Commercial Real Estate and Retirement Planning

We often browse through newspapers, magazines, business journals and 
the internet and regardless of how much we try; ignoring the vast array of 
retirement planning ads is next to impossible. It seems as though the last 
century has given birth to more investment vehicles than any one individual 
will ever use in a lifetime. Everything from stocks and bonds to IRA's and 
mutual funds are peddled in one form or another. And the number of securities 
brokers and financial planners willing to help pave the way for our retirement 
success are anything but scarce. What amazes me though is that of the 
thousands of retirement planning professionals in the U.S., very few if any 
actually recommend real estate to be included in their clients' retirement 
portfolios.

Advantages

Let's begin with the advantages of owning what I believe to be the greatest 
investment vehicle ever created; Commercial Real Estate. I want to clarify 
two important points before proceeding; first, the term commercial real estate 
and investment real estate will be used interchangably throughout this article 
and second, even though our homes are a potential gold mine in terms of 
equity and value, and make up what is more often than not our biggest asset, 
it lacks one of the three characteristics that classify it as investment real 
estate; Cash Flow (more on this in a moment and assuming that your principal 
residence is a Single Family Home). For purposes of this article, I would like 
for everyone to create a mindset that even though our home is indeed a very 
valuable asset, for retirement purposes, it should be considered icing on the 
cake rather than our largest contributor of net worth. The theory being that 
should our home ever be sold, a large portion of the proceeds will eventually 
have to be reallocated towards the purchase or leasehold of another home. 
In other words, we'll still need a roof over our head and therefore the full 
receipts of the sale may in many cases not remain fully liquid for retirement 
purposes.

With that said, lets analyze the characteristics that make up investment real 
estate and more importantly, the investment benefits they provide. There are 
four characteristics to consider:

Cash Flow, Tax Shelter, Equity Build-Up, and Value Appreciation.

1.) Cash Flow. As I mentioned earlier, all of the characteristics of investment 
real estate are in one form or another inherent in our primary residence 
(our home) except for Cash Flow. Assuming that our primary residence is a 
Single Family Home with no add-on apartments or studios or mineral rich land, 
then for obvious reasons if we are the primary occupants, there is a slim 
possibility of receiving cash flow from an additional source such as tenants 
residing on the property or an energy company drilling in the back yard. 
In investment real estate, Cash Flow refers to the property's periodic receipt 
of gross income minus all of its operating expenses. Cash Flow is usually 
measured in annual intervals and is classified as either Pre-Tax Cash Flow 
or After Tax Cash Flow. The former, Pre-Tax Cash Flow; is the total cash 
available after paying for expenses (i.e. management fees, utilities, repairs, 
property taxes, insurance, etc.) and mortgage debt (i.e. principal plus interest). 
After-Tax Cash Flow; is the total cash remaining after deducting income tax 
liabilities from Pre-tax Cash Flow.

2.) Tax Shelter. Inherent in Investment Real Estate is the ability to keep 
more of the periodic cash flow from operations through Property Depreciation 
and provides a mechanism to build a tax deferred net worth via a 1031 Exchange. 
Both of these are mere Tax Shelter examples of how Investment Real Estate can 
contribute towards a solid retirement portfolio:

a. Property Depreciation. As a common practice recognized by the 
IRS, Property Depreciation is an accounting concept that contributes 
towards the deduction of taxable income by recovering the costs of 
investment real estate thus improving cash flow. It's important to note 
that land does not depreciate; the concept only applies to the value of 
the improvements on the land. For example: say we had a multifamily 
apartment building with a total assessed value of $500k and of that total 
value, 40% would be allocated towards the land and 60% would be 
allocated towards the actual building improvement. Based on this 
example, only 60% of the value or $300k would be allowed for 
depreciation. It's important to note that there are various forms of 
depreciation and timelines that apply to each. For reasons of simplicity, 
we will not get into the intricacies of each here, however, the important 
point to understand is that investment real estate allows for depreciation 
which in turn improves cash flow.

b. 1031 Exchange. Section 1031 of the IRS code allows for a seller to 
exchange their investment property for another like kind property 
without having to pay capital gains taxes on the transaction. The 1031 
code in essence, does not exempt the taxes altogether but rather, 
defers them. These are specialized transactions which require qualified 
intermediaries who are well versed in the 1031 procedure. In the interest 
of simplicity, we will not go into an in depth discussion of a 1031 as it 
would require a lengthy explanation however, the important point once 
again is to understand that investment real estate allows for the growth 
of tax deferred net worth until and through retirement. Visit our section 
on 1031 Exchanges for more information on this topic.

3.) Equity Build-Up. While investment real estate is sometimes purchased 
all cash, more often than not, leverage is the tool of choice. Mortgage Debt 
financing makes up the majority of investment real estate financing in the U.S. 
A reduction in the mortgage debt occurs periodically, best measured annually 
and is covered by a portion of the gross income received from the property's 
operation. As the mortgage principal and interest is paid down, the property 
begins to build equity; the difference between its accumulating market value 
and any outstanding mortgage liabilities. As Equity builds on the property, this 
provides an opportunity to re-leverage (or re-finance) and use the newly found 
capital to acquire additional investment properties thus expanding the owner's 
real estate portfolio.

4.) Value Appreciation. The fourth and probably the most compelling reason 
for acquiring investment real estate is the increase in its market value through appreciation. 
The economic forces of supply and demand coupled with inflationary trends and property improvements contribute to an everlasting growth in property market value. Real Estate 
markets are local vs. regional therefore, an impact in one market may have little or no 
effect in another market. This can have either a positive or negative connotation 
depending on the type of impact. It's important to point out that historically, 
real estate market appreciation has averaged between 3% and 6% growth annually.