Purchasing residential investment properties with self-directed retirement funds is no different than buying rental properties with after-tax dollars in terms of finding the right property for your Self-Directed IRA, IRA Owned LLC, or Solo 401(k) Trust that meets your investing strategy. The key to this is doing the proper due diligence before you make that offer so when the right property does hit all the markers you have set out, you can act quickly and with confidence. Having a plan or template in place to measure a given investment property can help guide you through this process and fairly quickly weed out the less desirable properties from ones that will work for you and your Plan.
Making a Loan Decision
There are essentially 3 areas that we look at to make a loan decision on any investment property. Using these ideas can help you to evaluate a property to see if it works for your retirement plan.
- Cash flow sufficient to service all operating expenses and debt service.
- Location and Condition of the property.
- Adequate funds in the IRA or Solo 401(k) to meet funding requirements and reserves for continuing operation of the residential investment property.
Cash flow and operating expenses can be assessed from data available on the web and from local realtor/property management sources. What I mean by this is that you can access the generally known costs of real estate taxes, homeowner insurance premiums needed to insure the property, maintenance, management fees, HOA fees, and other expenses that come into play on a given rental property. You should have a model that takes into account the probable total rental income, minus all the operating expenses so that you can figure out Net Operating Income to service the potential debt you may want to use for the purchase of this property. Once you have your projected Net Operating Income figure for the property, just divide that annual figure by the annual debt service (Principal and Interest payments). Generally, the Net Operating Income needs to be at least 125% of the debt service.
Location and Condition
In real estate the common term is Location, Location, Location. By that, as an investor the properties targeted must be acceptable in terms of proximity to schools (if you are targeting families as potential tenants), transportation, shopping, employment centers, amenities and other factors that renters are looking for these days.
You should research crime in the area and surrounding neighborhood so that you can be comfortable that the property is safe for tenants and you as the owner when visiting the property. Properties in high crime areas are hard to keep tenants long-term, appreciation may be little to none, and when it comes time to sell, it may be more difficult.
Condition is paramount if you are going to purchase a “buy-and-hold” rental property.
Have a Home Inspection done by a professional home inspector or qualified contractor look at the home if you have any concerns about the various components such as HVAC, roofing, plumbing, electrical, foundation, siding, windows, appliances and so on.
Quantify any repairs needed to make the home “rent-ready”. And there will be some repairs needed on almost any home. You must be comfortable that the amount of repairs and rehab needed does not exceed your budget and comfort level. As a bank, First Western Federal Savings has a maximum limit of $10,000 in repairs that need to be done before the property is “rent-ready” for us to make a loan on it.
Can You Afford It?
Lastly, do you have the money? By that I mean does your SDIRA, IRALLC or Solo 401(k) Trust have the liquid funds available for the down-payment, closing costs, repairs, and at least 15% of the loan amount in reserves if you are contemplating a non-recourse loan on the property? There are always ongoing expenses with rental properties and there needs to be liquid operating funds available after purchase for repairs, tenant turnover and make-ready expenses, upgrades and other costs. You can analyze the funds you do have, measure those funds against the potential investment and without much difficulty gauge whether or not there are enough funds available to not only buy the property but have enough for ongoing expenses that most certainly will arise in the future.
Once you have a solid model that takes into account these issues and ideas, you can use that model to access any given potential rental property. That will help you to find the gems that will work for you and your retirement plan and help avoid the ones that may become money-pits or less than optimal rentals for your investment portfolio.
Roger St.Pierre, Sr. VP