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Biohazard Insurance on Rental Property Protects Owners, Tenants

Expensive and Emotional

By Rick Kahler CFP®

The call I recently received from a distraught client dealt with a disturbing question I’d never heard in all my 45 years of owning and selling real estate and my 35 years in financial planning. “Rick, my tenant committed suicide in my rental house. He shot himself. It was such a shock.

And then the biohazard clean up and repairs cost $30,000. My insurance only paid $10,000. What can I do to cover the difference?”

This client, who does not earn a high income, saved for several years to buy her first rental. One year ago she proudly put $30,000 down and borrowed $120,000 to buy a two-bedroom home for $150,000. Like most rentals financed with a loan, excess cash flow is nonexistent; her expenses and loan payment basically equal the rent. Her intention was to eventually have a paid-off rental property to help provide her retirement income.

We explored some options. She could borrow $20,000 with a five-year loan and monthly payments of $377. This would definitely mean reducing her lifestyle. She could sell the house and probably net enough from the proceeds to pay the difference. This would seriously impact her future retirement income goal. She could consider asking the estate of the deceased to cover the costs. The phone went silent as she pondered this idea. “That would be hard.”

The thought of who is legally liable for the damages of such a terrible tragedy is not a pleasant subject to ponder. Compared to the emotional costs for the victim’s loved ones, of course, the financial costs are insignificant. Yet they still must be dealt with.

In a home where a violent death occurs or a natural death goes undiscovered for some time, the owner of the property faces significant biohazard cleanup costs that must be done by specialists. In addition, repairs and replacement furnishings are often required.

Bringing an action against someone’s estate to recover such costs is a choice anyone would be reluctant to make. The estate may not have the means to pay such costs. Even if funds were available, asking for payment could seem cruel, callous, and heartless.

As my daughter said to me, “Put yourself in the shoes of that man’s family for a moment. Imagine the expenses you already have to take care of: the funeral, a casket, a headstone, a cemetery plot, and other duties that you have to carry out while you’re still grieving—only to be told you need to cough up an additional $20,000 dollars on top of it all.”

Certainly, my client is in an unenviable lose/lose position. Through no fault of her own, she either suffers a significant financial setback or faces the possibility of filing a lawsuit against the estate of the deceased.

Sadly, all of this could have been avoided if my client had purchased the proper insurance. She thought she had, because her policy had a rider covering damages from a crime scene and biohazard clean-up. Unfortunately, the coverage capped at $10,000.

I asked Amy Borella, a property casualty agent with Great Western Insurance, what the industry standard is for this kind of coverage. She said, “Every policy can have different endorsements and every company can cover claims differently. There is no standard for how a claim like this would be handled.”

***

***

Assessment

It was a relief to learn that my homeowners and rental policies did have coverage, with no cap. I strongly suggest, if you own rental property, to be sure the same is true for your policies. In case a tragedy should happen, adequate insurance provides protection for both you and your tenants.

Conclusion

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***

Mid-Year US Markets Investment Update 2017

Second Quarter 2017

[By Rick Kahler MS CFP®]

Most clients I have met with recently show surprise when I tell them the first half of the year was a good one for investors. As one client said,

“How is that possible with all the problems in the world?”

She ticked off the unrest in the Middle East, ISIS, our strained relations with Russia, the instability of North Korea, not to mention the tweeting antics of President Trump and Congress’s inability to fix health care or provide tax relief. To her, all these appear to be good reasons for markets to be going down, not up.

Her response isn’t unusual

Most people mistakenly assume that markets rise when there is good news and do poorly when there is turmoil and pessimism. Actually, it’s often the opposite.

The U.S. stock market has more than tripled in value during the runup that started in March 2009, when the world as we knew it seemed to be ending. The most recent quarter somehow managed to accelerate the upward trend. We have just experienced the third-best first half, in terms of U.S. market returns, of the 2000s.

Still, as good as markets were to investors, economic growth was admittedly meager in the first quarter. The U.S. GDP grew just 1.4% from the beginning of January to the end of March.

Round-up

The S&P 500 index of large company stocks gained 2.41% for the quarter and is up 8.08% in the first half of 2017. International stocks are finally delivering better returns to our portfolios than US stocks. The broad-based EAFE index of companies in developed foreign economies gained 5.03% in the recent quarter and is now up 11.83% for the first half of calendar 2017.

