Between 2000 and 2006, residential real estate prices have soared. Home prices across the country have appreciated by 30 percent or more – in some booming cities, as much as 50 percent. Plenty of people have been buying, thinking they are making a great investment. In truth, however, many have been speculating – buying without regard to the underlying economic factors but still expecting to make a huge profit.
This is a mistake you can and should avoid. While real estate does tend to go up, historically, it is essentially an illiquid asset – affording you limited control over when you can best offload it.
Your best real estate investments will be in areas where you have some comfort and level of experience. This may mean buying property close to you. You should also determine how much time you have to devote to your investments and your ability/tolerance for managing them. You may prefer commercial over residential real estate because the nature of the tenant relationship and the leasing terms (usually three to five years versus one year or less) are more stable.
Timing is also important. A booming condo market today may be tomorrow’s overbuilt condo market. You need to pay attention to overall economic trends in your area (as well as nationally). This includes tracking employment growth, demographics, permit activity and other economic indicators and data. If you do not have the time or background to make sense of the data, make sure your broker is up-to-date and smart about these trends. The economy is what drives the real estate market.
If you are interested in diversifying into commercial real estate but lack experience, you might consider purchasing company shares with a builder or regional developer. If you choose this option, just be careful that you are dealing with reputable companies with a proven track record.
Real Estate Investment Trusts (REITs)
REITs are another option. These are mainly publicly-traded companies that own, operate, or finance real estate and do not pay corporate income taxes as long as they return at least 90% of their income to shareholders as dividends. The market for REITs – which include everything from shopping centers, malls and industrial complexes to hotels, medical centers and apartment buildings – has been relatively strong. Yields have been more or less on par with the ten-year Treasury note, at about 4.54 percent.
However, you should understand the business cycle of the area in which you are considering investing before you make a commitment. Two sectors that have been strong in 2006 are apartments and hotels. Demand for apartments has been boosted by the high cost of single-family homes, coupled with a large number of condo conversions. The hotel sector has benefitted from increased business travel and a lack of full-service hotels in several major markets. However, over-building could very well dampen interest in these sectors within a few years. If you want to really get in on the ground floor, you would do well seek out a sector that is showing small signs of turning (upward) and has good prospects of a sustained climb.
1031 Exchange
The 1031 exchange is another popular investment vehicle. Under current tax laws, if you own an investment property and sell it at more than $500,000 profit, you must pay a capital gains tax. If you can identify a same-kind investment property you would like to buy withing 45 days of your closing – and make the purchase within six months – the 1031 exchange allows you to avoid paying this capital gains tax.
You can use the 1031 exchange several times and reap the same benefit of it every time – until the time at which you make a cash-in sale and don’t want to reinvest. At this point capital gains tax may catch up with you and you may wish you had paid the tax on your profits incrementally. The other part of 1031 exchanges that you want to be careful about is that you must place the proceeds from the property you are selling in escrow at closing. A qualified intermediary, such as a title firm, must hold the money in escrow until another property is purchased. The risk with this is that the area of escrow funds is not highly-regulated and if your title firm is not completely ethical (eg speculates with the funds with which you entrust it and goes bust before you are ready to make your next purchase), you could lose your investment.
Bearing these two potential pitfalls in mind, however, the 1031 exchange remains an option for making the most of a market opportunity when you have insufficient capital to do so otherwise. Just make sure that you have a lawyer go over the transaction to ensure that the replacement property meets the conditions for “same-kind”.
If you wish to sell an investment property without paying capital gain tax or using the 1031 exchange, however, consider selling it to a REIT. While you no longer own property directly, the REIT offers more flexibility. Your real estate interest is securitized so that partners can make their own financial decisions independently. There is no longer direct liability and operating partnership units (OPs) may be used as collateral for other investments. Capital gains tax is deferred indefinitely and you are assured of secure, steady income. Furthermore, your heirs are in a better position if you die.
Whatever real estate investment strategy you choose, be very mindful of the trends in the market and where you are in your investment time-frame. Residential sales, for example, have provided quick, easy returns for many in recent years but are not likely to continue to do so. If you are considering investing in residential real estate right now, you would do well to think long-term. If you are nearing retirement, you may do better to consider a REIT.