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Catching A Falling Knife?

Dear Ginny: A friend of mine advised me not to invest in real estate. He thinks real estate prices will be depressed for many, many years. The stock market scares me and I don’t understand it. In the past, I’ve bought and sold several houses and know how to fix them up. Is investing in real estate a good thing?

Stephen, I mean no disrespect to your friend, but I wouldn’t place much value on his opinion unless he’s been involved in and has expertise with the real estate market and economy in general. The other problem that I have with his opinion is that he is forecasting what he believes will happen with real estate prices many years into the future.

I say that real estate investing is worthwhile, especially for an experienced property buyer like yourself, but not for all investors. Inexperienced real estate investors often are not aware of all the time and energy required to buy, improve and manage property. Of course, just because someone hasn’t bought an investment property before doesn’t mean that they aren’t up to the task. Everyone has to start with a first investment purchase.

Real estate has produced comparable long-term returns to the stock market. Of course, as recent events have demonstrated, both can lead to significant losses in the short term! Real estate and stocks don’t always move in tandem, so investing in real estate may help diversify a stock portfolio and vice versa. Consider that when the stock market tanked in the early 2000s, for example, real estate continued to do well in most parts of the country.

Real estate should continue to produce solid returns for the long term. Why? For many reasons including the following:

First is limited land. The supply of land here on Earth is fixed, thanks in part to water covering about 70 percent of our globe. And because people are prone to reproduce, demand for land and housing continues to grow. Consider that the population of the United States was just 100 million in 1915, 200 million in 1968, 300 million in 2007, and is expected to approach 400 million by middle of this century.

Real estate is different from most other investments in that you can generally borrow up to 80 percent of the value of the property. Thus, your relatively small investment can be used to purchase, own and control a much larger investment. Of course, you hope that the value of your real estate goes up; if it does, you make money on your investment as well as on all the money that you borrowed.

Here’s a quick example to illustrate. Suppose you purchase a property for $200,000 and make a $40,000 down payment. Over the next three years, suppose that the property appreciates to $240,000. Thus, you’ve made a profit of $40,000 on an investment of just $40,000. In other words, you’ve made a 100 percent return on your investment. (Note that this scenario is a simplified example because you have expenses from the property that may exceed the rental income you collect. If the property’s income just covers the expenses, then your return is 100 percent.)

Leverage is good for you if property prices appreciate, but leverage can work against you as investors who bought in recent years have experienced. If your $200,000 property decreases in value to $160,000, even though it’s dropped only 20 percent in value, you actually lose 100 percent of your original $40,000 investment. If you have an outstanding mortgage on this property of $160,000 and need or want to sell, you’d have to pay money into the sale to cover selling costs, in addition to losing your entire original investment.

Another reason real estate is a popular investment is that you can make money in two major ways from it. First, you hope and expect over the years that your real estate investments appreciate in value. The appreciation of your properties compounds tax-deferred during your years of ownership. You don’t pay tax on this profit until you sell your property — even then you can roll over your gain (through a 1031 exchange) into another investment property and avoid paying tax.

In addition to making money from your properties increasing in value, you can also make money from the annual cash flow. You rent out investment property to make a profit based on the property’s rental income exceeding your expenses (mortgage, property taxes, insurance, maintenance, and so on).

In the early years of rental property ownership, your monthly operating profit may be small or nonexistent, although the increasingly good buys in many housing markets are changing this. Over time, your operating profit, which is subject to ordinary income tax, should rise as you increase your rental prices faster than your expenses. During soft periods in the local economy, however, rents may rise slower than your expenses (or the rents may even fall).

Unlike investing in the stock market, you may have some good ideas about how to improve a property and make it more valuable. Perhaps you can fix up a property or develop it further and raise the rental income accordingly. Perhaps through legwork, persistence, and good negotiating skills, you’re able to purchase a property below its fair market value.

Relative to investing in the stock market, it is easier for persistent and savvy real estate investors to buy property below its fair market value. You can do the same in the stock market, but the scores of professional, full-time money managers analyzing stocks make it harder to find bargains.