Real estate, as measured by the Wilshire U.S. REIT index, gained 1.78% during the year’s second quarter, posting a meager 1.82% rise for the year so far.

The energy sector, which was a big winner last year, has dragged down returns in 2017. The S&P GSCI index, which measures commodities returns, lost 7.25% for the quarter and is now down 11.94% for the year, due in part to a 20.43% drop in the S&P petroleum index. This proves once again the value of diversification. Just when you start to question the value of holding a certain investment or wonder why the entire portfolio isn’t crowded into one that is outperforming, the tide turns. If only this were predictable.

In the bond markets, longer-term Treasury rates haven’t budged, despite what you might have heard about the Fed raising interest rates. The coupon rates on 10-year Treasury bonds have dropped a bit to stand at 2.30% a year, while 30-year government bond yields have dropped in the last three months from 3.01% to 2.83%.

Some good news

The unemployment rate is at a near-record low of 4.7%, and wages grew at a 2.9% rate in December, the best increase since 2009. The underemployment rate, which combines the unemployment rate with part-time workers who would like to work full-time, has fallen to 9.2%, its lowest rate since 2008.

The current bull market is aging, however. The runup has lasted far longer than anybody would have expected after the 2008 crisis. Inevitably, although it’s impossible to predict exactly when, we are approaching a period when stock prices will go down. It is always good to remember that the stocks in your portfolio will eventually plunge by more than 20% (which is the definition of a bear market).

Assessment

This might be a good time to revisit your stock and bond allocations and be sure you are diversified into five or more asset classes.

 *** 

***

Conclusion

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***

Understanding 1031 Exchanges

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The Ultimate Infographic Guide

By 1031 Gateway

In this infographic you will learn how to defer your capital gains taxes utilizing a 1031 exchange, what kinds of properties qualify for 1031, what the basic 1031 rules and time limits are, and how to benefit your heirs by stepping up your basis.

***

1031Exchange

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Conclusion

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Retirement Portfolio Real Estate?

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Inefficient and Illiquid … But?

By Rick Kahler MS CFP® http://www.KahlerFinancial.com

Rick Kahler MS CFPWhat’s the best way to hold real estate in a retirement portfolio? For many investors, the answer seems to be “not at all.” That’s not the right answer. This asset class, appropriately owned, can help support you well in retirement.

Not like Stocks

Unlike stocks, which trade on a highly efficient and liquid exchange, trading real estate is inefficient and illiquid. The ease of buying and selling stocks is one of the major reasons the asset class is over-represented in most portfolios.

Based on the fascination of the financial press with the stock market, it’s easy to get the impression that stocks comprise the largest financial asset class. According to Matthew Yglesias, author of The Rent Is Too Damn High, the total value of commercial real estate in the US as of December 2013 was $20 trillion. This equals the value of publicly traded stock. (The largest asset class is bonds with $37 trillion.)

While one could make a strong argument for owning equal amounts of real estate and stocks in most retirement portfolios, very few hold any real estate at all.

Direct Ownership

Probably the worst way to hold real estate is to own it directly. The only popular retirement plan that allows direct ownership of real estate is the self-directed IRA. Unfortunately, the government discourages holding real estate this way by taxing it unfavorably. As I’ve described in a previous column, it’s not a good idea.

RLPs

Registered Limited Partnerships [RLPs] were a popular way to own real estate in the 1980’s. While someone must have made money on these investments, I don’t think it was the investors. I don’t know an investor who made a dime, but I do know some distributors and promoters who got very rich with them. The problem wasn’t the real estate but the lack of transparency inherent in a limited partnership. This allowed promoters and distributors to hide high fees and commissions that didn’t give the investors a chance of profiting.

REITs

Gradually, the real estate investment trust gained popularity as another investment vehicle for owning real estate. A publicly traded REIT is similar to an ETF (a form of a mutual fund) that trades on the major exchanges and invests directly in real estate. REITs receive beneficial tax breaks, must pass through 90% of their cash flow to investors, have a high degree of transparency, and are highly liquid. They also tend to specialize in certain types of real estate, so rather than hold REITs individually; I prefer to own a mutual fund that owns a diversified assortment.

