Below are the questions Blue Chip Realty hears most from our clients as they go through the process of leveraging their 401K or IRA to purchase an investment property.
Click the question to open up answers!
If your question isn't covered below, you may submit your own at the bottom of the page...
Are your services for purchasing a property really free?
Yes! We earn a share of the seller's proceeds, usually 2.5%, so we have no need to charge our clients (the buyers) for the advice, analysis and dozens of hours of work we put in to close a deal. You can see a whole list of these services here.
Once you purchase a property, and need a property manager, we do have a fee-based management service we can offer, which is detailed at the bottom half of the same page.
Can I purchase a home for myself to live in with my IRA/401K savings?
No (and yes). The IRS allows you to buy real estate with funds from your IRA/401K for investment purposes only. That means you cannot use the property personally or rent it to a relative of any kind, such as a sibling, uncle or child. However, you can transfer the property into your name as a distribution once you turn 59½ years old.
You'll need a lawyer/facilitator, custodian and non-recourse lender to purchase it. That gets fairly complicated, so find someone that has done this before to guide you. Also note that you can't manage the property personally so you'll need a property manager once you own it.
My partner and I could each withdraw $250K from our 401K and purchase a rental property via a self-directed IRA, but why should we? Its a hassle to buy one and manage, and there's probably an extra form I'll have to file each year with my taxes. Instead, I could just keep the combined $500K in the stock market and if I average a 5% return over 15 years, it'll be worth a bit over $1,000,000. Isn't a "double" good enough?
Yes, a double is good, but is it enough? Or would you rather get a "home run?"
If you leveraged that $500,000 along with a loan to purchase a $875K rental that appreciated the same 5% per year, at the end of 15 years the property would be worth over $1,800,000. Instead of doubling your original $500K, you almost quadrupled it. That's a difference of $800,000 which some folks might call a "home run."
So yes, it takes a little time to find the right home and there's a lot of papers to read and sign, but you can hire a property manager and a great real estate broker to help you with the whole process (we know a good one). Is that few hours of "hassle" now worth an extra $800,000 in retirement? Hope so.
See "The Payoff" section for math details.
My spouse and co-worker say I should keep 100% of my 401(k) in stocks (actually the S&P 500 Index Fund) versus putting half of it in investment property. Give me your best arguments to convince them otherwise.
First, ask them if they are able to double their leverage by borrowing money in a 401(k). Hint: the answer is NO, the IRS won't allow it. Then ask them if you can double your leverage by taking out a loan with a self-directed IRA? The answer is YES, the IRS allows it when purchasing property.
Next, ask them if you invest $200,000 in the market, does your broker (E_Trade, Fidelity, T. Rowe Price) pay down that $200K investment over time? I suspect they'll say "of course not!" which is true. Then ask them if you invest that same $200K into a $400K property, would the renters pay down your $200K over time. At that point they'll probably slap their foreheads and admit, "yes, you would get that all paid back."
The final kicker is what happens in 15 years. If you still owned the stock in the S&P 500 Index Fund and it appreciated 5% per year, it would be worth $416K. That's decent. If the fund paid a 1.9% dividend as they do today, you would earn $7,900 per year. Not bad. However, your rental house would now be worth double that at $832K, and the yearly rent you would receive would likely be around $56,400 a 7x difference versus an S&P 500 dividend. Which would you rather supplement your retirement, $8K per year or $56K per year?
The three components of making huge gains in personal wealth in self-directed IRA with real estate are: 1) The asset can be leveraged with a 45% to 50% loan, thus almost doubling the asset value that the "5% growth" applies to, plus 2) The renters pay your mortgage down to zero, and 3) Once the house is paid off, all the rent accrues to you - and you'll deserve it for being so smart!
These three arguments have won over many spouses and co-workers. Good luck!
Can you help me buy a rental in Neveda?
No. We are licensed throughout the State of California but not elsewhere. The good news is with such a booming economy here in the Golden State, there are a lot of lucrative deals to be had if you know where to look, and we know where to look ;-)
Why not have your 401(k) invest in REIT's versus real estate?
Real Estate Investment Trusts (REIT's) are a great vehicle to invest in real estate through your IRA, 401(k) or regular stock account. Their average increase in value due to cash flow and appreciation ranges from 5 to 9% per year in good years and -6% to +2% in bad years. Because they are so big, they have to spread their investments over a large swath of geographies and types of investments, which leads most to good, though not great, earnings, though still better than the average stock.
Purchasing via a self-directed IRA a student rental in a college town usually has several advantages over REIT's: 1) College towns do not usually have the same dips as other parts of the country during recessions, since kids will still go to college and still need to live somewhere. During a recession, the demand for college is much more inelastic versus demand for fancy cars and wines. 2) The BCR model is to target those "inelastic" students who want off-campus housing and whose parents have saved up for their kid's education for years. If the funds are in a 529 plan, they are usually moved into safer investments, like T-bills, as the child approaches college age. Thus, a sudden recession won't wipe out the kid's college savings and they can still move into a rental and pay market rates. 3) A self-directed IRA can be leveraged, a REIT can't. That alone can account for 40 to 50% more gain than other IRA investments. 4) Over time, the renters will pay off your original investment in the home where the company offering the REIT won't pay you back for your investment in their product.
Bottom line: REIT's are still a compelling investment vehicle, but in a different class than what could be attained via a leveraged investment in a lucrative rental with inelastic tenants paying top-of-market rent.
The home we are looking at, priced at $750K, is being sold by parents of a graduating senior. Since their daughter is living there, the rent is low for her and her 5 friends ($3,750). That's only $625 each. What rent figure should we use in calculating the Price-to-Rental ratio?
