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16 Real Estate and High-Risk Investments

YOU MUST BE KIDDING, RIGHT?

Friends Nicholas Belisle and Joseph Sanders both have aggressive investment philosophies. Nicholas invests primarily in residential real estate, and Joseph invests in commodities futures contracts. As longtime investors, they consider themselves experts, but occasionally, each has experienced financial losses. What are the odds that the typical investor will make money investing in commodities futures contracts?

A. 50%

B. 30%

C. 20%

D. 10%

The answer is D. Ninety percent of individual investors in futures contracts lose money. Funds used for these investments should be only those that one can afford to lose!

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

Demonstrate how you can make money investing in real estate.

Recognize how to take advantage of beneficial tax treatments in real estate investing.

Calculate the right price to pay for real estate and how to finance your purchase.

Assess the disadvantages of investing in real estate.

Summarize the risks and challenges of investing in the alternative investments of collectibles, precious metals, and gems.

Explain why options and futures are risky investments.

WHAT DO YOU RECOMMEND?

Britanny Day, a 37-year-old marketing manager for a large corporation in Long Beach, California, earns $110,000 per year. She saves an additional about $800 each month beyond her contributions to her employer's 401(k) retirement plan. Her total 401(k) holdings are worth $260,000.

Ever since her grandfather gave her some stocks as a child, Britanny has loved investing—and she has enjoyed a good track record with her efforts. Britanny is an active trader, often trading every three or four weeks, primarily in the oil, technology, and pharmaceutical prescription drug industries. Every year, she has some losses as well as gains. Her private portfolio is currently worth $160,000. Britanny has never bought or sold options or futures contracts, but her stockbroker suggested that she consider them. Britanny also has a friend who owns several residential rental properties that she bought when prices were low who has asked her to consider investing as her partner in her next real estate venture.

What do you recommend to Britanny on the subject of real estate and alternative investments regarding:

1. Investing in real estate?

2. Putting some of her money in an alternative investment, like a collectible or gold?

3. Investing in options and futures contracts?

YOUR NEXT FIVE YEARS

In the next five years, you can start achieving financial success by doing the following related to real estate and high-risk investments:

1. Before deciding to invest in real estate, carefully consider the disadvantages of such investments.

2. Invest only in real estate properties that have a positive cash flow.

3. Finance real estate investments with conventional mortgages, not mortgages with adjustable interest terms.

4. Use the price-to-rent ratio and discounted cash-flow methods to help determine the right price to pay for a real estate investment.

5. Do not put any of your long-term investment money into real estate or high-risk investments are they are not suitable.

A home tends to accomplish more than just putting a roof over your head. It is also an investment, because historically housing values have increased about 3 percent annually over the long term. A real estate (or housing) bubble for residential markets occurred in the United States in the middle of the last decade. The bubble saw rapid increases in home valuations (10 or 20 percent, or more, a year) until they were unsustainable.

real estate (or housing) bubble Rapid and unsustainable increases in home prices followed by sharp declines in values.

Then the real estate market crashed as home values plummeted 40 or 50 percent or even more in some communities. The “for sale” signs on millions of foreclosed homes also pulled down the values of nearby homes. Today over 10 percent of all mortgage holders owe more on their homes than they are worth (they are “under water”), making it extremely difficult for them to sell. Unemployment and underemployment also makes it difficult for many others to buy homes. Fortunately, the real estate market has started to recover, thus there are some reasonable investment choices available.

Investors with an aggressive investment philosophy who seek high returns and are willing to accept greater risks might consider owning alternative assets such as collectibles, precious metals, gems, options, and futures contracts. All these are referred to as high-risk (or alternative ) investments because they have the potential for significant fluctuations in return, sometimes over short time periods.

high-risk (or alternative) investments Present potential for significant fluctuations in return, sometimes over short time periods.

Many investment advisors today recommend that people put 10 percent of their money into alternative investments as a way to diversity their money, recommending for example that someone in their twenties have a portfolio of 65% stocks, 15% bonds, 10% alternatives, and 10% cash. They are wrong. Real estate and alternative investments are not suitable investments for long-term investing program, such as for your retirement, because they are too risky for you too diversify appropriately Think about it? How many real estate investments can you make? How many precious metals can you own? How many options and future contacts can you buy?