The fees and commissions associated with REITs are very low, which helps make them a good choice for investment portfolios. It is also another reason they don’t often show up there, since most financial vehicles are sold, not bought. Mutual funds, annuities, and cash value insurance pay much higher commissions than exchange traded REITs.

Wall Street solved that problem by creating the non-traded REIT, which does not trade on a securities exchange and therefore is highly illiquid. The benefits touted by salespeople are the potential for higher dividends, plus lower volatility than publicly traded REITs. Here’s the downside: Their lower volatility is an illusion created by their high illiquidity. They also lack transparency, which gives cover to charging high fees and commissions. The non-traded REIT is scarily like its older cousin of the 1980’s, the registered limited partnership.

USA

Assessment

Including real estate in a retirement portfolio can be a good idea as long as the ownership is properly structured. A mutual fund that holds a broad diversification of publicly traded REITS is one way to help you build a strong foundation for retirement.

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Conclusion

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Why I Hate Non-Publicly Traded REITS

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On Product Frustration

Lon JefferiesBy Lon Jefferies MBA CFP®

As my experience in the financial planning and investment advisory industries has grown over the years, there is one investment that I’ve seen no logical reason to own — non-publicly traded real estate investment trusts.

Josh Brown, one of my favorite analysts and author of TheReformedBroker.com nailed each of my frustrations with these products. Here is a significant excerpt from his post:

 ***

I consider non-traded REITs or nREITS to be part of the group of investments that are just absolute murderholes for clients – they pay the brokers so much that they cannot possibly work out (and they rarely do without all kinds of aggravation and additional costs). Further, I have yet to hear a single credible explanation as to why a broker would recommend a non-traded REIT over a public REIT other than compensation. The only explanation that makes sense to me is that 7% is a lot more than the 1% commission you get doing an agency trade on a NYSE-traded REIT. A reader with experience in the industry sent this to me and I found it hilarious. Below, a fictional, transparent conversation between an indie broker and his “client” that would never occur…

If Brokers Were Transparent:

Rep:

Before we wrap up our quarterly portfolio review I would like to talk to you about a new investment I think you might be interested in.  You have been looking for more income and this is an investment vehicle that pays a 7% dividend.

Client:

Sounds great, give me the details.

Rep:

With your portfolio size and risk tolerance I would recommend a $100,000 investment.  Given that amount let’s first go over the fees. If you invest $100,000 I will be paid a commission of $7,000. My firm is going to get $1,500 – $2,000 in revenue share. My wholesaler, the salesman that works for the investment’s sponsor company, will get $1,000. He is a great guy, buys me dinner and takes me golfing. The sponsor company is going to get around $3,000 to pay for some of the costs they incurred in setting up the investment. So after Day 1 there will be around $87,000 left over to actually invest.  I bet you are getting excited.

Client:

Are you on drugs? Why would I pay 13% in fees on anything?

Rep:

Don’t worry, it won’t feel like you are paying $13,000 in fees. The rules allow my firm to report your investment at $100,000 on your statement. You never really know what its worth but you will think you never lost money. Pretty sweet huh?

Client:

You have to be kidding.

Rep:

No, this is a really good investment. Let me tell you about the income component before you jump to any conclusions. Like I said this investment pays a 7% dividend and the dividend won’t change.

Client:

That sounds high and how do you know it won’t change?

Rep:

You see, the sponsor just picks the 7% dividend number out of thin air. Here’s how it works. You see the vehicle you are going to invest in is new and it’s going to take the firm a while before your net $87,000 is actually invested. Later on, maybe 2-4 years from now they will have the money fully invested and it will generate actual cash flow. So they just pay a quarterly dividend of 7% by giving you your money back. This is great from a tax perspective because return of capital isn’t taxed as income.

Client:

Are we on hidden camera or something?

Rep:

Ha, you are funny. I bet this next benefit will change your mind.

Client:

I hope so or I should start looking for another financial advisor.

Rep:

This is the best feature. You can’t sell your investment until the sponsor has the opportunity to create liquidity. You might be locked up in this investment for 7-10 years.

