William Jordan, president of the Sentinel Group, a financial planning firm in Laguna Hills, Calif., has always told his clients that they should own at least one rental property. Jordan "loves real estate as an asset class," he says.

But a few years ago, Jordan sent a letter to his clients explaining "why real estate will crash." Practicing what he preached, Jordan sold not only his own investment property, but also his home and moved into a rental, where he still lives. "I might have been a little early on my call, but the clients who took my advice are glad they did," Jordan says.

Of course, there's been no escaping the disastrous aftermath of the real estate collapse. By the middle of October 2008, one in six homeowners owed more on their mortgages than their houses were worth. As rising interest rates forced overextended subprime borrowers to default on their adjustable-rate mortgages, investment banks left holding these mortgage-backed securities had nowhere to turn. The contagion quickly spread to the U.S. markets and then internationally, as big-name mortgage lenders, insurance companies, investment banks and retail banks either went bankrupt or were bought out (fully or in part) by the government. Central banks around the world worked feverishly to restore confidence in the global markets.

And now? Is Jordan ready to rejoin the rolls of property owners? Not yet. "I'm still bearish," he says. "Originally, I had set 2009 as a target for getting back into real estate, but now I think it might take longer for the market to stabilize."

My own informal telephone poll suggests that advisors widely share Jordan's real estate outlook. This is a better time to buy property than 2005 or 2006, but there's no hurry. With credit tight and markets swinging wildly, now is a scary time to commit large chunks of capital to what is still a relatively illiquid sector. Good deals—perhaps great ones—may lie in the future.

On the other hand, investors who prefer a passive approach to direct property ownership might have some real opportunities today. Brad Case, vice president for industry research and information at the National Association of Real Estate Investment Trusts (NAREIT), says that, judgin—g by lessons learned from the last two REIT routs, this might be a good time to invest in REITs.

Real estate, of course, is a huge and diverse asset class, offering various types of properties and multiple ways to invest in them. The current investment outlook may differ, depending on where you're looking.

Looking for the Bottom

For clients who want to own property directly, the most common tactic is to buy a single-family home and rent it to tenants. That slice of the real estate market enjoyed the biggest boom in the early years of this century and has suffered the sharpest bust. Before Jordan will advise clients to invest in this type of real estate again, he wants to detect signs of hitting the bottom. "I'd like to see the amount of foreclosures level off or fall," he says. "I'd like to see prices stabilize, too."

Such buy signals have yet to appear. RealtyTrac's August 2008 U.S. Foreclosure Market Report shows that foreclosure filings—default notices, auction sale notices and bank repossessions—were up 27% from August 2007. In August 2008, the total number of U.S. properties that received foreclosure filings and the national foreclosure rate were both the highest seen in any month since the company began issuing reports in January 2005.

As foreclosures rise, home prices keep falling. The National Association of Realtors reported that the median existing single-family home price dropped 7.6% in the second quarter of 2008 compared with the same quarter of 2007, falling from $223,500 to $206,500. The Shiller-Case index of 20 large cities showed price declines of 16.3% in the year ended July 2008.

Another key indicator—the number of unsold homes on the market—is also discouraging. According to Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis, a five-month inventory of homes for sale might indicate a stable market. Right now, at the current sales pace it will take 11 months to clear the market of available homes.

From all indications, then, the market for single-family homes is still weakening rather than stabilizing. "Many investors are afraid of missing the bottom in real estate," Jordan says. "In truth, you don't have to pick the absolute bottom in order to make money. Judging from past cycles, investors will have a window of anywhere from three to seven years to make profitable investments."

Patricia Callahan, president of the American Association of Small Property Owners, cautions against buying when prices still may be on the way down. "It's usually safer to wait until a market starts going up," she says. Because of the transaction costs involved, investors should plan on holding property at least five years to get a worthwhile return, according to Callahan. Buying too soon may increase the costs of carrying the property and increase the holding period until you can realize a profitable sale.

Crunching Numbers

For rental property investors, the crucial metric is the ratio of the rents they can collect compared with the prices they pay for the real estate. Rents are still low in relation to housing prices, especially in California, Jordan says. If you look at housing values this way, buyers are still paying steep prices, considering the rents they can collect. Negative cash flow is likely, assuming the investor is paying interest on a loan for most of the purchase price.

