How Does Real Estate Fit into Your Financial Plan?

Compared to stocks, bonds and most other investment vehicles, real estate is a highly tangible asset – and an emotional one. We raise our children there, our vacations often revolve around it and it’s our piece of a beach or mountain we love. Nothing in a financial portfolio provides quite the warm feelings that memories and experiences wrapped up in their real estate bring.

That may be why it can be easy to lose sight of the role that real estate should play in our overall financial plan. Depending on the expense and value of real estate holdings, a portfolio can become over-weighted by real estate, creating a possible crimp in your financial plan success.

So how does real estate fit into your financial plan? Here are some questions to consider:

If you have a second home, how do its costs compare to the benefits?

For those who own multiple homes, it might be worth considering paring down the number you own, especially as you approach retirement. The costs associated with home ownership in general – and vacation homes, in particular – can be very high. In some cases, the cost of upkeep can negate the benefits of owning.  Depending on location, vacation homes may have high property taxes, higher than normal homeowner’s insurance rates, and if they’re offered as rental properties they may experience excessive wear and tear.

Often what owners earn in rent doesn’t come close to covering the cost of the home. We recently talked with a client who was spending close to $50,000 per year over the rental income just to maintain a beach home. When we walked him through this expense in relation to his financial plan, we illustrated that to continue to cover the expense, he would need an additional $1 million in his portfolio with a safe withdrawal rate of 4% – 5%.

For some people, the most prudent decision is to sell the house, invest the proceeds into the market, and rent a beach home when a dose of sand and surf (or mountain air) is needed. In this situation, you could rent a place on the coast three to four weeks each year and still possibly be ahead of the game financially.

Do you own property in another state?

Real estate owned in a different state adds another layer of difficulty and complexity. If the owner lives in Georgia and owns a house in Florida, for example, her heirs will need to go to probate in two different states when she passes away. This can become very time-consuming and expensive to manage since it usually requires hiring an attorney – or attorneys – one for each state. For one client who inherited a home in Florida, probate fees were $30,000 and the process took almost a year.

The probate process is a public process that takes place in probate court. The will can be widely contested by potential heirs in open court. Therefore, most families should want to avoid the probate process at all costs. There are several strategies that our clients have used in the past such as placing the home in a revocable trust or an LLC. As your family’s CFO, we can facilitate coordinating with your attorney to make this happen.

Is this a good time to downsize?

Empty nesters in particular benefit from considering whether current home (often the home in which they raised their children) still suits their situation. With school quality no longer a concern and hour-plus commutes a typical feature of suburban living, many are considering making a lifestyle change that means a shorter commute and/or a smaller (less expensive) home.

Usually, downsizing your home has the added advantage of reducing mortgage, tax, insurance, maintenance and utilities expenses. And by freeing up that cash, you have more to invest in the stock market – where could possibly enjoy a higher rate of return. You may increase the size of your nest egg, and the bigger your nest egg, the more you have to live on in retirement.

There’s also a significant tax advantage of liquidating your primary residence (you must have resided in it for two of the last five years): you are exempt from capital gains tax on proceeds up to $250,000 if you are single, and up to $500,000 if you are married and file jointly.

Is it possible you could face a cash crunch in retirement?

With a well thought-out and frequently reviewed financial plan, you can confidently plan for your financial needs. A financial plan will not just map out your wish list for retirement; it will include anticipating the “what-ifs” of life so that if you do face a cash crunch for some reason, you’re able to adjust your plan and continue to move forward.

Having said that, if you have significant assets tied up in real estate, you are limited in the resources available to convert investments to cash if you were to find yourself in a situation where you need cash quickly.

Real estate sold at inopportune times (quickly to generate cash) may not always bring the best return. While it’s true that, historically, real estate value increases over time, there are also dips along the way – and the occasional crash. Anyone who was forced to sell a home in 2008 or 2009 knows how difficult it can be to try to generate cash from a hard asset.

The bottom line is that it’s much easier and faster to liquidate a smaller portion of your net worth if you own stock than if you own a house.

Is real estate your biggest asset?

For many people, it’s true that more of their worth is tied up in their home than in any other investment. This can be a risky proposition. Diversification is vitally important to the overall health and well-being of any financial plan. Over exposure to real estate can bring the same risks that over exposure to certain stocks – like technology – or bonds can bring.

A good rule of thumb is to keep your housing expenditures at a maximum of 28% of your net income. Going over that level, you run up against the opportunity cost of having that money tied up in real estate instead of in a diversified portfolio. If you look at the S&P 500 from 1983 to 2013, average return was 11.3%, while home values increased 3% annually.⁽¹⁾

A home can be an emotional attachment – and that’s not a bad thing. But don’t let the emotional attachment override financial prudence and long-term planning. It’s important to put emotion aside and consider what actually makes sense from a financial planning perspective for your personal situation.

Smith and Howard Wealth Management serves as your family CFO, guiding clients to making wise, well-informed decisions about many aspects of their financial situation. We can help in the fields of investment management, tax planning, financial planning, estate planning and portfolio administration. Driven by a core set of values, we strive to fulfill our mission: We provide financial peace of mind.

(1) Source: Wall Street Journal