Client:

This feels like the Twilight Zone. Your firm allows you to sell this crap?

Rep:

Oh yeah, our firm sells a ton of it. In fact independent broker dealer firms like mine sold over $20 billion of these investments in 2013. Think about that. Reps like me made over $140 million dollars and our firms pocketed $20-$30 million.

Client:

This is crazy, what is this investment?

Rep:

Non-traded REITs. $100,000 sound about right?

***

Currency

***

Josh touched on every part of these investments that I despise — excessive commission paid to the so-called “financial advisor” (salesman), a supposed “dividend” that is really just paying the investor his own money back (essentially providing an interest-free loan), and a complete lack of liquidity and transparency.

When I begin working with a new client who owns one of these products, it is impossible to obtain accurate, current information on the investment (not even a true value is apparent). Even worse, if the client wants to sell the investment he would need to do so at pennies on the dollar. For the most part, once an investor purchases one of these products he just needs to forget about it and hope that one day he can get his money back.

Assessment

The bottom line is that if your advisor ever recommends a non-publicly traded REIT, I’d strongly recommend you walk out the door and start searching for a true financial advisor with a fiduciary responsibility to act in your best interest.

Conclusion

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On Doctors Investing in Commercial Real Estate

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Want a good way to build wealth? Own commercial real estate -OR-not!

By Rick Kahler CFP® http://www.KahlerFinancial.com

Rick Kahler CFPReal estate is one of the largest asset classes in the world. The family home is the largest asset many middle-class Americans own. And real estate makes up a significant portion of the net worth of many wealth accumulators.

Direct Ownership

Directly owning real estate is not an investment for the faint of heart, the armchair investor, or the uneducated. Most wealth accumulators would do well to leave direct ownership of real estate to the pros and invest in real estate investment trusts (REITs) instead.

Some Guidelines

Still, the lure of investing in a tangible asset like real estate is enticing for high risk tolerant investors who need a sense of control and interaction with their investments. If you are among them, here are a few guidelines that may keep you on a profitable path.

1. Don’t attempt to purchase investment real estate without the help of a commercial real estate specialist who is a fiduciary bound to look out for your best interest. Engage a Certified Commercial Investment Member (CCIM) with years of training and experience in analyzing and acquiring investment real estate. To find a CCIM near you, go to http://www.ccim.com.

2. You will sign a disclosure agreement that will tell you who the Realtor represents. Be sure the Realtor you engage represents you and not the seller, both parties, or neither party.

3. Never trust the income and expense data provided by the seller’s Realtor. While a seller represented by a CCIM will have a greater chance of supplying you with accurate data, most will significantly understate expenses and overstate the capitalization rate. Selling Realtors often understate the average annual cost of repairs and maintenance. I estimate this annual expense at 10%.

4. Another often understated expense is management. Many owners manage their own properties, so the selling broker doesn’t include an estimate for management expenses. They should. Real estate doesn’t manage itself, ever. You will either need to hire professional management or do your own management (always a scary proposition). Even if you do it yourself, you have an opportunity cost of your time, so you must include a management fee in the expenses. Most small residential apartments and single-family homes will pay 10% of their rents to a manager.

5. You must verify all the costs presented to you by the seller’s Realtor. Demand copies of at least the last three and preferably five years of tax returns. Research utilities, property taxes, legal fees, insurance costs, repairs, maintenance costs, replacement reserves, tax preparation, and management fees. As a rule of thumb, expenses will average 40% of rental income on average-aged properties where the tenants pay all utilities except water. Newer properties may have expenses as low as 35%, while older properties can be as high as 50%.

6. By subtracting the vacancy rate and stabilized expenses from the rent, you will find the net operating income. This is the income you will put in your pocket—assuming the property is paid for. By dividing the net operating income by the purchase price, you will find the return you will receive on your investment, called the capitalization or “cap” rate. In Rapid City, for example, the cap rate tends to be 4% for single-family homes, 5% to 8% for duplexes to eight-plexes, and 8% to 12% for larger residential and commercial properties.

Home for Sale

Assessment

Yes, Physician-investors and all of us can build wealth with real estate. You just need to educate yourself, work hard, start conservatively, think long-term, and be prepared for lean years. This is not a quick or easy path to riches.

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