Nevertheless, Jordan is not ruling out investment properties altogether. "You can always find hidden gems," he says. "As a rule of thumb, if you can rent a property for at least 1% of the purchase price each month, you have an opportunity for an excellent investment."

That is, if Alice Jones can buy a house for $200,000 and rent it to a tenant for $2,000 a month ($24,000 a year) or more, she has a good chance for positive cash flow and is not likely to be under financial strain while waiting for the property to appreciate. If she collects only $1,600 or $1,800 a month, though, Jones may well have negative cash flow and face years of feeding the property before a profitable sale is possible.
"Some investors might say, 'I'll make a larger down payment. Then I'll have lower debt service and positive cash flow, even with lower rents,'" Jordan says. "The problem with that idea is that there's an opportunity cost to making a large down payment. The chance to use substantial leverage is one of the advantages of owning investment property."

Damaged Goods

If there are hidden gems today, they might be found in property purchased from hard-pressed sellers. Investors can buy at various stages of the foreclosure process, including short sales (property priced below the outstanding mortgage balance) and REO (real estate owned by lenders after foreclosure). "It's possible to make money on these deals, but you have to be careful," Jordan says.

Investors must be especially careful about the physical condition of these properties. "There are lots of foreclosure properties selling at low prices," says Bob Cain, publisher of the Rental Property Reporter. "I even found one in Detroit you could buy for nothing. The question is, though, do you really want the property, considering its condition?"

According to Cain, the expense of a rental property only starts when you buy it. "Then you have to address any damages caused by the former occupants before they moved out," he says. "Some properties have been trashed." He suggests having a home inspector look at the property closely before making any commitments.
"Some things, such as holes in the wall, can be fairly easy to fix," Cain says. "However, if there is severe damage to the heating system or the foundation is cracked, you may be looking at spending a lot of money before you can rent the property."

Investors who buy from an owner-occupant in financial distress might be able to get a home that's in better shape. "Many homeowners, though, are in denial about how much their home is worth, so you won't be able to buy at a low price," Cain says. "That won't be a problem if you buy from a bank after a foreclosure, but properties that have been vacant for a while may have more problems that require expensive repairs."

Borrowing Trouble

Once investors find a home that's in good shape (or one in need of manageable repairs), they will want to buy it with someone else's money—a mortgage loan—rather than their own cash. If John Smith buys a $200,000 home for $10,000 down (5%) and sells it a few years later for $220,000, that $20,000 gain (a 10% price rise) would be a 200% profit on his actual cash outlay.

Unfortunately for buyers, home loans may be available, but they're hard to get these days, especially when compared with the first few years of the century. "It used to be that you just needed a pulse and a good credit score to get a loan to buy investment property," says Chris Zehnder, whose wealth management firm in Saint Cloud, Fla., is a member of the Alliance of Cambridge Advisors. "Now you need a down payment of 20% or even more; you also need to demonstrate you have enough income to carry the debt."

Financing for investment real estate is often more difficult to obtain than a loan for an owner-occupied home, especially if a client wants to buy out-of-state property. "In Missouri, for example, most foreclosures have come from properties owned by out-of-state investors, so financing for investors from other states has dried up," Jordan says.

Regardless of the borrower's residence, lenders may well restrict financing to investors willing to put some "skin in the game," in the form of a sizable down payment. Jordan also says that some lenders are reluctant to make loans to investors who already have outstanding mortgages on three or four different properties.

Despite all the cautions and concerns, determined investors still may be able to find good deals. "In some areas, this can be a really good time to be a landlord," Zehnder says. "Many people can't buy homes now, so they're looking to rent." If clients can find what Zehnder calls the "sweet spot" in the market—a reasonably priced home in a neighborhood where tenants are willing to pay decent rents—they may be able to make money.

Zehnder personally owns several moderately priced homes in popular areas. "I have had no problem in renting them to acceptable tenants at good rates," he says. "I bought one recently in central Florida, from a bank. After putting in some money for initial fix-up costs, I've had positive cash flow from the start." To Zehnder, buying investment property may be particularly appealing if a client is handy with a paint brush and is willing to work with contractors.

Commercial Property

"There has not been as much deterioration in commercial real estate as there has been on the residential side," says Sam Chandan, chief economist and senior vice president for research at Reis, a real estate research firm based in New York. "Costs have been accelerating and credit has gotten much tighter, so there hasn't been as much overbuilding." Generally, market fundamentals on the commercial side are sound, meaning that vacancy rates are reasonable by historic standards and there is not a huge number of new properties under construction.

