To beat the chilly, rainy winters in Portland, Ore., Verle and Carolyn Grove hop a plane to Hawaii each year - using their investment real estate to help fund the escape. "We've been vacationing in Hawaii ever since we were married, and we always talked about buying a place there," Verle Grove says. "We wanted a place to stay when we're there, and we also wanted an investment, a place for short-term vacation rentals, to help offset the cost of owning a condominium in Hawaii."

In 2003, the Groves paid $500,000 for a two-bedroom, two-bath property. In 2012, they bought a second property in the same community, this one with a single bedroom and bath, to allow for more flexibility when family and friends visit and to take greater advantage of peak rental periods, which in Hawaii are from December to April.

"If you want to live here for two months a year in the winter, you'll lose your maximum rent," Grove says. "This way, we can stay in the one-bedroom place and rent the two-bedroom place for decent money. One of the properties pays for itself, and the other one partly pays for itself."

The strategy passes muster with the Groves' advisor, Mark Ziety, a planner at Shakespeare Wealth Management in Pewaukee, Wis. "As long as people remember that investing directly in real estate is a business and treat it as such, it can be a beneficial part of a family's finances," Ziety says.

Investment real estate can also help balance a client's other portfolio assets, advisors say. "We think real estate is an important part of a client's portfolio. It behaves differently than other asset classes and it diversifies a portfolio," says Andrew Altfest, executive vice president at Altfest Personal Wealth Management in New York.



When clients are willing to take on property management, a planner's voice can be important in explaining risks and running numbers on potential properties - the most important factor in the investment's ultimate success.

Not every kind of real estate exposure is a good fit for every client. Direct property ownership brings risks and hassles that not every client is up for. On the other hand, Altfest adds, "Some people like to invest in real estate and they're quite good at it. You're not going to convince them that real estate isn't a good investment for them, and sometimes you shouldn't try." (See "Cash Flow Real Estate," p. 63.)

For those clients, planners have two roles to play. The first lies in taking a strategic view of real estate's place in a client's portfolio. "We look at their overall situation," Altfest says. "Rather than advising them on real estate itself, it's more a matter of how they're living, their goals and making sure that they're on a sound plan to meet their goals, given their real estate exposure."

A planner might also consider which properties make sense for the long term and which ones should be shorter-term investments, as well as how the rest of a portfolio might help balance an overweighting in real estate.

David Blain, president of D. L. Blain Private Wealth Management in New Bern, N.C., says he has sometimes advised clients to redeem a proportional amount of everything they own in order to buy real estate, for instance, or to cash out underperforming securities. Other clients might use cash to buy properties.

The second role involves actively coaching clients who want to buy their first (or even their 15th) residential or commercial property. Some clients may have significant purchasing experience and know-how and may need little more than advice about how much to put in, how to invest and which pot of money to use.

Other clients need more guidance. "We'll help analyze a purchase as an investment and look at whether it makes sense quantitatively," says Greg Friedman, CEO of San Francisco Bay-area wealth management firm Private Ocean. There's also a qualitative issue: "How does being a landlord mesh with the lifestyle they say they want?"

Along the way, planners may find themselves raining on a few parades. "Real estate can be like an intoxicating drug," says Judith McGee, CEO of McGee Wealth Management in Portland, Ore. - and, she notes, it's a potentially disastrous investment for someone who isn't ready to handle it.



Advisors say a real estate investment rises or falls on two factors: its ability to create a decent net cash flow and its owner's ability to market and maintain it.

If your clients pay too much for a property, they scuttle its cash flow potential. "The money is made on a property when you buy it," Blain says. "The price you pay is the largest determinant of whether [your client will] end up making money on that property or not. ... People say they can raise the rent and that it will appreciate, but you shouldn't rely on that happening."

To estimate cash flow, potential investors need to know a lot about a prospective purchase. How much do they plan to pay for the property, and at what interest rate? What rent might they be able to charge? How much will maintenance and taxes cost, and how often should they expect to have vacancies? Frequent vacancies can boost maintenance costs, too, since it's easier to rent an apartment that's been freshly painted or otherwise updated. On the plus side, depreciation can help reduce taxes.