16.1 HOW TO MAKE MONEY INVESTING IN REAL ESTATE

Real estate investing is not the same as buying a home in which to live, which was the subject of Chapter 9. Investing in real estate might provide you with extra income now and give a boost to your future retirement plans. But you have to do a lot of things right.

LEARNING OBJECTIVE 1

Demonstrate how you can make money investing in real estate.

Real estate investing is complicated given today's market conditions, thus you must become smart about taxes, financing, insurance, and community economics. Real estate investments are complex, and they are much riskier than investing in mutual funds and stocks. People often do not possess the mental toughness that it takes because investing in real estate is a job. Most people are not cut out to be a do-it-yourself landlord. Dealing with tenants requires a business attitude, not a willingness to view tenants as friends.

Real estate is property consisting of land, all structures permanently attached to that land, and accompanying rights and privileges, such as crops and mineral rights. For example, you can invest directly as an individual or jointly with other investors to buy properties designed for residential living, such as houses, duplexes, apartments, mobile homes, and condominiums. You also could invest in commercial properties designed for business uses, such as office buildings, medical centers, gas stations, and motels. You might buy raw land or residential lots, although they are extremely risky and often lose money for the investor. For someone considering an investment in real estate, there are two key questions that you must answer.

real estate Property consisting of land, all structures permanently attached to that land, and accompanying rights and privileges, such as crops and mineral rights.

16.1a Question 1: Can You Make Current Income While You Own?

The most important consideration for real estate investors in today's real estate market is not whether the price will rise enough in a few years to make a profit. The boom days of the rapidly rising prices of the housing bubble are probably gone in most markets. The focus for real estate investors now is whether the rental income will be sufficient to make ends meet while waiting for the property to increase in value.

If you invest in a property and you are paying out more than the rental income coming in, the negative cash flow exposes you to two risks: (1) whether you can afford to continue paying out that money month after month and year after year, and (2) whether you can make up for these cash flow losses when the property sells, which you hope will be for more than you paid for it. Get either of these wrong, and you lose your invested money and maybe more.

Know the Price-to-Rent Ratio To measure the current income in a real estate market, investors can begin by using the price-to-rent ratio , which is the ratio of median residential real estate prices to the median annual rents that can be earned from the real estate. The lower the ratio, the smaller the gap between annualized rental and purchase costs and the more attractive the decision to buy a home versus renting a similar one. If the price-to-rent ratio is too high, the prices for homes are likely to be too high.

price-to-rent ratio The ratio of median residential real estate prices to the median annual rents that can be earned from the real estate.

Nationally the price-to-rent ratio was 15 at the peak of the housing bubble. Now it is 11, which is back to 2004 levels. For recent information on price-rent ratios see Trulia (trends.truliablog.com/category/rent-vs-buy-index/) and Altos Research (blog.altosresearch.com/single-family-home-rental/). The ratio might range from perhaps 4 in Detroit to 35 in Honolulu, or more, depending on local market conditions— meaning how low or high housing prices are.

For investors, the lower the price-to-rent ratio is in a given community and a particular property, the easier it should be to earn back your investment. For example, in San Jose, California, a condominium renting for $2600 a month might sell for the high price of $890,000 for a price-to-rent ratio of 28.5(12 × $2600 = $31,200; $890,000/$31,200).

DO IT IN CLASS

Alternatively, a home in Pittsburgh, Pennsylvania, might cost $165,000 and rent for $1200 a month, thus providing a price-to-rent ratio of 11.5($165,000/$14,400 [$1200 × 12]). Investing in rental property with a high ratio will provide a profit only with a future increase in its resale value, which may be difficult to achieve in the near term.

Current Income Results from Positive Cash Flow For an income-producing real estate investment, you pay operating expenses out of rental income. The amount of rental income you have left after paying all operating expenses is called cash flow . The amount of cash flow is obtained by subtracting all cash outlays from the cash income. If the property has a mortgage (a common occurrence), payments toward the mortgage principal and interest also must be made out of rental income. Operating expenses such as mortgage payments, real estate property taxes, repairs, and vacancies may eat up half or more of the rental income.

cash flow Amount of rental income you have left after paying all operating expenses.