That's not to say that commercial real estate investments are trouble-free. The lack of available financing (and demands for large down payments) may reduce investors' returns; the bad-debt problems that have plagued the housing market may spill over to commercial real estate. It's possible that recent turmoil in the financial industry may lead to extensive layoffs and less demand for office space as well as sales of troubled firms' commercial properties.

"Retail real estate may be depressed if an economic slowdown causes less consumer spending," says Michael Dowd, senior vice president at Millennium Credit Markets, a New York-based affiliate of the United Group of Companies. "Many retail leases call for tenants to pay a percentage of gross sales, and those revenues may be down in 2009." As a result, Dowd is downbeat on investments in malls and shopping centers for now.

Nevertheless, some observers see opportunities in commercial real estate. Jordan has seen some promising offerings that would raise money from multiple investors for industrial and office properties. If they are approved by his broker-dealer, Securities Equity Group in Aliso Viejo, Calif., he might suggest them to selected clients.

Niche plays may prove to be rewarding as well. Dowd touts the virtues of investments in student housing (full disclosure: Dowd's company participates in these deals).

"A lot of schools need help from private developers if they want to be able to offer housing that today's students want," he explains. "Schools are outsourcing their housing to other parties." The demand for student housing is likely to keep growing as the so-called echo boomers (children of the baby boomers) make their way through the higher education system.

Demographics also play a role in another of Dowd's selections: developments offering housing to seniors. "When you own traditional rental housing, your best tenants are regularly leaving to buy a house," he says. "That's not true for senior housing. Turnover is lower, so vacancy rates also might be lower. In addition, when tenants do leave, you're not as likely to find that the walls and the lawn have been torn up."

Dowd also sees opportunities now in hotels and motels. "Demand for rooms is a function of the overall economy," he says. "When things pick up, you'll see more business travel and higher occupancy rates." Within the hotel sector, Dowd is upbeat on upscale and extended-stay properties.

REITs

If the commercial property market is fundamentally sound—but financing for investments is elusive—planners might suggest that clients invest instead in REITs, which generally own commercial properties. REIT prices tend to move before property prices, according to Case, so investing now might be a way to anticipate a cyclical recovery.

"Although we don't predict how markets are going to perform, the last two downturns were very similar to what we've seen so far this time," Case says. Those previous downturns occurred in the late 1980s, when the savings-and-loan crisis took a bite out of commercial real estate, and in the late 1990s, when investors were so determined to overload on technology stocks that they wanted nothing to do with real estate.

NAREIT's Equity REIT Index dropped 15.4% and 17.5% in 1990 and 1998, respectively. The 1990 fall was followed by seven positive years, and the 1998 decline preceded one small succeeding annual loss and seven winning years. Of those 14 years with positive results, eight had total returns in the 20% to 37% range. Further, the first recovery years delivered returns of 36% (in 1991) and 26% (2000) to courageous REIT investors.

Will REITs enjoy a re-rerun? So far, they seem to be following a similar script. NAREIT's Equity REIT Index dropped 15.7% in 2007; in the first three quarters of 2008, equity REITs were up 1.8%, sharply outperforming the broader stock market. If REIT prices have stabilized, as the 2008 numbers seem to suggest, the next few years might generate generous returns.

Not everyone is ready to run to REITs, though. "With REITs you give up some of the benefits of owning investment property," Jordan says. That is, REIT owners don't get the leverage and tax advantages that direct ownership can provide.

Yet REITs have supporters too. "It's not easy to buy homes cheaply enough to show a real cash profit in the early years," Dowd says. "The length of time that you hold on to a property before selling has implications for your internal rate of return. If you are making no cash profit or—worse—putting your own money into a rental property with negative cash flow with a single-family home, the opportunity cost can be significant."

While property investors are waiting for a direct investment to show a cash profit, a REIT could be generating a taxable dividend of 3% or more, Dowd points out. (The average equity REIT yield is now around 5%.) "If an investment property is costing you 5% a year to carry, it has to appreciate 8% faster than a REIT paying 3%, to make it a better deal," he says.

Dowd explains that this comparison is not meant to imply that you can't make money with direct real estate investments. "You can come out ahead if you buy properties well and manage them well," he says. "I just think you have to be sure you have a truly great bargain and not just a pretty good one for it to be worth the extra work and the increased risk of little cash flow."