Opinions differ on what a good property's net return should be, but planners generally agree that it should be at least 6% annually, particularly if the investor is paying cash. "You want an income that's at least as good as a stock dividend, and you want growth as well," McGee says.

She often sees client returns of around 2% net. At minimum, a property should be cash flow neutral, costing the owner less than the income it generates - though McGee says that might be more acceptable for young clients, who will realize a better return after they pay off the mortgage.

A client seeking real estate income will find it easier to generate respectable cash flow by purchasing a greater number of lower-priced properties, rather than a smaller number of more expensive places. Having a larger number of properties cushions the impact of vacancies, and lower-priced properties are more likely to be affordable for renters. People with more money, Blain points out, are more likely to buy a home than to rent one.

Multifamily units, from duplexes to apartment buildings, can also enhance cash flow, in part because of the building's common elements: roof, foundation, exterior walls, laundry facilities, community areas, location. (Anything larger than a fourplex will require either cash or commercial financing.) "Professional investors don't go around buying a bunch of individual houses," Blain says. "The cost structure is way out of line."

There may be exceptions, he adds, in purchasing distressed properties and adding sweat equity, or in buying out an investor who has gotten over his head. Remember, though, that buying foreclosures and short sales can often prove complicated and time consuming because it involves dealing with a bank's bureaucracy rather than with a motivated seller.



From the outset, it's vital to understand how active a manager your client wants to be. It's difficult to estimate a property's cash flow without knowing whether the owner will manage and maintain it, or will hire someone for the job. "Someone has to be willing to go there themselves and do a little work on the property, or the property has to be making enough to pay somebody to manage it," Blain says. "Even if you pay someone, you need to supervise."

Temperament is important, particularly in dealing with tenants, McGee says: "You have to be able to deal with people and hold them accountable. A lot of people are sloppy about how they handle their tenants, and it gets them in trouble." Credit and background checks, as well as damage deposits, should all be part of tenant selection.

Expect that vacation properties, where tenants might stay for a matter of days or weeks, will cost more to manage than standard residential or commercial real estate. Grove says he pays a manager 20% to 30% of rental income to manage the Hawaii properties, in part because he and his wife aren't always in the area. "The more you do yourself, the less expensive it is to maintain," he says. "Even so, you need someone as an on-island contact - and you have to check it out yourself a couple of times a year."

That might be more hassle than some clients want. "I definitely have a conversation with clients to make sure they understand that the investment comes with a lot of headache, especially when you are working and if you're kind of a novice at this and don't have a team of experts," says Sharon Olson, an advisor in Bloomington, Minn.



Analyzing numbers, coaching tenant selection - it sounds like a fair bit of work for something that doesn't enhance assets under management. No matter, planners say.

"It's just another business. We have business owners, and sometimes they have to put money into their businesses," Ziety says. The money belongs to the clients, who can buy real estate if they want to, he adds. Talking about real estate gives planners a chance to continue building client relationships, Blain adds, adding that he's even gone to look at properties with some of his best clients.

In the final analysis, Olson says, the planning business is about getting clients where they want to go. "If you're more concerned about your pocketbook than you are about clients reaching their long-term goals, then I don't know that you're earning your keep," she says.



Even when it doesn't boost AUM, real estate investing offers opportunities for creative financial management and estate planning - areas where planners can really shine.

At the most basic, real estate gives clients the option of a 1031 exchange. One of Blain's clients, for instance, had an island vacation house in North Carolina. When she reached her 60s and maintaining it became too much work, she did a 1031 exchange into some condos in a college town, where her grandchildren now live with paying roommates. When the client passes on, her heirs will inherit her investment real estate at a step-up in basis.

Private Ocean's Friedman found another way for a client to benefit from a property that had become a hassle. The client lived in one of 12 units in an apartment building he owned. "The property built tremendous wealth and caused him amazing duress," Friedman says.

