Use Real Estate Equity To Generate Reliable Income For You, Not The Securities Salesman
- How leveraging equity near retirement is a gain for the salesman and a risk for you.
- Why it doesn't make sense to increase your risk profile at an older age.
A reader asks, “I'm 61 nearing retirement and a lot of financial gurus say I should leverage my rental property equity to buy stocks, real estate, etc., for retirement. Is it a good idea?”
There are two answers to that question – the scientific answer and the realistic answer…
The scientific answer is that you should do whatever provides the highest after tax return net of all fees and expenses.
Science says that if leveraging up provides a higher return then it's theoretically a better choice; however, THERE IS A HUGE DIFFERENCE BETWEEN SCIENTIFIC THEORY AND ACTUAL PRACTICE.
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I'm not a big fan of anyone nearing retirement re-leveraging equity to be reinvested in volatile assets (like stocks) for the following reasons…
- Financial leverage is the only form of leverage that cuts both ways. It makes the good times great, and the bad times unbearable.
- Re-leveraging real estate equity will incur lots of fees and expenses creating an immediate loss. This might be good for the salesman in search of commissions pitching the idea, but it all comes out of your pocket, creating a net negative investment return before you ever get out of the starting gate.
- Increased leverage raises your interest carrying costs and debt to equity ration thus increasing your risk of financial failure because you have less room for error. Your additional investments must provide a compounded (not average) return in excess of interest costs and expenses before ever adding a dime to your pocket. Most people lack the investment skill to reliably achieve that goal.
Actual practice shows there are historical time periods where a high leverage strategy would have worked out well, but there are historical time periods where it would have been a miserable failure.
Whether it works to your advantage or not is completely dependent on future asset returns, which is unknowable.
The only thing you know for sure is your risk profile and expenses will increase, but you can't know if your future returns will increase as well (no matter how much the salesman pitches you with historical return evidence to support his ideas).
The whole problem with this strategy is two pronged: future returns are unknowable but your interest costs will absolutely increase.
Unless you can forecast expected returns to exceed interest costs reliably and with a strong degree of confidence, then you have no basis for increasing your risk through leverage.
In fact, I'm hard pressed to think of a circumstance where I would implement such a strategy in my own portfolio.
It generally doesn't make sense to re-leverage your rental real estate equity and increase your risk profile as you near retirement.
Your retirement objective should be sustainable cash flow in excess of expenses that adjusts for inflation – not maximum wealth. Real estate equity provides the former and leverage is targeted for the latter.
The pitch to apply high leverage strategies primarily exist because salesman are highly motivated to earn double commissions both on the mortgage refinance, and on the reinvestment of the proceeds from the refinance into other assets.
It's a double-down for the salesman… but a high risk play for the retiree.
Others may disagree, but that's my two cents worth.
What do you think? Tell us in the comments section below…
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Would there be any scenario that would make sense in moving money from equity in a rental property to the Condo mortgage that has lost a substantail amount in value in todays market, when nearing retirement?
What strategy could be used to reduce cash flow for a Condo that a person is upside down with and has a higher than market percentage on thirty year mortgage?
@Ken – Difficult to answer accurately without a lot more information. Also, this question is heading toward personal financial planning specific to your unique situation where your own adviser would be more appropriate. I try to keep this blog focused on principles and concepts that all my readers can apply as opposed to analyzing specific investments that only interest or apply to one reader. Hope that makes sense…
Todd, you gave the right answer, and you did it in a nice, even, and measured way. I’d say it a bit differently:
God no!!! In this market? Are you nuts? Get yourself away from those “financial gurus” ASAP and get thee to a real retirement specialist while you still have some money left.
Now that that’s out of my system…
It seems there are a lot of salespeople and market “cheerleaders” out there who are playing fast and loose with statistics. And, it seems some of them are more than happy to fleece whomever they can find who will listen to them. Add to that, people have lost a lot of money, and are panicking about being able to retire. That makes them willing to take chances to get “back on track.” This is a recipe for disaster.
Taking greater risk with the hope of making more money is not a good idea. Contrary to the “common wisdom,” risk does NOT equal reward… risk equals risk. Sound strategies equal reward, but they are not as “sexy.”
Todd, I hope your reader will heed your advice.
@Marc – Thanks for your input. I appreciate your addition to the conversation. I’m sorry it took so long to release this comment from the system but I was camping for 8 days with no phone or internet access. Yes, my response was measured and balanced for obvious reasons, but my emotional response was closer to yours.
Todd, you are one of a few financial advisors that talks about real estate besides stocks. I retired on rental income at an early age (42), now going on 68. I still would like to leverage up more just to have something to do. Don’t worry about inflation or cash flow as it increases every year unlike most retirement programs in retirement.
I know exactly what I’m doing with real estate, buying, selling ,rehabbing or keeping for cash flow. Even though, with all my experience, leveraging can be a scary and unpredictable thing. Cash flow is a given, renters aren’t.
Your financial articles are well written, thanks.
Wouldn’t it be tax savvy to leverage the equity in a rental because a loan (cash out) from a mortgage is tax free money? If I’m just collecting rental income on a paid off property, then I pay taxes on that rental income as opposed to taking equity out (tax free) and letting the renter pay off the mortgage where I further increase my tax deductions.