Calculate the Rental Yield Investors also calculate the rental yield on properties, as shown in Equation (16.2). This is a computation of how much income the investor might pocket from rent each year before mortgage payments as a percentage of the purchase price. Most properties yield about 4 percent of income annually, although the rental yield may be as little as 1 or 2 percent and as high as 8 or 9 percent.

rental yield A computation of how much income the investor might pocket from rent each year (before mortgage payments) as a percentage of the purchase price; divide the annual rent by 2 and then divide by the purchase price.

DID YOU KNOW

Invest in Foreclosed Property Using a Short Sale

Foreclosure is the legal and professional procedure in which a mortgagee, or other lienholder, usually a lender, repossesses a home and sells it because the borrower has fallen behind in making payments on the loan. Prior to foreclosure, the homeowner has three options: (1) depart the property and try, for moral reasons, to repay the lender the deficiency, (2) declare bankruptcy, or (3) try to arrange a short sale. Oftentimes the remaining balance owed on the home is more than the property is worth. Unless the lender is willing to modify the terms of the loan, the lender then pursues the homeowner for the deficiency.

In a short sale the lender accepts less than the full mortgage amount and often forgives whatever debt is left unpaid. The deficiency amount is the difference between the amount owed and what the bank collects at the short sale. When a bank agrees to a short sale, the homeowner hires an agent to find a buyer. New rules require lenders to provide preapproved terms for short sales; thus, an investor's bid is more likely to be accepted. Lenders agree to absorb the loss, although they might demand the homeowner make some kind of payment or share the loss. A debt that is forgiven may be subject to income taxes. A short sale may be a buying opportunity for investors, although negotiating with banks is sometimes a cumbersome and lengthy process.

Less expensive properties often offer higher yields. The formula assumes half of rental income goes for expenses other than debt repayment.

San Jose

Pittsburgh

Purchase price

$890,000

$165,000

Annual rent

31,200

14,400

Annual rent/2

15,600

7,200

Yield (annual rent/2/purchase price)

1.75%

4.36%

A slowly growing economy can lead to unfinished units and losses for real estate investors.

16.1b Question 2: Can You Profit When You Sell the Property?

The capital gain earned in a real estate investment comes from price appreciation. It is the amount above ownership costs for which an investment is sold. In real estate, ownership costs include the original purchase price as well as expenditures for any capital improvements made to a property prior to sale. Capital improvements are costs incurred in making changes in real property—beyond maintenance and repairs—that add to its value. Installing a pool and adding a room represent capital improvements.

capital improvements Costs incurred in making value-enhancing changes (beyond maintenance and repair) in real property.

Repairs are expenses (usually tax deductible against an investor's annual cash-flow income) necessary to maintain the value of the property. Repainting, mending roof leaks, and fixing plumbing are examples of repairs, but in the eyes of the IRS they are not capital improvements.

repairs Usually tax-deductible expenses necessary to maintain property value.

DID YOU KNOW

Money Websites in Real Estate

Informative websites for investing in real estate, including price-to-rent ratios in your community are:

Altos Research (blog.altosresearch.com/single-family-home-rental/)

LasVegas4Us.com discounted cash flow calculator www.lasvegas4us.com/JwwDCF/discounted_cash_flow_calculator.htm

Realtor.com (www.realtor.com/)

Trulia (trends.truliablog.com/category/rent-vs-buy-index/)

Yahoo real estate (homes.yahoo.com/)

Zillo (www.zillow.com/)

In markets in which real estate is difficult to sell (too many properties on the market and too few buyers), perhaps because of continuing job losses in a sluggish regional economy, residential housing prices might decline 2 or 3 percent annually for a long time. That means continuing deflation in home prices in some markets year after year.

CONCEPT CHECK 16.1

1. What are the two key questions to consider before investing in real estate?

2. Distinguish between the price-to-rent ratio and the rental yield as measures of current income.

16.2 TAKE ADVANTAGE OF BENEFICIAL TAX TREATMENTS

The U.S. Congress, through provisions in the Internal Revenue Code, encourages real estate investments by giving investors five special tax treatments.