Friedman helped the client set up a charitable remainder trust and gift the building to the trust. That let the client sell the building without paying taxes on the increased value, invest the sale money in passive assets - and take a huge charitable tax deduction. "It ended up doubling his cash flow from this asset," Friedman says. It also funded the client's new life - as a tenant in a luxury rental.



A client couple in McGee's practice inherited apartment buildings from their parents and wanted to pass them to their three sons. The catch: They wanted to favor their first son, who had shown initiative and industry, over his brothers.

McGee helped the clients create an LLC to transfer $5 million in property, all of which was owned free and clear, on a discounted basis. (Because the clients also have substantial assets under management with McGee's firm, she says, she did not charge extra for the planning work.) An operating agreement gives the husband management authority and an income, which he can place in a deferred retirement plan or use at his discretion.

The parents will then gift their three sons with equal shares in the LLC - but according to the operating agreement, the oldest son will assume his father's role, managing the property in return for regular payments.

All three will get incomes at their parents' discretion, and inherit when their parents are gone - and the second and third sons will get at least enough income to cover taxable events. Though the parents hope the three will work together to handle the family wealth, there is also a restriction that will bar the second and third sons from overruling their older brother.

In addition to protecting the investments, the plan also removes the investment properties from the clients' estate and takes some income off the parents' tax return. "Excess income can go to build wealth," McGee says. "Instead of distributing money to his sons, the father can invest that money."

Back in Hawaii, the Groves have substantial equity and could sell, but they're not planning to. "Both our children's families love coming to Hawaii. When we're gone, they may want to keep it," Grove says. "It gives them a financial foothold in Hawaii, where property is expensive and getting even more so. They could rent it out, have it managed or live in it."

While he and his wife are living, the pair of properties also offers the choice to sell both condominiums and use the money to buy a bigger place, one that they could live in full-time. "By having invested in real estate, we have options," Grove says.



Ingrid Case, is a Financial Planning contributing writer in Minneapolis and a former editor at Bloomberg News, is the author of Your Own Two Feet (and How to Stand on Them): Surviving and Thriving After Graduation.




Not every client needs to directly own a commercial or residential rental property, of course. There are many ways to get real estate exposure into a portfolio, including passive investments that take less lifestyle commitment from clients.

REITs are the most obvious example. Mark Ziety, a planner in Pewaukee, Wis., says he taps a variety of REITs if passive real estate exposure is right for a particular client. "Often, clients bring up real estate," he says. "Some people didn't realize that they already owned real estate in that form, and in a couple of cases that satisfied them."

Advisor David Blain of New Bern, N.C., likes private ownership deals. "A few companies have pools of real estate, structured as a limited liability corporation or a limited partnership," he says, citing Bell Partners as one such firm active in North Carolina.

Some of Andrew Altfest's clients are eligible to invest in the TIAA-CREF real estate variable annuity, which offers ownership of large properties in major areas around the country. Property is diversified by sectors - office, industrial, retail, apartments - and clients get exposure to account performance. "It's set up as a variable annuity, but without the exorbitant fees that other variable annuities have," says Altfest, executive vice president at Altfest Personal Wealth Management in New York. He also highlights the Third Avenue Real Estate Fund (TAREX), which owns real estate operating companies and stocks of companies that may not be in the real estate business, but have significant real estate assets.

Master limited partnerships are another possibility. "Last year was a fabulous year for that particular class, but when things get too popular, you have to watch your valuations and make sure you're not buying at the top," says Portland, Ore., advisor Judith McGee.

One investing choice that's fallen out of favor: asset-based mortgage lending. Greg Friedman, CEO of Private Ocean in the San Francisco Bay area, says he recommended it for about 10 years as a way for clients to invest in real estate. No longer, though: "That was very lucrative and made people a ton of money, but in 2008 and 2009 this got into trouble because people stopped paying their loans," he says. "Now they have properties instead of getting checks, and that's too much stress for clients." - Ingrid Case

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