Real Estate Beckons as Wall St. Stumbles

Michael Rosenblatt has two words of advice for investors spooked by the debacle on Wall Street: real estate.

The San Jose retiree began buying rental properties in the 1970s. The steady stream of income--as well as the price appreciation--has provided a welcome dose of profitability at a time when his other investments are swimming in red ink.

“I have about 55% of my assets in rental real estate,” Rosenblatt said. “As each day goes by and I look at the losses in my [stock] portfolio, I am so glad.”

Many investors may be ready to follow Rosenblatt’s example. The stock market has been falling for nearly 2 1/2 years. Buyers of Treasury bonds have watched the yields on those securities dwindle. Cash accounts pay almost nothing.

Residential real estate in California and other regions, meanwhile, has been racking up double-digit annual gains.

Real estate analysts are debating whether the housing market has assumed bubble-like proportions, ready to pop just when everyone decides prices will keep rising indefinitely.

Even so, for many Americans real estate remains the truest shelter from financial markets’ storm.

“Objectively, real estate is a very favorable investment compared to equities right now,” said David Lereah, chief economist at the National Assn. of Realtors in Washington. “Home price appreciation is very strong, and it’s going to remain strong because there’s a lean supply of homes. You also have historically low interest rates. You can use those low rates to leverage your investment and provide an even better return.”

Besides owning your own home, there are several ways to invest in real estate: buying shares of real estate investment trusts or mutual funds that own REITs; investing in commercial projects, such as strip malls or small office buildings; and buying individual houses for quick resale.

But for a long-term investor with a regular income who can come up with a modest down payment, owning rental property may be the most attractive option, experts say.

There are plenty of risks, of course. Tenants don’t always pay the rent, and some may trash the property. Housing prices could fall, causing invested capital to languish. What’s more, all real estate involves a time commitment from the investor, and apartment complexes in particular can require endless maintenance.

And there’s always the risk of the “negative”--industry-speak for when the rent doesn’t cover the cost of the mortgage, insurance and property taxes.

These are all important considerations, but they may be easier to stomach at a time when stocks are threatening to suffer their third losing year in a row.

And for those jaded by the corporate chicanery that has turned some billion-dollar companies into dust, there may be some comfort in owning a tangible investment that you can drive by each day.

One way to get started in rental real estate with a minimum of capital is to buy a duplex and live in one unit while renting out the other. This approach is particularly viable for young couples buying their first home, said Fred Pizzuto, a real estate agent who owns a duplex in Big Bear. The rent helps pay the mortgage, and you get the tax breaks that come with owning a home as well as owning a rental property.

“Fix it up and within three or four years, you’ll have that moving along well enough that you can buy something else and move out,” Pizzuto said.

Sounds simple enough. But it’s often not easy to find the right property at the right price. Evaluating any real estate investment--whether or not you intend to live there--is complex, and there is little professional direction for the newcomer.

“It’s not like Wall Street where there are a lot of analysts sitting in offices, coming out with reports on what you should buy,” said Glenn Sonnenberg, president of Legg Mason Real Estate Investors in West Los Angeles. “There is no national market for real estate. It’s a bunch of local markets and sub-markets.”

How do you decide what to buy?

For investors buying properties on their own rather than through a syndicator like Sonnenberg’s company, he suggests staying close to home, where they’re better able to evaluate prices, crime, schools and the rental market.

“The danger is to go too far afield,” he said. “If I were to buy, I’d want to buy in my neighborhood, where I know what the good streets are and where the shopping is. Buy what you know.”

Price is always a critical issue with investments, but it may be particularly so with investment real estate.

Rental real estate generates returns in two ways: appreciation of the property and income from tenants. A buyer has to determine whether he or she will earn a decent return on invested capital--the down payment--over the long run, and whether the rent will cover the cost of the mortgage, property taxes and insurance, among other expenses.

If the rent doesn’t cover those costs, the buyer has to put additional money into the investment each month. Calculating returns without taking those additional capital infusions into account is like counting total dollars in a 401(k) savings plan while ignoring the fact that additional money has been pumped into the account throughout the year.

It’s an important point when comparing potential returns on real estate with what you might get from other investments.

Right now, with the stock market’s prospects dicey, and many fixed-income securities paying minuscule returns, the comparisons often favor real estate, experts say.

Over long periods, residential real estate has appreciated at about a 4% annual rate, according to the National Assn. of Realtors. That compares with about a 5% annual return for government bonds and about 11% for stocks.

But because of leverage and tax breaks, real estate still may have an edge even if the nominal annual return stays close to historical averages.

Consider a hypothetical investor who buys a $100,000 home, putting 20% down and financing the $80,000 balance at 7%. His monthly mortgage payment is $532.25. With property taxes, insurance and maintenance costs of $125 a month, he’ll have positive cash flow if he can charge more than $657 per month in rent.

If the property appreciates 4% a year it will be worth $148,000 after 10 years. The mortgage, meanwhile, has been paid down to $68,650.

If the owner sells, he’ll pay a 6% Realtor’s commission, reducing his net sales price to $139,120. Still, he walks away with $70,470--an annual return of 13.4% on his original $20,000 investment.

Meanwhile, along the way he may have gotten tax breaks that reduced his net cost of owning the property.

The catch: It’s difficult to find deals in which rents will fully cover the monthly costs of holding the property, real estate experts say. Moreover, it’s not unusual to have months when a rental unit is vacant, generating no income.

Also, the cost of borrowing to buy a rental property may be higher than on owner-occupied homes, lowering the long-term return.

The biggest risk is that tenants will fail to pay their rent, forcing a landlord to hire attorneys to evict them.

“You’ve got to maintain a cash cushion” of at least two or three months’ rent to cover vacancies and nonpaying tenants, said Judith Martindale, a financial planner who owns two rental units in San Luis Obispo.

Finally, don’t underestimate what might go wrong when you have tenants.

Consider Donna Englander’s first rental experience. She and her husband rented out their Redondo Beach home at a below-market rate to a friend while they were out of town for six months. The friend failed to repair an old wall heater that suddenly started spewing soot throughout the home.

When Englander returned, she and her husband had to replace the furnace and repaint the entire house, at a cost of several thousand dollars.

One lesson, experts say, is that you should never skimp on property insurance when you’re a landlord.

Many real estate investors choose to simplify the process by hiring a management firm to find renters, check potential tenants’ credit and references and make necessary repairs.

Although management companies can be expensive for vacation rental homes--charging as much as one-third of the rent--the fees usually range from 5% to 10% of the rent collected for longer-term rental properties.

Englander, who is now renting their house at market rates to strangers, considers the management fee well worth the cost.

“I bought a book called ‘Every Landlord’s Legal Guide’ and handed it to my husband to read so we could do this right,” Englander said. “He got to about Page 10 ... and he threw it back at me and said we’re hiring a property management firm.”