Obviously, I would ensure the rent more than covers the mortgage payments allowing for vacancy, repairs, etc…
Depends on your goals and what happens to the investments you place that capital in. Your reply makes many assumptions that may, or may not, be valid. For example, if the goal is secure, inflation adjusting cash flow that you can never outlive then your scenario doesn’t make sense. If the assets you invested in underperformed net after taxes and fees compared to just leaving it in the property then it wouldn’t be true. If you hit a deflationary decline like 2008-2009 then your losses would be greater by releveraging the equity potentially causing you to risk losing everything and not surviving long enough for values to return. Again, you’re making many assumptions that may or may not be true in the future.
You missed my point. The point being to use the loan $$ to replace the rental income to live off. The would be no taxes and fees. I can collect $10k rent a month from 10 rental properties ($1k each) and pay taxes on that income or simply pull $120K out (tax free) from one property and let the renter pay that back. I would pay refinancing fees which I could also write off in taxes against my other rental income ($9k a month now as $1k would go towards the mortgage loan). I just doubled my monthly income and hedged against inflation as 19K today is certainly worth more than 10 or 30 years from now when the mortgage is paid back. (Fixed rate mortgage of course)
I don’t like that idea at all because of the additional risk introduced. You’re living off the principal value as opposed to the income. That’s like slaughtering the cow because you can enjoy more beef today even though you forsake a lifetime of sweet milk from the animal as a result. If the property declines in value or interest rates rise you could get in trouble; whereas, the income based approach carries no such additional risk.
Once again, you missed the point. Selling the property would be killing the cow.
1. Taking out a FIXED RATE MORTGAGE means my interest rates would NOT rise.
2. Property declining in value will not matter as long as you keep it rented. And YES, with the rent far exceeding the mortgage leaving room for rental rates decreasing if need be and still cover the mortgage. Plus the fact that you would have $120K accessible if the markets did crash. Now you have $4 to buy more houses. Even when the markets tanked people still had to rent! Why? Because nobody was lending money. While cash buyers made out in 2008- 2014, many people simply cannot afford to buy even when a $300K house in 2006 was now $95K. Most didn’t have $95K cash or even $45K cash.
I like your investing ideas, but didn’t YOU say TAXES were one of the biggest retirement problems? I don’t mean to sound argumentative, but I am simply trying to see all angles and so far it seems that “What if’s” are the argument against this strategy. What if your house is washed away & insurance & government doesn’t cover it for 10 years like Katrina in New Orleans? Or an act of terrorism hits it. Then your out 10 years income and ALL your “principle” is gone. What if you pay extra for super flood and terrorism insurance and nothing happens? Then your out 10’s of thousands also and once again you have to trust that the insurance companies will pay in a timely fashion should you make a claim. I am looking at this as a long term idea involving multiple properties.
*** Plus the fact that you would have $120K accessible if the markets did crash. Now you have $4 to buy more houses. <– Should read have "$$" to buy houses, not $4.00. Lol. Sorry
I have a comment for Jack.—I do not believe you are looking at this correctly, with all due respect Jack. You are contemplating taking out a loan on your paid for rental house and you are thinking you are substituting this loan money for income and that to repay this loan with the income you are making from a renter will not be taxed because it is paying off the loan. That is incorrect, assuming I am understanding your logic, as the government will in fact tax the income from the renter regardless of what you are using the income for. My banker will loan me money for my business all day long but when my business makes income I will have to pay taxes on it to pay off the loan. It’s the same thing. Also your income assumption of $1000 per month which you are now making will now be lowered because out of the $1000 you will have to pay interest on the loan.
Better to let any future houses you may buy stand on thier own in terms of loans. If you are a successful landlord, which it appears you are and you have several houses paid for I doubt you would be turned down for a loan to buy another even in the event of another economic downturn.
Hope this helps.
I don’t agree when you say: “The scientific answer is that you should do whatever provides the highest after tax return net of all fees and expenses.”
The scientific answer on whether you should leverage your mortgage would be: it depends on the level of risk you want to take. It you tell you that you can get whatever rate of return you want! It depends on how much debt you want to have (can have – the bank may not allow it!). Personally, as a financial advisor I wouldn’t advise a guy with 61 years old to leverage on its house unless he is very very risk taking. Why? He is 61 years old! If the asset he buys with the leverage (house, or if he is tapping his home equity, stocks, for example) and the assets lose value he would be in a dire condition.
What you must understand is that for every return there is a risk you are taking. The scientific answer for the problem you stated would then be twofold: first, would leveraging up provide an adequate risk/return portfolio and second would you be confortable with that risk/return portfolio?
For most folks (and for what i’ve read you included) the focus is on returns and returns only. The reality (and also the scientific approach) to investing shows that every investment is risky and you can’t really predict a return because it can be either positive or negative (assets may rise or lose value) which is basically the definition of risk. So what the scientific community advises people to do is to have a portfolio with the minimum possible level of risk for the risk/return they desire. But if they desire much return they will also have a lot of risk (they may lose even more than they have!).
Having read the comments I must say you do understand the risk question (particularly the answer to Jack). However, I advise you to reformulate the article because it induces people to focus solely on return (which is the reason why you probably got comments like Jack which fails to see that excessive leverage may lead to wipping out is assets during a deep recession.
So the answer to Jack would be: yes, you may leverage, and on a tax point of view it makes sense but it only does if he is confortable with the level of risk he is taking (during the financial crisis real estate investment trusts with highly leveraged positions were completely wiped out). So Jack, do you feel confortable with the increased leverage? If you can’t rent the real estate during a downturn for how long will you be able to make payments on the mortgage? (that’s risk!)