Investing in Real Estate

John Wiley & Sons

Chapter One

Flashback summer 2002: My telephone rings. I pick it up, and it's Dr. Cynthia Stephens from Los Angeles (where during the previous three years property prices had jumped nearly 30 percent).

"I'm so worried," she says. "I think I've chosen the absolute worst time to buy a home."

I calmly assure her, "No you haven't."

"What do you mean?" she replies.

"Well, I'll tell you an even worse time to buy-five years from now, ten years from now, or any other time in the foreseeable future."

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Coincidentally, around the same time that I heard from Dr. Stephens, I was interviewed by Business Week (Susan Scherreik), Fortune (Brian O'Keefe), National Public Radio (Chris Farrell, Katherine Scott), Smart Money (Gerri Willis), Mutual Fund (Mark Klimek), The Wall Street Journal (Terri Cullen), and the New York Times (James Schembari). In one way or another, each of these journalists asked similar questions and expressed concerns similar to those of Cynthia and other homebuyers, investors, and journalists who frequently call me.

"Are we in a real estate bubble? Are properties still a good investment? Is it better to start switching money back to stocks? Can we expect property prices to stop appreciating? Won't stock returns outperform all other types of investments over the long run? Doesn't owning property create too many headaches? Shouldn't property buyers lay low until prices come back down?"

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Readers of the fourth edition of this book will recognize that I have written here in this fifth edition the same opening passages. Why? Because the same controversy about real estate still circulates today.

In fact, just this week, Gerri Willis, now with CNN/Money, called to ask my views on Robert Shiller's latest edition of Irrational Exuberance.

There, Shiller concludes that today's real estate prices parallel the tech bubble of early 2000. Like most media commentators and so-called experts, Shiller's talk of a "bubble" reveals that he knows next to nothing about investing in real estate.

At the time of the tech wreck, the stocks of the NASDAQ paid investors a dividend yield of less than one-half percent. Even worse, the dot-coms paid zero dividends. "No worries, mate," came the typical response, "We don't care about dividends. We're investing for the appreciation."

Unfortunately, those tech dreamers failed to realize that investors (i.e., speculators) who hang their hopes on appreciation without income rarely earn enough returns to justify their risks. As a real estate investor, you do not face a similar situation. Rental properties yield the highest income flow of any investment alternative. Hence, no bubble. (Please do not confuse a "bubble" with cyclical price movements. When bubbles burst, prices fall by 70, 80, 90, or even 100 percent. Recovery-if it comes at all-can take decades. No rental property market in the United States has ever suffered through such an era. And no one I know of has suggested this type of collapse.)

More importantly, as a savvy real estate investor, you can actually earn your profits from property from eight different sources:

1. A dependable and growing flow of income

2. Mortgage payoff (amortization)

3. Value creation (property improvement)

4. Instant gain (bargain purchase price)

5. Government benefits (tax credits, tax deductions, rent vouchers, advantageous loans, etc.)

6. Strategic management

7. Value increases (appreciation)

8. Inflation

In the chapters that follow, you will discover how to make each of these sources of profit work for you. You will discover how properties can provide you a near certain path to financial security and prosperity.

Before we get started, let me clarify my point: No one can predict short-term price movements. By the time you read these words, property prices in some markets may have stalled-or even retreated. No one denies that short-term property prices can cycle down as well as up. But I emphatically reject the faulty reasoning that concludes property prices have reached a long-term peak (as did tech stocks) and can only enter a precipitous decline. Far more importantly, however, you must realize that to profit in property, you do not need appreciating prices.

Don't believe me? Then consider this example. Assume that you pay $250,000 for a property today. You put $50,000 down and finance the balance of $200,000 over 20 years. During this total period, your rent collections give you no surplus cash return. They merely cover your property expenses and pay off your mortage. The price of this property doesn't go up. You sell at the end of year 20 for $250,000-exactly the same amount you paid. Even without an increase in this property's price, you have multiplied your original investment of $50,000 fivefold.

Now think how much more you can earn if we abandon such a pessimistic (unrealistic) outcome. As noted, you can also profit by finding bargain-priced properties, creating value, strategic management, and inflation. Nevertheless, let me postpone discussing those benefits until later chapters. At this point, I want to show why you can count on property to provide you excellent returns without appreciation.

