Rethinking Real Estate : Investments: Though the Southland market has slowed, the outlook is not all bad if investors are willing to hold properties for up to five years.
When Siavosh Ardalan bought a three-bedroom home in Woodland Hills late last year, he thought that the prospects for real estate investing were bright. Prices had been appreciating at double-digit rates for the past two years, and homes in the San Fernando Valley were being snapped up almost as quickly as they were listed.
After pouring thousands of dollars into remodeling--putting in new windows, french doors and a marble fireplace--Ardalan listed the house for sale in November. But by then, Southern California’s hot real estate market had cooled. And now, six months after buying, he’s just hoping to break even.
Although prospects seem bleak, with home prices declining or flattening here and nationwide, investors like Ardalan should take heart. The outlook for real estate is not all that bad--as long as investors are willing and able to hold on to their properties for as long as five years.
True, the industry’s heyday--when values rocketed up 20% and 30% annually--is over for at least the foreseeable future. But many experts say real estate is still superior to other investments, including stocks and bonds, if held longer.
“The key is the difference between speculating and investing,” said Sanford R. Goodkin, executive director of Peat Marwick/Goodkin Real Estate Consulting Group in San Diego. Speculators who expect to turn a quick profit are likely to be disappointed this year, he said. But investors who are looking for returns over three- to five-year periods will probably do well, he added.
And by taking advantage of leverage--the ability to buy with borrowed funds--and tax benefits, even modest appreciation rates in real estate can deliver healthy returns. Indeed, even if real estate appreciates substantially more slowly than stocks, the return after five years, for example, is often many times richer because of the combined effect of tax breaks and leverage.
The catch, of course, is that in times of declining values, investors can lose much more on a leveraged real estate investment than they would when buying stocks without borrowing.
“Leverage is wonderful on the way up, but murder on the way down,” said Phillip Holthouse, partner at the Los Angeles accounting firm of Parks, Palmer, Turner & Yemenidjian. “If you buy a piece of real estate and the price drops 15%, you’ve probably lost your entire investment. Whereas in the stock market you can leverage only 50%, so you need a 50% market decline to lose everything.”
But in what real estate experts call a “normal” market--one in which prices escalate slightly faster than the rate of inflation--real estate almost can’t be beat, according to Parks Palmer.
Parks Palmer analyzed the financial benefits of investing in stocks and real estate under three different scenarios, given various rates of appreciation, financing rates and numerous other factors. In all cases, real estate came out on top.
If a single male earning $45,000 annually, for example, had $13,000 in the bank and wanted to invest, he might logically consider both real estate and stock.
With $13,000, he could buy a $130,000 condominium paying 10% down and financing the balance. If he got a 10.5% fixed-rate mortgage, paid two points (a point equals 1% of the loan amount) in loan fees and realized a 5% annual rate of appreciation on his condo, at the end of five years, he would have posted a profit of $25,962--even after paying his real estate broker a $9,955 commission. In other words, he nearly tripled his money.
On the other hand, if he put the $13,000 into the stock market, earning a healthier 11.5% annual return, he would end the five years with a profit of only $6,013. That’s a 46% return.
The reason for the huge disparity? This investor was able to reap the reward of appreciation on a $130,000 home, even though his actual cash investment was only $13,000. A higher return in the stock market can’t possibly make up for the difference. In fact, even if stocks yielded 15% versus 5% for real estate, the gain on the stock investment would still be only $9,570, according to the Parks Palmer analysis.
That kind of leverage is generally not available in the stock market. Typically, the most an investor can borrow to buy stock is 50%.
So what happens if stocks appreciate 15% and the investor buys on margin? The stock market return soars to $22,717--or nearly as high as the return on real estate.
But there’s still a catch with the stock investment: taxes. Generally, homeowners can defer or avoid taxes on gains on the sale of their personal residence if they take the proceeds and buy another home of equal or higher value. And capital gains taxes on other types of real estate often can be deferred or avoided by swapping for properties of similar or higher value.
But the same is not true for stocks. Unless the investor has capital losses to offset the gain, or is able to trigger some other tax strategy, he may have to pay both federal and state taxes on the capital gain. In this case, the taxes would amount to about $7,800, reducing the total stock profit to about $14,800.
Moreover, stock dividends are also taxable--even if they are immediately reinvested in the stock market--and that also increases the cost of investing. (For the purposes of this example, it was assumed that dividends would account for about three percentage points of the total return in the stock market.)
“If the two options are equal from an economic basis, I’d tend toward real estate because of the tax benefits,” Holthouse said. “The other advantage is you can dispose of real estate without triggering a capital gains tax, which allows you to keep all your equity in something that will appreciate.”
Of course, not everyone is bullish on real estate now.
