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Real estate for retirement...good idea?
'We're close to retirement and thinking of using home equity to buy a rental property. Can it work?'
October 12, 2005: 8:38 AM EDT
By Walter Updegrave, CNN/Money contributing columnist

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NEW YORK (CNN/Money) - My husband is 60 and I am 56. Since house prices are rising so rapidly, we're thinking of taking some of the equity in the condo we own and using it to buy a second property. We'd then rent that one out and use the money to pay off our debts prior to retiring. What are the pros and cons?

-- Carla Gacki, Jacksonville, Florida

Ah, real estate, the miracle investment! It can make you rich and enhance your retirement security. Best of all, even after a five-year spike in values, you can still count on annual gains of 5 percent, maybe even 10 percent or more, over the next few years. At least that's what homeowners who were polled in a recent RBC Capital Markets survey believe.

Maybe it's time for a reality check.

I certainly don't want to rain on real estate's parade. It's been a great investment. And I'm not one of these doom-and-gloomers predicting that house prices are about to fall off a cliff. I'm no more comfortable calling turns in the real estate market than I am in the stock market.

But this I do know: When any investment starts generating the kind of unbridled optimism that real estate does now and tech stocks did before that and junk bonds before that and the Nifty 50 before that, well, you can't help but wonder if the market's getting a little frothy and caution should take precedence over greed.

Looking closely at the idea

So let's take a look at what you propose. You say you're going to use some of the home equity from your condo to buy another one for investment. What you mean, of course, is that you're going to borrow that equity, presumably by taking out a new mortgage or a home equity line of credit.

Either way, you're taking on a new debt on which you will have to make loan payments. By the way, if that loan isn't large enough to cover the purchase of the investment condo, you'll also have to take out a mortgage on the new condo and make payments on that.

Let's look at the pros first. If things work out well, you'll rent out the condo and the cash flow it generates plus appreciation in its value will be more than enough to cover regular expenses such as maintenance and property taxes plus the interest on the loan you took out on your present condo.

In the best case scenario, you'll have an investment that throws off enough cash flow in rent to cover your ongoing expenses -- and, as time goes on, even more -- while the value of your property continues to appreciate. A nice double-whammy return.

But this is hardly a certainly. The rent you can get on the property depends largely on the health of the rental market in your area. If the market for rentals is weak, you may not be able to command a rent high enough to cover ongoing expenses. Which means you would have to kick in some money to cover expenses.

In other words, on a cash flow basis at least, you would be what real estate investors call upside-down: shelling out more than you're taking in. That's not uncommon, particularly in the early years of a rental property.

As for price appreciation, that's not a given either. There's no doubt that over the long term real estate values tend to rise a percentage point or two more than inflation. But after big runups, we have seen periods where prices stagnate or even decline, and sometimes it can take years for them to regain their peaks.

To see how house prices have fared over the past 25 years or so in a variety of markets, check out the price index for Metropolitan Statistical Areas compiled by OFHEO, the federal housing regulator. Note: the figures aren't in dollars, but you can compare the increase in price from one period to the next by calculating the percentage increase or decrease in the index value from one date to another.

At the very least I would consider the possibility that you could end up with a condo that's not throwing off enough money in rent to cover expenses and that is appreciating very slowly in value, or not at all.

What are the odds for success?

So how likely is it you'll see a good outcome vs. a lousy one, or something in between? No one can say for sure, but to get any real sense, you should first do some research.

What will you have to pay for the type of condo you're considering? What sort of rent are such properties getting? What's the demand like? How much will you pay on the loan you use to extract home equity from your present condo? If you've also got to get a mortgage on the investment condo, what sort of rate will you have to pay on that? (Remember, rates are typically one-quarter to a half-percentage point higher on investment properties, maybe even more.)

Then run some numbers. Given the rents you'll likely have coming in, will your property generate cash to you -- or will you dig into your own pocket to cover loan payments and other expenses? I'd run a few different scenarios, an optimistic one, a pessimistic and one in between. Do the same for the property's appreciation prospects.

Don't forget to factor in tax benefits -- property taxes and loan payments are tax-deductible, and you can also deduct depreciation on a rental property. (Remember, though, if you take depreciation deductions and sell for a gain, you'll likely have to pay tax on the "depreciation recapture," or the portion of that gain attributable to depreciation. For details, check out IRS Publication 544: Sales and Dispositons of Assets.)

This may seem like a lot of trouble to go to. But if you want to invest in real estate like a true investor rather than someone just jumping on a fad and hoping for the best, this is the sort of analysis you should be doing, or hiring an account or other financial adviser to do for you. (For more on what you need to consider before becoming a landlord, click here.

Frankly, if your aim is really to pay off your debts prior to retiring, I think you ought to consider a simpler toward that goal: After saving whatever you can in tax-advantaged accounts like 401(k)s and IRAs, put as much money as you can toward your outstanding loans.

Start with high-interest credit card debt first, then work your way down to other personal loans and auto loans. Once you're through there, you can pay off home equity debt if you have it, and finish off by making extra payments to your mortgage.

Granted, there's no big score potential here. But the nice thing is that you can accomplish your goal without taking on yet more debt and without incurring any investment risk.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."  Top of page

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