It can be financially risky for an investor to become overly committed to a single investment class, Becoming too focused on a particular type of investment makes it difficult to maximize the performance of an investment portfolio because not all investment options are being considered.
While the single most important factor in each investment choice you make is likely to be the expected or anticipated investment performance, most investors are also likely to consider overall portfolio diversification as well as suitability of any particular investment to their individual risk profile. Comparing investments within a particular investment class (for example, one stock versus another stock) is relatively straightforward, but it can be more challenging to compare across different investment types.
Since real estate is a particularly popular investment for individuals that have a self-directed IRA with a custodian such as Quest Trust Company, let’s examine some of the factors that are relevant to comparing real estate investments to other investment types.
Liquidity. Liquidity is perhaps the biggest distinguishing factor between real estate and many other types of investments. When you hold investments in publicly traded stock, for example, it’s easy to open or close investment positions whenever the market is open. Some investors may even trade in and out of a particular stock multiple times within a given trading day.
In contrast, the timing of a transaction to buy or sell real estate is generally measured in days or weeks (and often even months). It’s therefore important to assess your liquidity needs before making any real estate investment. Investors or retirement savers with significant other assets, or whose investing timeframe is very long) are generally in a better position to bear the potential downsides of relatively illiquid real estate investments.
Leverage. Using leverage (i.e., borrowing money to make an investment) is generally much more common for real estate investments than other investment types. With the proper use of leverage an investor can significantly boost their investment returns, but only if your total cost of borrowing is low.
Furthermore, in the context of a self-directed IRA, using leverage to purchase real estate can trigger certain unrelated business taxable income (“UBTI”) liabilities for the IRA. If the UBTI rules are not fully understood, an investor who uses leverage to purchase real estate in a self-directed IRA can find themselves in a very bad financial position trying to come up with the funds to pay those taxes.
Expenses and Taxes. Real estate investments generally involve a much higher level of ongoing expenses. Whereas investments such as stocks and mutual funds may not cost you anything beyond your brokerage commissions to buy and sell, owning real estate comes with property tax liabilities, maintenance and upkeep fees, as well as possibly even management fees. These expenses are generally tax deductible against any income you receive on the property, but the value of this deduction will generally be lost within a self-directed IRA. When trying to compare real estate with other investments, be sure to fully consider all associated expenses.
Regardless of the size of your self-directed IRA, there’s a good chance that real estate can help you meet your retirement goals. Understanding how to compare real estate investments with other investment types is the first step in making the right financial decisions.