“Housing in the U.S. is really extraordinarily flat and it looks like it is going to remain that way,” said Hugh Johnson, chief investment officer at First Albany Corp., a regional stock brokerage in Albany, N.Y. “I think you are much better off in the stock or bond markets. I think the returns are going to be much better there.”
Regardless of the tax breaks, if real estate prices fall and stocks appreciate, the investor is losing out, Johnson added. And in many parts of the nation, real estate prices are dropping.
Even in California, where real estate historically has appreciated faster than for the rest of the nation, some sellers have had to cut prices. And even then, buyers are not flocking to their doorsteps. Many houses are taking more than six months to sell.
“We are having a lot of difficulty selling in this marketplace even though seven or eight months ago we had people begging us to sell it for $60,000 more than what we’re asking now,” said Rick Gould, who is selling an expansive home in Calabasas Park. “I may get killed on this deal.”
Stock experts say a big problem with real estate is that it is not easy to sell quickly. Stocks can be sold in seconds, and if the investor finds himself strapped for cash in a down market, he can sell just a portion of his stock portfolio. In real estate, it’s generally all or nothing. And even in a good market, a home may take several months to close escrow. In a bad market, there’s virtually no limit on how long the process may take.
“There’s really no comparison,” said Eugene E. Peroni Jr., director of technical research at Janney Montgomery Scott, a Philadelphia-based brokerage. “Stocks offer much more liquidity than real estate, and the real estate market has topped off in many areas of the country. On a total return basis, I think equities are offering the better return--not just now, but probably for the next couple of years.”
If real estate values fall or stagnate for a significant period, even the tax benefits and leverage would be insufficient to salvage the investment, these experts note.
But real estate experts contend that the current softness in the market is an argument to buy.
“It is always the hardest to invest when it’s the best time,” said Martin Cohen, a real estate investment manager and president of Cohen & Steers Capital Management in New York. Real estate is a cyclical business, he added, which means that often when appreciation rates have been the highest and it looks like it’s a good time to jump in, it’s not. And vice versa.
“If one has a long-term perspective and believes that real estate is an essential element in our society, then this is an ideal time to be investing,” he said.
However, he added, there still may be some short-term problems in the market, depressing appreciation rates for the next year or two.
“If you are taking a one-year horizon, you might do better this year in Treasury bills than in any other investment,” he said. “But if you look at a five-year horizon, the picture changes. Over the longer term, I wouldn’t be at all reluctant to project a higher rate of return in real estate than in Treasuries.”
However, location and “staying power” remain key elements in making money in real estate, according to industry experts.
Even with overall appreciation rates flat or down, many believe that home prices in certain communities will soar. Washington state, Las Vegas, Reno, Sacramento, Fresno and some inland cities throughout California will participate in the real estate boom that peaked in higher-priced Southland communities last year, said Goodkin.
The reason? Continued economic and population growth will spur demand for lower-cost housing. Cities such as Palmdale and Lancaster, where homes can still be had for under $150,000, will find home sales brisk, these experts believe.
But investors need the financial wherewithal to wait out bad markets, said Stan Ross, managing partner of Kenneth Leventhal & Co., a real estate accounting firm in Los Angeles. That means being in a position to make several months of mortgage payments, if necessary, to hold on to the property until the cycle turns positive again.
Of course, if the location and market are so poor that appreciation rates will not be substantial even if the investor waits, it’s best to sell and cut losses, Ross said.
Ross and Goodkin contend that apartments may be a good investment now because supply is low and the rental market is strong. However, Holthouse cautions, investors must take a realistic look at cash flow projections for any apartment investment because appreciation rates and tax benefits will probably not be enough to bail out an uneconomic development.
But when it all works out well, the financial rewards in real estate can be stunning, even for those without a lot of cash.
Gary Holme, now president of the Los Angeles Board of Realtors, is a prime example. He said he bought his first apartment building, a five-unit complex in Sherman Oaks, with $500 when he was 20 years old in the early 1960s. Holme’s friends and relatives thought that he was crazy because the market was then in turmoil, with high vacancy rates and little resale demand.
A few years later, he refinanced the building and bought a house and two North Hollywood apartments with the $120,000 he extracted from the refinancing. Later he refinanced again and bought eight Encino “park homes”--900-square-foot residences that he quickly resold for a 60% profit. In all, he has refinanced that initial apartment complex three times, buying other real estate with the proceeds. While he has lost on a few deals, he believes that there are few better investments than California real estate.
Bad markets are the best time to buy, he adds, because sellers are willing to negotiate and buyers can pick up good deals.
“In a down market, the guy with a little financial backing can do very well,” he said.
Even Rick Gould, who acknowledges that he may lose money on his Calabasas home, agrees. “You live in Southern California all your life and you begin to appreciate the fact that real estate appreciates, regardless,” he said. “Am I discouraged? Yes. But the honest truth is, if I had money right now I would buy another piece of property.”
