We have a rule when investing IRA funds in real estate — never put the principal at risk. Most of the IRA investors we assist are of the age when they are consciously thinking of kicking back, putting their feet up, and enjoying the fruits of a lifetime of work.

The majority of the IRA accountholders we see are in a position where they will probably not be able to recoup the principal portion of their retirement fund should it be squandered away. Therefore, steps must be taken to be as certain as possible that the principal portion of their retirement fund is not in jeopardy. Probably not a bad idea — whether you have the time and ability to recover or not.

IRA account holders typically have chosen to invest their IRAs in real estate and trust deeds to increase their retirement income as rapidly as possible in the years remaining before the blessed event. Because of the need to be cautious with the principal, yet grow the retirement funds at the fastest possible rate, we end up with dichotomized goals.

While it sounds implausible, it can be and is accomplished. We achieve the goals by mentally separating the principal from the return when investing. By treating the principal and the return as mutually exclusive vehicles, we are able to protect one and yet reach out for the higher returns available in real estate investing.

Think of it as always wearing a seat belt, and yet sometimes driving over the speed limit. You are in a hurry to reach your destination and are willing to take some risk (speeding) to get there on time, and you want to make sure you live through it (seat belt).

Some investments may offer too many seat belts and too little speed, e.g., CDs and treasury bills. Some have too much speed and too little safety, e.g., some stocks and unsecured loans. Real estate and real estate-related products can offer just the right ratios.

Let's look at just one example where the investment has been arranged to provide both security and a good return.

Trust deeds for safety and speed

Trust deeds are readily available in the marketplace and with a little investigation can provide a very profitable vehicle for IRAs. Banks continually buy and sell mortgages and trust deeds on a large scale. They are also available to the individual investor.

If you own a home, chances are that you are paying someone or some bank on a loan that was provided to help you acquire ownership. That promise to pay (promissory note) is secured by your home with a trust deed or mortgage. If you stop paying, the bank takes your house. If you continue paying, you get to keep the house and the bank makes money because they charge you interest.

When you buy a trust deed for your IRA, you are buying that promise to pay a certain amount of money over an identified period with a specified amount of interest. If you purchase the trust deed at less than face value, you can increase the yield beyond the stated interest rate. Let me demonstrate.

A trust deed and note payable monthly in the face amount of $57,000 with an interest rate of 8 percent and a term of 20 years is purchased for $47,537; that is, a discount of $9,463. The note is all due and payable in seven years. There will be a balloon payment of $46,150 at the end of seven years and the monthly payments are $476.77. Because the note is purchased for less than the face value (discount) the yield is 12 percent instead of the 8 percent interest on the face of the note.

The trust deed is in first position (no liens senior to it) and secured against a rental property that has a due on sale clause. The property is valued at $75,000 making the purchase price of the note 63 percent of the total value. If the borrower defaults on the loan and the IRA forecloses on the property, it will receive $27,463 more than it paid for the note. This provides excellent security for the principal invested. It is highly unlikely the market will drop by more than 35 percent in the time the client is holding the note.

Let's look at how we reach for the higher return with the principal secured. If the note pays as agreed, the return will be 12 percent which is a very good return. Because of our knowledge of the market, circumstances of the owner of the rental property, and the due on the sale clause, we have an additional advantage.

We know that the average turnover of rental houses is much shorter than the duration of this contract (seven years). In addition, the owner is in the process of fixing up the property for resale.

If the property sells prior to the seven years, there is a bonus for the purchaser of the note. This is known as the "time value of money" concept. When money is received sooner than expected, it produces a higher yield.

Assume the note pays off 21 months into the contract. Because the payoff is received sooner than expected, the yield to the IRA will be 19.5 percent. The security has been provided by the loan to value ratio and the chances are taken on the return on investment. In this case, the worst that could happen is a 12 percent return, and by executing due diligence and finding out about the intentions of the borrower, we are able to obtain a 19.5 percent return.

We must, at least mentally, separate the principal from the return when investing retirement funds in real estate. If you are going to speed (take some risk), you must have your seat belt fastened (secure the principal) at all times.

Copyright © 1995 by Patrick W. Rice