Moreover, I do not advise you to choose real estate because property investors in the past have earned superior profits. I encourage you to invest in property because economic and demographic facts confirm a profit-generating future.

A DEPENDABLE AND GROWING FLOW OF INCOME

Before you choose an investment, weigh the amounts of income (rents, dividends, or interest) that investment is likely to yield relative to other potential investments. Is the flow of income dependable? Will it grow over time? Will it guard you against inflation?

Always recognize this truth: An investment that falls behind other types of investments in terms of income must (sooner or later) suffer in value. In contrast, investments that yield superior flows of income will show higher rates of long-term appreciation. Investors never buy assets, per se. They buy flows of future income. With that said, let's see how income properties stack up against stocks, bonds, and annuities.

Property versus Stock

Compare two investors, Sara and Roy, who have each accumulated investments worth $1,000,000. Sara owns rental houses; Roy owns stocks. Who is likely to achieve the most annual income? The average dividend yield on stocks (the S&P 500) has been bouncing around 1.5 and 2.0 percent-quite low by historical standards. In contrast, the dividend yield (i.e., net operating income) on rental houses and small apartment buildings (owned free and clear) typically falls within the 6 percent to 12 percent range. Let's say Sara's properties yield around 7.5 percent.

Based on these respective yields, the corporate management of the companies in which Roy owns stocks would mail him checks totaling $15,000 to $20,000 a year. As a reward for owning properties, Sara's property manager would mail her checks totaling $75,000 a year.

Even if we assume that Sara's current returns from property actually fall in the low range (say, 6 percent) and that Roy achieves a dividend yield from stocks that's greater than the S&P 500 average (say, 3.0 percent versus 1.5 to 2.0 percent), Roy's stocks will pay him only $30,000 per year versus the $60,000 a year that Sara's real estate will pay her.

To keep matters simple, we didn't count leverage (see Chapter 2). Through long-term mortgage financing, Sara could boost the amount of property cash flow that her $1,000,000 yields. By using mortgage money to help her buy more properties, Sara could actually pull in $100,000 to perhaps as much as $140,000 in yearly cash flow.

Unfortunately, Roy can't safely use borrowed money to boost his yearly income from dividends. He would have to pay interest on his margin account at the rate of, say, 4.0 to 8.0 percent a year. Yet (even after our generous yield assumption) Roy earns an annual cash return of only 3 percent. Even the mathematically challenged will realize that Roy could soon go broke paying $40,000 to $80,000 a year in interest while receiving a mere $30,000 in income.

The Nest Egg Dilemma. Financial planners now acknowledge the problem that low dividend yields create for stock market investors. Low cash returns mean that relatively few Americans can ever hope to accumulate a stock market nest egg large enough to provide them a livable income in their later years. In recognizing this fact, financial Web sites now display "retirement calculators" that presumably help you figure out safe rates of portfolio liquidation. The "stocks for retirement" crowd now admits that to live comfortably, future retirees must plan to eat much of their nest egg. Yet anytime you chew down capital, you face the risk that you will run out of money before you run out of life.

Because stocks don't produce much income, retired stock investors are pinched between that proverbial rock and a hard place: (1) Draw down cash too quickly and you end up living on food stamps and Section 8 housing vouchers; or (2) spend cautiously, clip coupons, search out every senior discount you can find, and you miss the enjoyable lifestyle that accumulated wealth should make possible.

Volatility of Returns. More bad news for those who want to count heavily on stocks for the long run. We return to March 2000. The S&P is flying high, and the NASDAQ has sailed into the stratosphere. Your plans to retire comfortably at age 55 in the year 2008 are moving along quite nicely. In fact, you're shopping for a vacation-retirement home. Then, wham! You're hit with previously unimaginable losses. During the next two and one-half years, the value of your stock portfolio sinks 40 percent. By July 2002, its value has fallen back to where it was in 1996-six years earlier. What do you do? What can you do?

Up until March 2000, most stock investors erroneously believed that the market just plugs along dependably, handing out appreciation gains of 10, 12, or 16 percent year after year. Market blips? No worry, the S&P will surely bounce right up again. Only recently have these investors begun to learn that depressed markets don't always roar to new highs. Bear markets can slumber for decades (e.g., 1907-1924; 1929-1954; 1964-1982; 2000-?).

And that unhappy fact throws up another type of stock market nest egg dilemma: If, over the next 20 years, you want to build a nest egg of $1,000,000 (today's dollars), how much do you sock away each year? No one knows the answer.

