If financial advisors ask clients the rate of return for their rental real estate investment property, they should expect to hear a number at least 5 percentage points higher than the actual one, according to the founder of The Real Estate Whisperer Financial Planning.
That’s because of calculations based on “optimistic assumptions, untracked costs and the absence of formal benchmarking” among many owners, said Rich Arzaga, founder of the Monument, Colorado-based firm, in a presentation at this week’s Financial Planning Association Retreat in Oak Brook, Illinois.
“It’s where ownership bias meets the reality of returns,” Arzaga added. “Whatever they say, knock out at least 5%.”
Despite the substantial role of real estate in wealth, the asset class may sometimes get overlooked by planners who leave an often-emotional decision that is critical to clients’ retirements to professionals from other fields who work more closely on investment properties.
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A void in the profession?
Instead, more planners should maximize their value to clients by taking them through a realistic cash-flow estimate incorporating every expense that they can then apply to a long-term forecast of their assets in retirement, Arzaga said. Even for high net worth clients in particular who generate tens of thousands of dollars in rental income each year, the risks and costs of a property that isn’t meeting their investment expectations can eat up their holdings over time.
“I want to propose that this is an idea that you can use that will expand your thinking about the way we approach this business,” Arzaga said. “I think the way we approach it now is great, but I still don’t see it in any of the curriculum — whether it be the licensing certifications, none of the designations — none of them focus directly on real estate investments.”
Arzaga shared the case study of two 58-year-old clients from San Francisco he called Kevin and Lynn who had a net worth of $3.6 million and rental income of $75,000 per year through a property that was separate from their residence. Through debt service payments and other expenses, however, their costs on the property amounted to $76,000. If the couple followed through on their plan to retire when they turned 65 while keeping the same quality of life that cost them $312,000 a year, they would run out of their assets by age 84, Arzaga estimated.
“Somebody with a $3.6 million net worth, this is kind of not what they expect, right?” he said. “So that’s why they come to us. And luckily, they came to us.”
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A better course of action
If the couple were to sell the property in a tax-advantaged 1031 exchange for a better-performing asset or simply spin off their rental holding, absorb the taxes and reinvest the holdings into their long-term portfolio strategy, their assets could amass value hundreds of thousands of dollars or even millions higher than their current scenario.
One of the main misunderstandings stems from the cost of maintaining rental properties, according to Arzaga. In his example, the clients mentioned their amount of income and told him that the number included their expenses. He saw that they had miscalculated when he examined their itemized deductions on Schedule A of their tax returns.
Operating expenses include taxes and the preparation of them, insurance premiums, legal fees related to entity filings and other matters and two major areas — maintenance reserves and property management. In terms of maintenance, the owners should build in costs of about $30,000 to $40,000 every decade for concrete, foundation work, a roof replacement or similar upkeep, Arzaga said. Property management poses difficulty as well.
“Most people like to do that on their own. Most people aren’t capable of that,” he said. “It’s important, and it’s a big asset. And some decisions they’re making are because they’re not professionals in this area.”
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Providing value outside investment portfolios
These realities may be tough for the clients to hear, but they usually come around after planners lay out the cold calculation of the costs and risks involved with a lot of small-scale rental properties. Assisting clients in making smarter choices about their real estate is “more significant than beating the S&P 500” and a “much more noble cause,” Arzaga said.
“Understanding how real estate can impact a family’s finances, I think, is essential to being a comprehensive advisor,” he said. “You’ve got to be comfortable talking about these things. You don’t have to be an expert, but addressing them, to do a service for your clients.
