Funding retirement with rental income

By Bankrate.com

If you're willing to take the plunge, rental properties offer a rare opportunity to generate extra cash in post-work life. Indeed, a well-located unit in a middle-class neighborhood can produce an extra $200 to $1,000 per month after expenses.

"Real estate can be a wonderful asset to have in retirement, because when you have tenants, you have money coming in every month and, if you don't have pensions, that's important," says Barbara Pietrowski, a Certified Financial Planner in Roanoke, Va., who specializes in rental real estate.

Pros and cons of rental properties

Pros	Cons
Generates income each month Tax advantages  (e.g., depreciation) Increasing rents over time Ability to fix mortgage costs	Expenses and upkeep Deadbeat tenants Risk of empty units Illiquid asset

According to author and landlord Andrew McLean, you may not need to produce a profit right away to make the purchase of an income-producing property worthwhile, especially if you are secure financially and have the right time horizon to retirement.

"Rents are always going to go up, the value of your property is almost always going to go up and most of your costs are going to stay the same, particularly if you assume a fixed mortgage rate," says McLean, who has written the books "Investing in Real Estate" and "Making Money in Foreclosures."

"Eventually, even if you're only making a little in the beginning, you will watch your income climb over the years."

McLean, who owns three rental properties, spent $18,000 two years ago converting a workshop behind his house into a rental house.

It generates $1,000 in income each month, which pays the note on his entire property.

"It's an ideal way to supplement my income," he says.

Another big plus of income-producing properties is that the Internal Revenue Service lets you depreciate the building portion of your property (minus the land) over 27.5 years, which means much of your cash flow will be tax-deferred, Pietrowski says.

"You'll have to recapture that depreciation when you sell, but if you never sell it and you own the property when you die, all that depreciation goes away," she says. "Your heirs don't have to pay it."

The downside

 

Rental properties, however, also come with risks.

For starters, they're expensive.

Banks typically require a larger down payment and charge higher interest rates for rental property than they do for owner-occupied homes.

Real estate in general is also an illiquid asset.

Should you be forced to suddenly sell, you may find yourself in the midst of a down market (as is currently the case across most of the country) and unable to unload your home for a reasonable price -- if at all.

At the same time, you may not find renters when you need them, which would force you to cover the mortgage yourself.

Walter Molony, spokesman for the National Association of Realtors, notes investors in income-producing property should keep at least six months worth of reserves on hand in the event they fail to find a renter.

The other downside of rental property is that it turns you into a landlord, complete with deadbeat tenants and 3 a.m. calls to fix the broken boiler.

Not everyone is up to the task.

You can pay a property management company to handle the dirty work for you, but you'll have to pay them between 7 percent and 10 percent (higher in some resort locations) of your monthly rent for their trouble.

What to look for

 

If you're looking to purchase a rental property, McLean says you should focus on single-family homes in a good school district, since those are the two most important criteria for future tenants.

Also, buy a property large enough to accommodate future additions or renovations, he says.

"Get the largest piece of land you can for future development," he says.

Average investors should focus on properties that generate positive cash flow of at least 6 percent (above costs) and should be prepared to buy and hold, especially in today's spotty market, according to Pietrowski.

"You have to be in it for the long haul," she says. "One thing you don't want to do in a market like this is overextend yourself. Those who do eventually get a bad tenant and end up losing their house. Those who don't can wait it out."

Perhaps the most important point is to buy a place close to home. That way, you can keep tabs on your investment, even if you choose to use a property management company.

"You run into problems if you go too far away, particularly out of state," McLean says. "I've heard of cases where an unscrupulous management company told the owner that the property was vacant when it wasn't, and kept the monthly rent for themselves."

However, in some cases, taking the risk of buying and renting in another town may pay off. For example, if you're 10 to 15 years away from retirement and you know where you'd like to live, it's potentially wise to purchase a rental property in your future town, Pietrowski says.

"That is a very viable strategy," she says. "Buy a house now, get it mostly paid for before you retire using income from the renter and when you sell your current house and move, pay off the rest of the mortgage."

Elements of a good buy

• Single-family home
• Good school district
• Enough land for future renovations
• Close to landlord's main home
• Generates positive cash flow of at least 6 percent (above costs)

Do your homework

 

Before you buy anything, hire an inspector to rule out any big-ticket potential repairs, like problems with the foundation, roof or structure of the home.

Also, do some research to determine expected monthly costs, including insurance, taxes, mortgage and maintenance fees.

Local real estate agents (and the newspaper classifieds) can tell you how much comparable rental homes command in the area, how long properties are staying vacant between renters and how quickly similar properties are appreciating -- in case you need to sell.

Always consult a tax adviser for any tax implications rental property may have.