In a recent financial planning case study, a client expresses concern over his growing debt. The fact that the wealthy individual even has debt is puzzling. Despite holding several million dollars in stocks and bonds, as well as rental property, the client’s income is limited. In fact, the client is so short on cash that he is forced to borrow money to cover his living expenses.
Why does this happen? Why is a person with ample wealth forced to borrow money? The answer has to do with the type of wealth – how the individual has invested their money. In this instance, the majority of the client’s investments are either in qualified retirement plans (subject to both taxation at the marginal rate and an early withdrawal penalty), or in real estate. Before we talk about solving the client’s problem, let’s go over real estate as an investment.
Rental Property & Leverage
Real estate can be a great way to build wealth. One of the reasons why real estate can be so profitable is because of leverage. Leverage is a financing instrument. Said simply, an individual can borrow the vast majority of money needed to buy a property. That’s leverage. It magnifies any increase in property value, potentially creating handsome investment returns.
However, leverage is a double-edged sword. Using leverage runs the risk that an investor may owe more money on an investment than the investment is worth. This happens in a down market. Large swaths of people experienced this personally with the housing bubble.
Investment return comes from rental income (dividends) and a rise in property value (capital appreciation), minus the cost of maintaining the property. Sometimes, the result of income relative to expenses can be a good deal for the investor – generating positive cash flow. Other times, the opposite is the case: with the expenses of a particular property looming far too large relative to the income generated.
Rental Property Liquidity, or Lack of It
Another important factor is liquidity. Liquidity measures how fast you can sell your investment. In short, know individual real estate holdings are far more illiquid than any investment traded on any stock exchange. Though a $100,000 real estate investment and a $100,000 stock market investment are equal in value, the stock market investment will enable you to have $100,000 in hand more quickly.
The importance of getting your money back quickly is why liquidity should be considered in addition to investment return. All else being equal, a real estate investment should produce a higher return than a liquid investment because it is illiquid. (Investment nerds call this the illiquidity premium.) That is, if you’re going to be stuck with a particular investment for a longer period of time, that investment should pay you more money for the inconvenience. Alternatively, for those investors who do not need their original investment returned to them immediately, the illiquidity premium offers the opportunity to score a higher investment return.
Creating a Financial Plan involving Rental Property
Back to our case study: In creating a financial plan, we evaluated the investment return of the various rental properties. We found that the investment return on one of the properties was extremely low. This presented us the opportunity to problem solve: by selling this property, the client would be able to not only dump a poor-performing investment, but generate cash to pay off his debt, and facilitate a resource for any future spending needs that does not require an interest charge.
The issue presented in this hypothetical scenario – money tied up in a poor-performing real estate investment – is a real problem faced by financial planning clients today. Why is this the case? While rental properties can be a good investment, people usually do not stop to evaluate the performance of their particular holdings – real estate or otherwise. A thorough analysis of your assets can help determine their value.
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If you’re unsure if your rental property investment is right for you – or would like an analysis of your existing real estate holdings – work with a fee-only financial planner to help you evaluate the performance of your rental properties. Given the subject matter, consider working with an individual who specializes in real estate, has particular real estate expertise, and/or has a licensed real estate broker on their team.
Swensen, D. F. (2009). Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. New York, New York: Free Press.