Yes, many properties will have rent set under-market when you are buying a rental home. The sellers may not be professional investors and in other cases, may be subsidizing renters they are related to. Thus, don't use "current rent" but "market rent" when calculating the P2R ratio. If you are purchasing a home in a college town, market rent usually ranges from $750 to $850 per student, depending on the area. You'll be able to raise rent at the end of the lease, which is usually in June.
Why don't more banks offer non-recourse loans?
Many "regular" home loans are bundled by banks into packages and sold to institutional investors. The Investors borrow millions of dollars at a very low interest rate (ex. 2 or 2.5%) and earn interest on the bundled mortgages at a higher rate (ex. 4 to 5%). Their profit is the spread between rates. Their risk is that certain borrowers stop paying their mortgage, but the banks have a recourse and can go after other assets of the borrower. This is a very "liquid" market and easy to buy and sell the bundled securities.
Non-recourse loans are not that liquid since there are few investors that want to bundle these higher risk assets, especially since there is no recourse beyond seizing the house if the owner stops paying. It is not a liquid market; and thus, big banks usually don't see it worth their time and effort.
For these reasons, non-recourse loans have a higher loan rate and a shorter repayment period, and are usually a specialty of a few smaller banks. BCR has a list of the top-3 if interested.
For a non-recourse loan, does it really take the advertised 45 to 60 days from application to close-of-escrow?
The fastest Blue Chip Realty has seen a bank close a non-recourse loan was 28 days. They state 45 to 60 days because there is a lot of paperwork to go back and forth with the buyers and sellers, and most customers are not quick at reading, signing, scanning and sending back the materials quickly. If the buyers, sellers, agents and escrow officers are all "on the ball", it is possible to close in 30 or less. Just don't h \old your breathe...
If we get a 20-year non-recourse loan at 6.25%, can we pay it off sooner? It looks like your spreadsheets shows if we get a "lucrative" rental and use the rents to pay down the mortgage a few hundred extra per month, we could have it paid off in about 15 years. Are the banks okay with that?
Yes, the non-recourse lenders are fine with that. BCR highly encourages paying down the loan faster so you can retire earlier If you follow the Blue Chip Model and apply extra rent collected to pay down additional principle each month, you should be able to pay off the property in under 15 years. Some clients are on-target to have their "401K rental" paid off in 13.5 years.
What will our out-of-pocket expenses be to make an invetment? We prefer to pay all the costs out of the 401(k) money we are transferring, versus using our regular bank accounts or credit cards. Is that possible?
Yes, not only is it possible, but it is the only way you are allowed to do it. We have a spreadsheet you can ask for here with all the expected costs and fees to make an investment. Expenses (such as custodial fees, wire transfers, title and documentation fees) are all paid through escrow, which in only allowed to have been funded via transfers from your IRA or 401(k) accounts. That's better for you since it is pre-taxed earnings.
PROPERTY MANAGEMENT QUESTIONS
I like the idea of renting to "inelastic" students (and their parents) because it leads to higher rents and profits, but I'm a tad nervous about renting to these non-adults and worried they could damage the home and not keep it in good condition. How do you recommend preventing that?
This issue is solvable with the following 10-step procedure BCR initiated:
- VETTING: All students are vetted before being accepted to rent, including conversations with every student's parent, employer and previous landlord.
- CAMARADERIE: Groups are chosen based on their camaraderie and history together, which is a good indication they have mature communication skills with each other.
- GUARANTOR: BCR has a parent personally guarantee the monthly rents by signing a Guarantor form. This legal document, along with a one-on-one communication channel with a parent of every renter, is great insurance against missing payments. Since the student knows this, they are also on "high alert" not to cause any trouble.
- PHOTOS: Over 100 photographs are taken of the rental before move-in and kept as a record of the condition of the house. Students sign a form at move-in agreeing to the condition of the property.
- LIABILITY: Blue Chip Realty uses a contract that defines that all students are liable for all rents of the group, and for all damages to the house. Thus, in a 5-person rental, if one student breaks a window, the other four are also liable. What this leads to is the the 4 will "twist the arm" of the trouble-maker and make him/her cover the damages so they don't have to. This has proven to prevent most damages to rental houses before they happen (or at least before they are reported).
- DEPOSITS are kept from each student and need to be replenished immediately if some are used to fix damages.
- PENALTIES: The contract also includes an addendum that the students must sign that assigns an escalating penalty for any noise complaints involving the renters. The first is $400 which comes out of all renters deposits. If there was one person causing the noise, the others would insist that person pay them back their penalty fees or the landlord could arrange it.
- INSPECTIONS: The properties are inspected regularly so any problems can be caught and remedied early.
- MOVE-OUT: Before the renters move out, the property is inspected and compared to the photos from the beginning of the year. If there are any damages, not due to normal wear and tear, they must be remedied before move-out or deposits will be dipped into.
- SIGNATURES: A move-out form is completed and signed by both the student and the property manager and presented to the owner.
Do the students pay rent the whole year or just while they are in classes?
Students pay rent all 12 months of the year. In California, the average is between $750 and $850 per month x 12 months.
What happens if a student decides to transfer or drop out of school before the end of the lease?
First, that student's deposit will cover the first 30 days after they depart. Next, the other students have signed a contract to be repsonsible for "all" the rent, so they have an incentive to replace that tenant ASAP. The good news is that there are often dozens of transfer students joining a university on a monthly basis, so the students should immediately contact their Housing Office and let them aware of a vacancy. Next they should post on the most popular university housing sites, often a Facebook page, to advertise their opening as well as to text their network of friends. A replacement tenant is often found within the 30 day window. If not, the remaining students have to divvy-up and pay their share to cover the missing rent.