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Individual investors own more than 14 million properties in the United States, comprising nearly 20 million units.* For consultants, these numbers indicate that direct real estate investments can represent the current net worth and future financial health of a significant number of their clients.
Consultants should guide these clients in developing a strategy around their real estate assets as part of a long-term financial plan. Focusing on these three issues with clients who own real estate can reveal important considerations for integrating investment properties into their wealth plan.
“Often, advisors don’t think to ask these questions because they don’t see real estate as an asset they’re managing in a liquid or custodial account,” says Rob Johnson, head of wealth management at Realized, a platform that helps advisors and investors manage investment property wealth. “But for holistic planning, they need to understand where the client’s assets fit across all their investments.”
To start the conversation, consultants should use three questions to find out what investment properties their clients may have and what they might have considered doing with them.
1. Where does the real estate sector fit into your overall wealth management plan?
Consultants typically begin conversations with clients by assessing their current financial situation and how it affects their short- and long-term goals. If a client owns one or more properties, it is important to evaluate how these assets complement more traditional income sources and the role they can play in building wealth over time.
Some clients may have a clear idea of the role their investment property plays in their financial situation, while others – usually those who inherited or received real estate in a settlement – may need support to integrate their holistic portfolio. Clients who are still decades away from retirement will likely think about their real estate holdings very differently from clients who are closer to or even in retirement.
For clients at any stage of their wealth management journey, it's a good idea to discuss the benefits of real estate as an investment. For starters, real estate has the potential to generate strong returns, especially since some investors may qualify for related tax exemptions and deductions. It can also be less volatile than many other assets, and because demand for real estate is strongly correlated with expanding economies, it can be a good hedge against inflation in the long term. Add in the diversification benefits that come with adding another asset class to the investment mix, and the advantages of real estate are hard to dismiss.
2. What is the net profit of your investment property?
That said, direct real estate ownership comes with challenges. Number one: managing the ongoing expenses of the property, followed by keeping up with taxes and insurance. “Just having an investment property and knowing it’s generating some income isn’t enough,” says Johnson. “Ultimately, every investment property owner should do an analysis on their own or in conjunction with their financial advisor about what the net income from that property is.”
This analysis can be complicated due to the erratic nature of income and expenses related to rental properties. For example, the loss of a tenant can result in a gap in rental income, or unexpected repairs may require a significant expense that impacts long-term revenue. It is important to discuss these possibilities with clients and consider them when discussing the long-term income-generating potential of a property.
Taxes can also reduce real estate income, with cash flow and direct property income taxed as regular income. And a client planning to liquidate faces a significant tax burden. Profits from the sale of real estate are taxed as capital gains, which leads to the last important question:
3. Are you interested in keeping the property, selling it, or exchanging it for another real estate investment?
Some clients may not be interested in getting rid of their direct real estate investment. The property may have sentimental value or generate enough consistent income to make it worthwhile to keep. Obviously, clients who opt for continued direct ownership of a property must contend with the time, effort, and expense involved in maintaining it.
Liquidating a property offers an obvious benefit: the money that comes from the sale. Many individuals choose to go down this path as they approach retirement, aiming to convert an illiquid asset into more liquid property. Unfortunately, unfavorable market conditions, capital gains taxes incurred on profits, or both can erode potential gains.
But few advisors or clients are aware of a third option: swapping direct real estate ownership for passive ownership in managed portfolios using a 1031 swap. These swaps allow taxpayers to defer paying capital gains tax on the sale of an investment property by replacing the sold property with a “similar” property of equal or greater value. This strategy can provide more predictable real estate income with less risk and carries the potential for intergenerational wealth preservation.
In the next articles in this series, we will explore the pros and cons of 1031 exchanges in more detail. For now, remember that real estate investments can be an excellent part of a diversified wealth management strategy – and an asset that no advisor should ignore when meeting with a client.
