It sounds like a dream situation: Buy an oceanfront cottage as a vacation home, and years later, use it as an idyllic retirement home. Ideally, this sounds like it could work, but with any investment, especially real estate, there are significant risks to be weighed.
For most people, the goal in buying real estate is to have a comfortable home to live in, as well as increasing net wealth. Buying a vacation home now for retirement later may very well increase someone’s wealth over the long term. But, since all real estate is local, this decision depends on each market. Therefore, it’s necessary to weigh whether investing elsewhere like in a lower risk, lower hassle diversified portfolio of financial assets like stocks and/or bonds could have a better outcome than real estate.
Before you buy, ask yourself if you can invest better elsewhere.
Let’s look at a financial example. Let’s say your plan is to buy a $200,000 second home by investing $60,000 cash (down payment, plus closing costs, plus rehab and furnishings) and take out a $150,000 mortgage. If you are not renting it out (more about those ugly duckling negative cash flow vacation rentals later), your second home will be cash flow negative to the tune of $1,000 per month in paying the mortgage, property taxes, homeowners insurance and repairs. That annual negative cash flow amount will inflate slightly each year with higher taxes, repairs and insurance.
After 15 years you will have a cumulative $260,000 to $300,000 of cash invested in the property — $60,000 at purchase plus $12,000 (and inflating) per year multiplied by 15 years.
Let’s look at how you might do financially. If your second home is worth $315,000 at year 15 due to a 3 percent annual value appreciation, and you sell it, you subtract out $25,000 (8 percent) selling costs as well as the $100,000 remaining mortgage balance, you will have $190,000 left over. However, you have already invested up to about $300,000 into the property, so right off the bat you are underwater by approximately $110,000. Note: You’d be at breakeven if the price increased annually at 4.39 percent for those 15 years to $440,000.
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But that doesn’t include the opportunity cost of the interest or dividends you would have earned if you invested all the $300,000 into a financial asset, nor any capital repair/replacement/upgrades that you certainly will have done at some point over that 15-year period.
With financial assets, if you had invested your cash at a 5 percent return, you would have over $430,000 in the bank at year 15. That’s a lot more than the net $190,000 you would have earned on the second home! Note: if you earned a 6.0 percent return = $480,000 in bank, 7.0 percent return = $533,000, 8.0 percent return = $593,000.
To add to that, how do you really know that you will want to retire in a certain place in 10 to 15 years? Or, what if you end up not using it too much, what if you get divorced, decide to move somewhere warmer or colder?
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To reduce your risk and increase the chances your wealth will increase, you probably are better off keeping your monies in a more liquid and less risky asset than a second home. Starting a diversified “retirement home buying fund” over buying a retirement home is probably a better idea. When you get close to retirement, you’ll have plenty of cash to buy your retirement home!
What about renting it out?
But what about renting it as a vacation rental? Before you buy, make sure it’s a good real estate investment with projected positive returns. While it depends on location, most fancy condos or beach houses, where the net rental income is very low compared to the purchase price, usually have projected negative cash on cash returns. So if you buy a fancy property with negative (4 percent) cash on cash returns, even if it appreciates 2 percent per year, you are typically at a 0 percent, or worse, return on your equity cash investment. That isn’t a deal most experienced investors would take.
Note that operating expenses on vacation rentals are like hotels, for every dollar that you collect in rent you pay 75 percent out in expenses for taxes, management fees, furniture, cleaning, utility bills, etc., before making your monthly mortgage payment!
Lower risk moderately priced regular rental properties run about 30-40 percent expense ratio with reasonable mortgage payments. It is the moderately priced units that have decent cash on cash returns.
Lastly, don’t fall for the “but you get an income tax write-off” pitch. Most Americans get very little net tax benefit from the mortgage interest deduction (alternatively, rental properties have excellent write-offs). Also, you should never make an investment decision based on hoped-for tax benefits; the tax benefit will not save the day on a bad real estate investment.
The moral of the story is that if you are going to invest your cash into an asset, like a second home, that produces only negative cash flow for the term of your investment, you’re stuck hoping some outrageously high appreciation in value will compensate for the negative cash flows. And hoping for appreciation in value is not a very sound, or likely to be successful, investment strategy!
Leonard Baron, MBA, CPA, is a San Diego State University Lecturer, a Zillow Blogger, the author of several books including “Real Estate Ownership, Investment and Due Diligence 101 – A Smarter Way to Buy Real Estate”, and loves kicking the tires of a good piece of dirt! See more at ProfessorBaron.com.