I frequently run across ads touting the benefits of utilizing money in your Individual Retirement Account (IRA) to purchase investment property.  And it’s not just me.  Les Christie in CNNMoney recently reported that amateur investors are buying up homes using cash in their retirement accounts in order to get in on hot housing markets.  The big question: is this really a good idea?

Certainly real estate is an important asset class in which to diversify your investments.  But just as with investing in individual companies, when you buy an individual property you are taking on non-systematic risk – that is, the additional risk that something could happen to your particular investment that doesn’t affect others in the same asset class.  In the case of investing in a company, it could be the loss of a key customer or the appearance of a strong competitor.  With real properties it might be an environmental problem or a renter leaving.  Rather than investing in a single company or property, wouldn’t it make more sense to invest in multiple ones to spread out the risk?  There are Real Estate Investment Trusts (REIT) that do just that.  And you can take your money out at any time.

The second problem has to do with asset allocation.  Let’s say you want to put 50% of your investment portfolio into stocks, 30% into bonds, and 20% into real estate, and you’ve got $400,000 total.  Can you find a house or condo in the Bay Area cheap enough such that you can limit your investment to $80,000 and remain cash-flow positive between the rental income, the mortgage, and all the other expenses of rental property management?  Especially now, with hedge funds, foreign investors, private equity and wealthy real estate partnerships snapping up houses for cash and driving up prices.  Do you choose to blow away your asset allocation plan and instead plow $200,000 or $300,000 in that rental property, or have the stamina to wait for the market to cool down?  Jack McCabe is a Florida-based real estate consultant, where property prices have achieved double digit growth in the last year.  According to him, “They bought a lot of stuff cheap last year, but now they’re paying market value…sometimes they’re overpaying.” And as home prices rise, profits are harder to come by.  “There’s no way they can get an 8% return buying at today’s market prices,” he says.

What about the riskiness of real estate investments?  Take a look at San Francisco residential real estate over the last twenty years.  From 1990 through 1999 the average growth in prices averaged 3.1% per year (based on Case-Schiller data).  And from 2000 through 2009 the average annual price growth was almost exactly the same.  You’d think housing price growth must be pretty stable.  Well, it’s not.  Look at 1990 – 1994 and 1995 – 1999.  For the first five years the growth was -1.4% per year, followed by 7.7% for the next five years.  And for the first decade of the 2000s, it was even more volatile.  From 2000 through 2004 prices grew by over 12% per year, then declined by 6.7% per year over the following five years.  Is this the kind of asset in which you want to put a huge portion of your next egg?

Also consider what happens when a tenant stops paying rent for a few months or if a condo or homeowners association imposes special assessments to pay for major repairs.  Will you have the wherewithal to cover those unplanned costs?  LM Funding, based in Tampa, buys delinquent fee accounts from condo associations and collects the debts.  Many of the condo owners they collect from resort to further depleting their 401(k)s or IRAs when they come up short for expenses like maintenance fees.  In some cases they’ve already used up those funds to buy the property in the first place.  And should any of them lose their jobs, any unpaid part of a 401(k) loan will come due immediately and could be subject to income tax and possibly a 10% early withdrawal penalty.

Real estate can be a solid investment, but if you’re thinking of using retirement plan money, it’s extremely important to apply discipline to both limit your risk as well as to invest the time to manage it properly.