13 Passive Real Estate Investing Mistakes to Avoid in Retirement – Part 1

Passive real estate investing can add income and long-term growth to a retirement plan, as long as the investment fits your timeline, your cash needs and the account you invest from. Most of the costly mistakes retirees make happen before they ever compare two deals. They come from sizing, timing and account choices. This two-part series covers 13 mistakes. Part 1 covers the six planning mistakes, and Part 2 covers the seven that come up when judging the deal and the sponsor.

What is passive real estate investing?

Passive real estate investing means putting money into property that someone else finds, finances and manages. In a private offering, often called a syndication, a sponsor runs the property and investors contribute capital in exchange for a share of the income and any profit at sale. Investors don’t deal with tenants, repairs or lenders. They also give up control, and in most cases they can’t get their money back until the property is sold or refinanced.

That trade works well for some retirement plans and poorly for others. The six mistakes below are where it usually goes wrong.

Mistake 1: Putting too much of your nest egg into one deal

At 35, a bad investment is a setback. At 62, it can change when you retire, where you live and what you leave behind. The closer you are to retirement, the less time you have to recover from a single loss.

Private offerings often have minimums of $50,000 or more, which makes it easy to end up concentrated without meaning to. An investor writes a large check to the first deal they like, and a meaningful share of their retirement now depends on one building, one market and one sponsor.

A few habits help:

• Set your total private real estate allocation first, then divide it across deals. Don’t let the first deal set the number.
• Spread across sponsors, property types and markets. Three deals from the same sponsor in the same town carry much of the same risk.
• Size each investment so a total loss would hurt without derailing your plan. For an illiquid investment, that is the test that matters.

Mistake 2: Locking up money you’ll need before the deal ends

Most private real estate offerings plan to hold the property for five to ten years, and there is usually no market where you can sell your interest early. Even when the operating agreement allows a transfer, finding a buyer is slow and often means accepting a discount.

That matters more in retirement because spending needs change. Health costs, helping family, a move or a new roof can all call for cash at a moment the deal isn’t ready to return it.

Before investing, map the expected hold period against your own timeline:

• What year would I realistically need this money back?
• What happens to my plan if the hold runs two or three years longer than projected?
• Do I have enough in liquid savings to cover several years of spending without touching this investment?

If the answers make you uneasy, the investment may still be a good one. It may just be the wrong size for you.

Mistake 3: Expecting distributions to arrive like a paycheck

Many retirees look for real estate investments for passive income. Some properties produce steady distributions. Many don’t, at least at first.

• A stabilized property (already built and leased) may start paying distributions soon after closing.
• A ground-up development usually pays nothing during construction and lease-up, which can take two to three years or longer.
• A value-add property may reduce or pause distributions while renovations happen.

Each of these does a different job. Trouble starts when an investor buys one while expecting the cash flow of another.

Questions to ask any sponsor:

• When are distributions projected to begin, and what has to happen first?
• How often are they paid: monthly, quarterly or annually?
• Can they be paused, and under what conditions?
• How much of the projected return comes from ongoing cash flow, and how much depends on a sale or refinance at the end?

If you need income from this money in the next few years, a deal whose return comes mostly at sale won’t meet that need, however strong its projections look.

Mistake 4: Borrowing against your home to invest near retirement

Some investors fund private deals with a home equity line of credit (HELOC). The equity is sitting there, and the projected return is higher than the loan rate, so it can feel efficient.

The trouble is timing. HELOC payments start right away. Distributions from a private deal may not start for years (see Mistake 3). In between, you are making loan payments from your retirement income, often at a variable rate, secured by your house.

Before borrowing to invest, ask yourself:

• Could I make the loan payments for the full hold period if the deal paid nothing until it sold?
• What happens to my budget if the rate on my line goes up?
• Am I comfortable putting my home behind an illiquid investment?

There is also a qualification point many people miss. Under SEC rules, the value of your primary residence doesn’t count toward the $1 million net worth test for accredited investors. Home equity can make someone feel wealthier on paper than the rules consider them to be.

Mistake 5: Using an IRA without learning its rules

For investors whose savings sit mostly in retirement accounts, a self-directed IRA is often the practical way to passively invest in real estate. These accounts are held at custodians that permit alternative assets, and they come with rules that catch people off guard.

Raise these with your CPA and custodian before you invest:

• Debt inside the deal can create a tax bill inside your IRA. When an IRA invests in property bought with a loan, part of the income can be taxed as unrelated business taxable income (often called UBTI, or UDFI for the debt-financed portion). The IRA owes the tax, and the custodian may need to file a separate return (Form 990-T) for the account.
• Required minimum distributions don’t wait for the deal. Once you reach RMD age, you must take distributions from a traditional IRA every year whether or not your private investment has paid anything. If most of the account is tied up in illiquid deals, you may need cash from elsewhere in the account or an in-kind distribution.
• Your custodian will need annual valuations. Expect paperwork, and expect custodian fees on top of the investment’s own fees.
• Prohibited transaction rules are strict. You generally can’t personally use, guarantee or do business with property your IRA owns. Breaking these rules can disqualify the whole account.

An IRA can still be a sensible vehicle. The account type changes the math, so learn the rules before the money moves.

This section is general information, not tax advice. Rules change and individual situations differ.

Mistake 6: Playing it too safe for a 25-year retirement

“Safe” is the word most people reach for as retirement gets closer, and protecting what you’ve built makes sense. A retirement that starts at 65 can also last 25 years or more. Over that span, one of the largest risks is quiet: each dollar buys a little less every year.

Here is what steady inflation does to the cost of the same lifestyle:

What $50,000 a year of spending costs over time

Hypothetical illustration assuming a constant 3% annual inflation rate. Actual inflation varies and has been well above 3% in some periods.

A portfolio built only to preserve principal can lose ground every year in real terms. Many retirement plans hold some growth-oriented and inflation-sensitive assets for this reason. Real estate is one category investors consider, because rents and property values have historically tended to adjust with prices over long periods. That tendency isn’t guaranteed, and it does nothing for you if you need the money before the investment pays out.

Aim for balance: enough stability to cover near-term spending and sleep at night, and enough growth to protect your purchasing power for the decades after that.

A quick planning checklist

Before you compare passive real estate investment opportunities, you should be able to answer yes to each of these:

1. I’ve set a total allocation to private real estate, and this investment fits inside it.
2. I won’t need this money before the projected hold ends, plus a few years of cushion.
3. The deal’s distribution timing matches when I need income.
4. I’m not relying on borrowed money to fund it.
5. If I’m investing through an IRA, my CPA and custodian have walked me through UBTI, RMDs and prohibited transactions.
6. My overall plan still has enough growth to keep up with inflation.

Next in this series: Part 2: The 7 Deal and Sponsor Mistakes covers the mistakes investors make when judging the deal itself: chasing headline returns, skipping the fee section, overlooking leverage and trusting claims they can’t verify.

This article is for educational purposes only. It is not an offer to sell or a solicitation of an offer to buy any security, and it is not investment, tax or legal advice. Private real estate investments are speculative and illiquid and involve risk, including the loss of your entire investment. Examples are hypothetical and do not represent any actual investment. Talk with your own financial, tax and legal advisors before making investment decisions.