Is Real Estate Right for Your IRA?

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Author: Updegrave, Walter longview@moneymail.com

the long view

Need another sign that the real estate market is getting frothy? How about this: Real estate has become a hot investment for IRAs. Not REITs and real estate funds, mind you, but actual brick-and-mortar single-family homes, condos and apartment buildings. In fact, over the past two years, estimates suggest, the amount of IRA money going into real property has more than doubled.

With stock prices still mired 20% below their highs of five or so years ago and house prices up more than 50% over that time, I certainly understand why real estate may look like a savior for sagging retirement accounts. But just because it's become this decade's "sure thing" investment doesn't mean you should stake your retirement on it. Here's why.

As a practical matter, real estate is a hands-on investment that demands time and attention. You've got to choose the right property, maintain it and find suitable tenants. Dealing with the myriad rules governing IRA accounts makes the task even more challenging. For example, since the amount you can contribute to an IRA is limited by law--$4,000 this year, plus an extra $500 if you're 50 or older--you've got to have a sizable balance in your IRA before you can even entertain the idea of buying property. Moreover, since you can't personally guarantee a loan against IRA assets, you'll likely have to shell out all cash for the purchase.

Tax rules also require that the money for every aspect of the investment, including local taxes and maintenance, come out of the IRA, not your pocket. So if a sagging foundation costs, say, $20,000 to repair, but paying cash for the property has drained your account, you've got a problem, Houston. If you kick in the funds, the IRS will consider all or nearly all of the money to be an excess contribution on which you'll owe a 6% penalty every year it remains in the account.

Just as you should hold a variety of shares in different industries to diversify your stock portfolio, so should you own a few properties in different areas to ensure your IRA's value isn't dependent on the fortunes of a single real estate investment.

But since only 20% of IRAs have balances of $100,000 or more, most people don't have enough to buy even one property, let alone several. And even if your IRA is large enough, spreading your money among several properties could leave you seriously overweighted in real estate. Stashing more than 15% of your retirement savings in real estate, I think, is pushing it. So if you're going to devote, say, $75,000 to property, you should have at least another $425,000 in stocks, bonds or funds. Otherwise, instead of lowering risk, you'll be increasing it by concentrating your holdings in one asset class--one that a big portion of your net worth is already riding on if you own your home.

Although real estate is more stable than most financial assets, prices can and do fall, especially after huge run-ups. In some cases, values have taken almost 10 years to regain their peak. I'm not predicting Armageddon. But it's important to remember that as more and more people pile into an investment, the greater the chance that its future returns will dwindle or even turn to losses.

If you really feel you must add real estate to your IRA, I'd recommend investing 10% to 15% of your account in REITs or, better yet, a real estate mutual fund like our MONEY 50 selection, Cohen & Steers Realty (CSRSX; 800-437-9912). This way, you'll get real estate's main benefit--diversification that can reduce the level of risk in your portfolio--but in a no-muss, no-fuss way.

Hmm, the upside of real estate without the hassle. Now that's a real plan.

GRAPH: NO SURE THING: When the Los Angeles housing market went cold in the early '90s, prices took nearly a decade to recover, proving that real estate can go down as well as up (and stay down awhile).

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By Walter Updegrave

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