Should You Buy Real Estate?

So you've had it with stocks and mutual funds and want to buy real estate instead. That's something I'm hearing everywhere. The stock market slid for most of last week, on war news, spurts in energy prices, stinky business profits and fears of slower growth this spring. Despite last year's post-September rally, tech stocks are still down by more than half from their March 2000 peak while Standard & Poor's index of 500 leading stocks remains 26 percent in the red.

Meanwhile, prices for homes--the real estate we know best--keep pushing up. Gains may be slowing, but this bull still runs.

Odds are that you've been an easy winner, with the home you own. Over most of the past two years, average prices soared at their fastest quarterly rates since 1979, according to data compiled by the Office of Federal Housing Enterprise Oversight. Gains have been running at the rate of 8 to 10 percent a year.

In rising markets, you get far higher returns on your actual cash invested (the down payment plus any mortgage prepayments). For example, say you put 20 percent down on the average house at the start of 2001. You'd have earned 23 percent on your money in just 12 months, says real-estate economist Jack Harris of Texas A&M University (he adjusted for ownership costs, tax benefits in the 15 percent bracket and the money you save by not having to rent an equivalent apartment).

If you put 5 percent down, your average return would have soared to 68 percent (that's leverage--earning a big gain on very little cash). Over the same period, Vanguard's largest index mutual fund, which tracks the performance of Standard & Poor's 500 stocks, fell by 12.2 percent--the second bum year in a row.

Home values rise and fall, like everything else. Back in the early 1990s, price gains were generally punk. In some places, owners lost serious money. But if they held on, values bounced back. The average house bought in December 1991 and sold 10 years later returned a net gain on capital of 9 percent a year, Harris says--and more if you refinanced when interest rates fell.

Median home prices dropped or slowed a bit last year, especially after September 11. In many cities, however, prices have suddenly kicked up again. Sales remain at near-record levels. "It takes a big bust to crack the housing market and we haven't had one," says economist Karl Case of Case Shiller Weiss in Cambridge, Mass., which analyzes housing data.

Kenneth Rosen, head of the real-estate center at the University of California, Berkeley, sees average prices rising 4 percent over each of the next two years. That's about half the growth rate of recent years but enough to deliver a solid return on capital. Long-term, home values rise a point or two over the inflation rate.

Still, let's face it: the only "investing" you've done was to buy a nice house and get lucky. You might move on to a ski condo or beach cottage, but that's personal, too. You use the place a few weeks a year and rent it when you aren't there. Annually, you'd earn more in a bank account and with no upkeep. But it's no fun vacationing in a bank. If you can get renters to help you pay for your recreation, profit hardly matters.

Becoming a true investor is quite another story. Once you start purchasing rental houses, vacant land or small office buildings, you've started a real business. You have to consider costs, management and cash flow, as well as potential appreciation. You'll need tight valuation guidelines to find the deals most likely to make a profit. Your temperament matters, too. Can you evict a weeping, unemployed, single mother who doesn't have money to pay the rent? Even if she has a puppy? If not, what then?

Don't be fooled by the dumb idea that real estate must be valuable "because they're not making any more of it." In fact, they are. You might buy a building lot on spec, only to find that tons of better lots are soon carved from local farmland. You might choose a rental house in a place where builders are banging together new houses faster than people can buy. The industry is "making" more real estate all the time.

A typical first investment is a rental house in a blue-collar neighborhood. Modest properties have been rising faster in value than ritzier ones, and aren't as likely to be overpriced.

You cannot expect to waltz into a real-estate office, buy a rental property at market price, then passively wait for your just rewards. In almost all cases, your rents won't come close to covering your costs. Every month you'll have to pay something out-of-pocket.

You expect to make a bundle, of course, when you finally sell. But will you really? Prices have to rise by enough to repay your losses plus interest and still deliver a double-digit annual return (to compensate you for taking the risk). Most investors don't even know how to figure their gains this way, says planner Mark Sievers of Fairfield, Calif. They're often earning less than they think.

Rental properties are worth their price when rents run 5 to 10 percent above all your known costs, says John Reed of Alamo, Calif., the author of 16 fine books on real-estate investing (www.johntreed.com). Expenses include renovations, carrying costs during vacancies and a reserve fund for maintenance. Most traditional rental properties don't meet Reed's guidelines today, but when you find one, it should be a honey.

You might buy a property and improve it--say, by subdividing so you get an extra lot to sell. But forget about most "fixer uppers." Everyone wants them, so they sell for more than they're worth.

A third strategy is to search for properties you can buy for 20 percent less than you believe they're worth. That usually means researching weird stuff such as bankruptcy sales or properties with clouded titles you think you can clear.

If none of this sounds easy, that's what I intend. Busy investors are probably better off in mutual funds. In the 10 years ending in December 2001, Vanguard's S&P index fund returned 11.9 percent, after tax--and that includes two really rotten years. You can make real estate pay, but only if you truly approach it as a pro.