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...

6 comments:

Anonymous said...

Dear Mr. Williams:

Self-directed IRAs are about far more than real estate. You can invest in precious metals, private stock, promissory notes, and many other types of investments.

The individual chooses what they want to invest in, or not; self-direction is not for everybody and they must perform their own due diligence.

Many Custodians and Administrators do not provide clients with investment advice, and are prohibited from doing so by regulators.

Regarding fees, it is true that fees for most self-directed accounts are higher - when you compare to self-managed mutual funds. However, compare them to what most investment advisers charge and they can be quite competitive if not attractive.

Last, get your facts straight. You wrote: "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."

First of all, minimum distributions are required to begin by age 70 1/2 for most IRA accounts. However, in a Roth IRA, no minimum distributions are ever required.

Second, while having cash in the account is certainly a good way to manage the required distribution, distributions may also be made in fractional percentages of real property in the case of real estate. Any Custodian or Administrator trustee of an IRA holding real estate will convey to the account holder how this can be done.

Thank you.

Ross Williams said...

"minimum distributions are required to begin by age 70 1/2"

To be very precise, minimum distributions have to happen before April 15th the year after you turn 70 1/2. Someone born in June or earlier will have to make their first withdrawal the April following the year they turn 70.

But someone born in July will not turn 70 1/2 until January of the following year. They won't have to make their first withdrawal until over a year later in April at age 71, 3 months before their 72nd birthday.



"distributions may also be made in fractional percentages of real property in the case of real estate."

In theory. In practice, that is both expensive and difficult. Each year you have to accurately determine the value of the property to the satisfaction of the IRS. You have to pay the normal costs of real estate transactions.

"Self-directed IRAs are about far more than real estate."

The New York Times article I referenced only addresses real estate. That was what I was responding to. But I think the basic point applies to most other potential investments. You are adding costs that will reduce the return relative to whatever extra risk you are taking on. You are better off in a mutual fund. Unless you can afford to gamble with your retirement money.

Drivers Seat said...

I agree with Anonymous' points. In addtion, what is supporting the Dow at 13,000. I would hate to buy into that right now other than dollar cost avg. Sure, it could go up or it can come crashing down. The economy isn't exactly peachy with really bright prospects. However, RE prices are still down and holding pretty steady. They say buy low, sell high.

My money is going to RE right now and not all of it. Yes, I will change my mind when the pendulum swings again. That is being a prudent investor.

If you purchase good rental property it should spin off enough cash flow to provide a healthy return from operations that could cover the minumum distributions when required. Plus you have appreciation in value. If done right, it is like an annuity with ability to appreciate.

I don't understand your forth point. If you have a buy and hold strategy on stocks/bonds your investments would be taxed at the capital gains rate. Thus, a mute point. If you use a stock broker, there could be commissions on both the purchase and sale of stock resulting in a similiar 6% commission. In either case you are paying for the advise.

I have no pony in this race other than being a well educated investor looking for alternative investment strategies to diversify my portfolio. The same due diligence applies to picking a self directed IRA company as in picking a stock broker or mutual fund company or RE agent. There are slippery people all over the place. It is up to each individual to find good help. Hopefully, you have a network of people you trust to provide great referrals for trusted advisors.

Ross Williams said...

" The same due diligence applies to picking a self directed IRA company as in picking a stock broker or mutual fund company or RE agent. There are slippery people all over the place."

Yes there are. But you don't have to be very worried if you are buying index funds from Vanguard, Fidelity and other major mutual fund companies.

"If you purchase good rental property it should spin off enough cash flow to provide a healthy return from operations"

If you buy good dividend paying stock it should provide you with a healthy return from dividends. The problem in both cases is making that selection with any certainty for the long term.

"The economy isn't exactly peachy with really bright prospects."

That depends on your investment horizon. If you are looking out 20+ years, then the current economic situation is a poor indicator of success.


"However, RE prices are still down and holding pretty steady."

If you aren't investing in foreclosures, real estate prices are still high. They are down only when compared to bubble prices.


Cash flowing rental properties remains dicey in most markets. and the nature of the real estate rental market is that when profits are certain, the supply increases and vacancy rates go up. That makes cash flow even more uncertain.

Losing a single month's lost rent will wipe out an 8% annual return. A bad tenant can easily cost you several months rent. Avoiding bad tenants is not always possible, even with good management. But poor management practices will make the problem more frequent.

The rental market is not a passive investment opportunity, its a business. Long range success depends on how well you, or the people you pay, manage the business.

Anonymous said...

"If you buy good dividend paying stock it should provide you with a healthy return from dividends."

Around here rents on a $70K townhome runs about $1K/mo or $12K/yr. Subtract taxes, association fees, etc and the investor receives about $8K net, or about 11% return. What stock has 11% dividends?

Both stock and real estate values vary over time. However, while an individual company can go under and the stock value go to zero, a nice 2 BR townhome is very unlikely to drop to zero value.


"That depends on your investment horizon. If you are looking out 20+ years, then the current economic situation is a poor indicator of success."

That is stockbroker talk. When things are going well they say "buy", when things are going poorly they say "invest for the long term, buy". So look back over the past 10 years... how well has the market done over the decade? Would have done just as well under the mattress.


"Losing a single month's lost rent will wipe out an 8% annual return."

A month of vacancy does not equate to wiping out the annual return. Assume a $70K townhome generates $12K in rent, costs $4K/year to operate, resulting in $8K margin which is an 11% return. Losing 1 month rent reduces the margin from $8K to $7K, which is still a 10% return. Not bad.


Ross Williams said...

If you can get those numbers, then yes real estate works. But you won't get those numbers in most markets for very long.

The monthly payment on a 70K mortgage would be somewhere around $350 per month. How many people pay $1000 for an apartment they can buy for $350? And why is anyone selling it for so little when it will generate several thousand dollars per year in net income?

In addition, you probably won't find a 70K condo with those low association fees. Unless , of course, the developer is still selling new condos and underwrites the condo association with "warranty repairs" to keep the fees low. Which means the fees will start to go up once all the units are sold and the owners have to pay the full costs of maintenance.

I think this is fantasy, which is what scammers prey on. Its too good to be true.