You can assume stock market appreciation of 6, 8, 10, or even 12 percent a year. But persistent (and sometimes lengthy) ups and downs of the market render financial planning tougher than predicting sunny days in Seattle. Stocks may fail to yield anything more than a poverty level income, and just as worrisome, you can't reliably estimate the amount of income (or wealth) you will receive. Stock price volatility along with low dividend yields can shatter the best-laid nest eggs.

What about Bonds?

Quality bonds pay more annual income than stocks, but they still lag leveraged returns from income properties. However, let's say that to boost his income, Roy moves his portfolio from stocks that earn a dividend yield of 3.0 percent to 30-year bonds yielding an above market rate of 6.0 percent. Sounds good until you think longer term. Unfortunately, that $60,000 a year that Roy now receives from bond interest will remain at $60,000 year after year for the next 30 years. This annual income will never go up, and its purchasing power will continue to fall. If, during the next 20 years, the consumer price index (CPI) advances at an average annual rate of 3 percent, Roy's $60,000 income would equal purchasing power in today's dollars just $33,220; after 30 years, $24,719.

Compare this (curently above market) bond income with Sara's (below current market) rental income of $60,000. The bond interest looks about the same-for now. Over time, though, Sara's rental income will continue to increase. If Sara's properties average a 4 percent rent increase each year, here's how her $60,000 of net income would grow:

5 Years 10 Years 20 Years 30 Years $72,999 $88,814 $131,467 $194,603

You must recognize that rental properties are called income properties not only because they yield competitively favorable incomes today but also because that income will multiply itself over time. For future income that you can live well on for as long as you live, no investment comes close to matching the amount and certainty of income provided by rental properties. Inflation does not eat away your rental income because (unlike bond interest) rents tend to increase over time.

Don't Fall for the Annuity Sales Pitches

With stock market jitters and low CD rates rattling the retired and near retired, peddlers of annuities have tried to grab an increasing share of the investment and savings dollar. One such company regularly runs an ad in The Wall Street Journal with the following headline:

Lock in 6.00 Percent

Fixed annuities are today's ideal investment. Compared to dividend yields of less than 1.5 percent and CD rates of 2.5 to 5.0 percent, 6.00 percent return might seem attractive.

But as with bonds, fixed annuities expose you to substantial inflation risk. Even worse, as with stocks, to pay a decent income, annuities eat into your capital. As another disadvantage, many annuities include heavy front-end expense loads and fees in addition to early redemption fees. Don't be misled (as my retired parents almost were). Most people cannot wisely use annuities to satisfy their need for a sufficient, dependable, and growing source of income. And if you get in and want out, you may pay dearly for that privilege.

Are Rent Collections Dependable?

"Okay," you may be saying, "You've convinced me that, dollar-for-dollar, rental properties throw off more income than stocks, bonds, CDs, or annuities. But what about vacancies and deadbeat tenants? Who needs that kind of headache?"

Good point. That's why Chapters 11 and 12 show you how to manage your rentals with reduced time, effort, and risk. When you follow the policies and practices discussed in those chapters, you will see how to achieve low turnover, high tenant retention, and an eager waiting list of good people who will prefer your properties to inferior rentals offered by other owners.

Review Your Market. To verify what I say, review your local rental housing market. Can you find any well-located, well-kept houses or (competently managed) small apartment buildings that remain available for rent for any lingering period of time? Probably not, if they're priced and promoted effectively. Except in isolated cases, smaller residential rentals typically suffer vacancy and collection losses of less than 5 percent per year.

Beware of Superficial "Market" Vacancy Rates. As I write, news stories report that, nationally, average apartment vacancy rates have climbed above 6 percent.

Do not read too much into these types of "market" averages. Typically, these vacancy averages do not apply to the types of properties that you will own. Instead, so-called market vacancy rates and rent concessions primarily refer to two types of properties: (1) apartment mega-complexes whose hundreds of units persistently suffer revolving-door occupancy, and (2) ill-maintained properties that attract the dregs of the human populace. (I received a Department of Housing and Urban Development [HUD] foreclosure offering for a 22-unit rental property that not even rats and cockroaches would want to call home. Of the 22 units, only 9 were occupied.)

(Continues...)

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Excerpted from Investing in Real Estate by Andrew James McLean Excerpted by permission.
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