secure is it? Well one of the great things about real estate is that it will always have some value, whether it’s in the building or the land itself. Real estate offers regular IRA account holders a possible higher return with moderate risk versus investing in securities that they do not understand.
Real estate does have risk involved, but unlike stocks, bonds, and mutual funds, the risk in real estate can be controlled and is fully comprehendible by almost anyone. Some of the risks involved in real estate are leverage, renters paying the rent, natural hazards, and maintenance. Leverage in real estate is when an individual has to borrow money to complete the purchase of the property, and this is part of the reason why real estate crashed starting in 2006. Credit was too easily given out to borrowers who were not qualified to take on the risk. However, due to the times, lenders have reverted back to the standards of old, requiring a down payment of at least 20% of the home value, verifiable income resources, and a good credit rating by the credit agencies. As an investor in real estate who wants income and appreciation, you will want to put down a good portion of the purchase price in the form of a down payment, if not the whole purchase price, and by doing so, you can avoid the risk of over-leverage. Dealing with renters involves risk of not knowing the ability of the renter’s capabilities to pay the rent on time, but we can solve that issue easily by checking the renter’s credit reports and verifying information on the application that they are good candidates for rental. Natural hazards and disasters can be a type of real estate problem, and although it happens in rare occurrences, there are remedies. First, you can avoid properties in natural hazard zones as these properties have a higher risk associated with them. But if you believe the risk is worth it, you can get property insurance to compensate for the risk of the property being in a natural hazard area. No matter if you buy a property in a natural hazard zone or not you will want to get property insurance for emergencies that may arise from unexpected events, such as fire. One of the last risks of owning real estate as an investment is whether or not the property will be maintained by the renter in keeping the appreciation value up. This is why most landlords request a deposit to protect them from improper care of the estate; investors can also allocate a portion of the monthly rent to go towards maintenance care of the property. The risks associated with real estate are inherent, but they are all, for the most part, under your control, thus it helps moderate your risk which is something securities cannot offer you.
Real estate as an ideal investment does have some limits on how the property can be used, and also some guidelines to follow. These limits or rules for prohibited transactions are outlined in Section 4975 of the Internal Revenue Service (IRS) code. A prohibited transaction is any improper use of the retirement plan by the plan participant or any disqualified person, either directly or indirectly. A disqualified person can be:
o A fiduciary of the plan. This includes yourself, any advisors of the plan, such as the custodian or administrator
o Your spouse
o Lineal ascendants and descendants and their spouses (i.e., parents, children, grandparents)
o A person providing services to the plan
These limits are easily avoidable and your custodian can help determine every investment to make sure these prohibited acts are avoided. Another transaction that is prohibited when owning a property in your IRA is that you cannot directly benefit from the property will it is under the ownership of your IRA. For example let’s say that Bob owned a cabin in Lake Tahoe, California; neither Bob, his spouse, children, nor parents can use the property for a ski trip for one weekend while under the ownership of the IRA. So it is best to keep the property as a separate rental, and avoided any miss use of the IRA real estate.
So hopefully now you are more knowledgeable about using real estate as an investment vehicle to improve your return for your IRA, but how exactly are you going to do it? Well one of the first thing you will have to do is find a custodian that will allow you to invest in real estate. You can consult one of the previously mentioned custodians about setting up an account. After you have transferred or opened your account with the custodian, you can then have some fun shopping for the proper real estate investment for your portfolio with your Real Estate Broker. Once you have found the suitable real estate investment that meets your risk tolerance, and have negotiated the right price with your real estate broker you can instruct your custodian to fill out the check for the property. The custodian will then issue the check that will go to the escrow company that you and the seller have both agreed to use. The title of the property will then be held in your IRA account name. For example if you were using ABC Custodians the title of ownership will read, “ABC Custodians FBO (for the benefit of) John Doe IRA Acct# 12345.” Buying real estate with your IRA is as simple as if you were buying real estate without the IRA; the only difference is how the property is holding ownership. Once the time comes for you to sell or distribute the property you can contact the custodian, and start the process just as if you were selling your own house or distributing from your IRA.
With reliable information, investing for your retirement can be a lot simpler than using stocks, bonds, and mutual funds. Most IRA participants have little or no knowledge of how to best utilize these investment tools, thus finding themselves at a disadvantage during trying times. Real estate is an investment that most people comprehend and recognize because they appreciate the need for housing as a basic necessity. Real estate is also simple to navigate and the risks are manageable as compared to other investments. This type of investment also offers potential income and appreciation that is comparable to higher risk stocks. Real estate investment can be as secure as a government bond yet offer a higher return than would typically be expected. In following Warren Buffet’s advice, it would be advantageous for you to assume more responsibility for your future and invest your IRA in a financial tool that is familiar to you.