Money Management and the Economy

Friday, April 20, 2012

Self-Directed Real Estate IRA's the New Scam?

You aren't smarter than the market. It really is that simple.

You know the marketing folks have been out talking when the New York Times does a fluff story on some new way to make more money with your investments. So watch out for the new scam promoted by the same media advisers who told you a few years ago to buy the most expensive house a lender would finance.

Paul Sullivan story is about people'e successful investment of their retirement money in real estate using a self-directed IRA. He provides us with several "success stories".  Of course they are all recent converters to this idea and, not surprising, all but one of the people whose story Sullivan tells are also in real estate sales.

The problem isn't really Paul Sullivan. Its that there is no one who makes money by digging out the horror stories from people who invested their retirement funds in real estate at the height of the housing bubble. There aren't any public relations firms devoted to debunking exotic investments so long as they remain exotic.

There are, in fact, several problems with self-directed IRA's.

The first problem is fees. They are typically far higher than for standard actively managed investment funds. So if you are following the standard advice to look for a low fee mutual fund, this is the opposite. These are an ongoing cost that cuts into any return you receive.

The second problem is lack of diversification of your risk.  During the housing bubble the claim in the media was that there had been a sea-change in valuations of real estate that explained the almost nationwide appreciation in prices. It turned out its was just a bubble. Its likely any future increases in prices are going to be driven by local conditions. So you are betting you bought the right house at the right price. Your investment is tied in up in one property. If prices go up in your area, that's great. But if they don't, you are stuck.

The third problem is liquidity. You can't sell part of the house a little at a time. You will need to sell it all at once. In the meantime you need enough cash in your self-directed IRA to cover any unexpected expenses on the house. If it should need a new roof or other major repair, you can't pay for it out of your own income. While you can borrow on the house, but you can't personally guarantee the loan so you are likely going to pay a substantial premium in interest. When you are 72 and are forced to make minimum distributions, you will need to include the value of the real estate in calculating that amount you take out. Again, this means you have to have enough cash in the account to meet the minimum distribution.

The fourth problem is that real estate does not provide the same investment advantage in an IRA that other investments do. Any appreciation in real estate is normally taxed at the favorable capital gains rate. This means that the tax advantage from holding real estate in your IRA is usually much smaller than for other investments. Its also important to remember you will likely have to pay your real estate agent 6% of the value when you sell.

What this comes down too is that these are VERY high risk investments. You may get a great return, you may suffer a big loss. There are a lot of costs that will cut into any return you do get. Ignore the PR campaigns in the financial media. If you want to gamble, this isn't really the best way to do it. Buy a high risk mutual fund with low fees instead. Keep it simple s...