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Mark's Market Blog

Part II: Real Estate

By Mark Lawrence

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To invest in real estate, you could simply buy some and hold it for a while. In the last few years, a lot of people have made a lot of money doing just this. There are inherent problems with buying and holding real estate. First, the investment is not very liquid, which means it takes a fair amount of time, effort, and money to convert dollars into real estate or real estate into dollars. You must presume that getting your money out of your real estate will take about 90 to 180 days, and cost you 8% to 10% of your total selling price in commissions and closing costs. Second, it costs money to own real estate. Property taxes vary from 1% to 5% around the country. Homes develop problems, most real estate investors consider that maintenance costs another 1% to 2% per year. If you rent the real estate out, you will have an occupancy rate, meaning that, on average, your house will not be occupied and rent will not be paid for a month or two out of each year. Renters traditionally are hard on property, you may consider that it will cost a few thousand dollars in cleaning and repairs each time a tenant leaves. And, if you decide to sell the property, tenants can be a terrific pain. In a house, they will often be quite uncooperative as selling the house means they have to move. If it's an apartment building, less than full occupancy is a red flag to prospective buyers. Finally, you must consider the rental market. Depending on where your property is located, your gross annual rental income can be anywhere from 3% to 10% of the selling price. This is sometimes measured in a housing P/E (Price to Earnings) ratio: divide the average house selling price by the average annual rent paid on a 2 bedroom house. When this number gets over about 25, you must be concerned that you're looking at a housing price bubble. For example, if typical rent on a 2 bedroom house is $1000 / month, then the annual rent is $12,000. 25 * $12,000 = $300,000. If the average selling price of single family homes in your area is over $300,000, you should start to be concerned that housing prices are not sustainable. It should be noted that this number, 25, is proposed to be relevant at current mortgage rates of 5.5% - 6%. I expect a different, lower number would apply at higher mortgage rates. Since a hypothetical real estate bubble would most likely be burst by lowered liquidity coming from higher mortgage rates, this is an important observation. The last real estate bubble burst in '89-'90, it was not pretty for many who had expensive homes. The last major bubble to burst was the Internet stock bubble, that was not pretty for many who had a lot of money in technology stocks.

An alternative to owning real estate directly is to invest in a REIT, a Real Estate Investment Trust. These are effectively publicly traded corporations that buy and sell real estate, and you buy and sell shares in the corporation. There are Equity REITs that actually buy and sell property; Mortgage REITs that buy and sell mortgages; and Hybrid REITs that do both. Since REITs are effectively just another stock, they are quite liquid. If your REIT is publicly traded, you can sell your shares today and get your money out. You can even pick what type of real estate you want to invest in. Some REITS invest in homes, others in apartments, others in commercial property, others only in medical facilities.

One reason to choose to invest in a REIT is as a hedge. Suppose you would like to retire in Florida in 15 years, but you are concerned about how quickly Florida real estate is appreciating. If you invest in a Florida REIT, your investment should go up roughly as fast as Florida real estate, making it more likely you can afford your retirement home.

You must be careful when investing in a REIT. Unfortunately, REITs have been used for scams. For example, a contractor will build a building for $100M. The contractor then sells that building to a REIT (which the contractor manages) for $170M, thus locking in a huge profit when the REIT is fully subscribed. Then, the contractor awards himself a substantial property management fee of 5% to 7% from the REIT, which is subtracted out of the REIT annually. The result is that the investors are unlikely to make any money for many years - the contractor has already priced the building at a price well into the future. Not all REITs are like this, but you must investigate carefully before investing in a REIT, checking on comparable sale prices in the same market and reading in the prospectus about any management fees and who gets them.

If you make money on REIT shares, you will be taxed at the capital gains tax rate, typically substantially lower than the earned income rate. If you own and live in a house, then the first $250,000 of your profits ($500,000 if you're married) are tax free. You can use this tax exemption once every two years. This means in a quickly raising real estate market you can make a lot of money tax free, so long as you're willing to move a lot and property values keep going up.

Of course, if real estate values stop going up, or, heaven forbid, start going down, you might walk out your front door one day and discover that you're not in Kansas anymore, and there's a wicked witch (or a wicked mortgage banker) who's mad at you. . .

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