Real Estate's New Rules
Relatively new clients came to planner Russ Weiss recently with an idea. The couple wanted to buy their daughters home in California, putting down $400,000 and mortgaging the rest. The association fees, taxes and mortgage payments were about equal to what they could get in rent, recalls Weiss, a planner at Marshall Financial Group in Doylestown, Pa.
Not so fast, Weiss thought. It took a little reframing for them to see it differently. They werent going to make any money on the $400,000 they were putting down, and they were going to take on all the risks of being a landlord.
Plus, I estimated that they would need an additional 3% a year to pay for annual maintenance, he says. They werent going to be well paid for the illiquidity and risk.
Eight or nine years ago, during the highest-flying portion of the real estate bubble, Weiss clients might have gone ahead. Now, however, they were willing to at least consider holding off. In that, they are like a lot of other potential real estate investors: Theyve seen what could happen.
Even with more cautious buyers, many real estate markets have become more competitive overall, says Andrew Altfest, executive vice president at Altfest Personal Wealth Management in New York.
The market has continued to recover for a number of reasons, Altfest says. Interest rates are low, the unemployment rate is going down and the economy is improving. Theres a lower supply of desirable properties and a thirst for yield among investors. All these things are pushing real estate prices up.
In the wake of the crisis, many investors who had cash or good credit treated the subprime crisis as a sale. Purchasers profited from a generous spread, buying properties at bargain prices from distressed owners or foreclosing banks, and charging rents that have only improved as the recovery has gone forward.
It was a fairly brief window, says Kevin Meehan, regional president of the Wealth Enhancement Group in Itasca, Ill.
Its still possible to lock in a healthy spread between income and investment, Altfest says but higher prices mean smaller spreads and narrower margins of error. And there are other challenges.
More expensive real estate eats up more cash and can mean servicing a bigger loan. It occupies a bigger proportion of a less-diversified portfolio. If prices increase faster than rents, the more expensive property will return less cash, making its owner more vulnerable to the financial hits of vacancy, maintenance costs and careless or destructive tenants.
Some property investors think they can work with a smaller spread. Others see ways to improve cash flow by upgrading a property, its management or both. Maybe the building is 90% occupied, but I think I can bring that rate up, Altfest says.
Both strategies require buying property thats priced to reflect its current drawbacks, rather than its potential.
You have to be very careful about what youre buying and what youre paying for it, Altfest says. The things that look rich are things you have to be more cautious about purchasing. A high-quality, multifamily property thats fully leased in a desirable area of a good market with good tenants is going to trade toward the high end of its range. A lot of money is chasing those properties. There isnt as much room for improvement.
When the cycle changes, he adds, you could be at risk because it could depress prices.
For clients who are willing to look carefully and take advice from planners, the picture for real estate may still be attractive. But real estate is a notoriously emotional purchase, and advisors may have to work hard to persuade clients to listen.
One challenge, both in boom and bust cycles, is that investors tend to undercount the cost of time spent on management tasks. A lot of people going into real estate for the first time and who are used to passively investing arent aware of the people hours involved, says David Haraway, a financial advisor in Colorado Springs, Colo.
Nor do buyers always understand their risks and expenses as landlords. Investors typically pay higher interest rates, insurance premiums, taxes and maintenance than do homeowners, and must factor in the cost of vacancies and other unpleasant surprises all while leaving a valuable investment alone with strangers much of the time.
In Colorado Springs, we have military families renting to other military families. Many arent good renters. Theres one in our neighborhood thats had five tenants or so in the last 10 years, and theyre rehabilitating the property. Is that in the budget? Haraway asks.
In addition to the expense and risk of the property itself, real estate can also take up a disproportionate share of a clients portfolio. I dont like more than 20% of anyones net worth in investment real estate, says Jane Nowak, a financial planner at Wealth & Pension Services Group in Smyrna, Ga.
Any more than that, Nowak says, and the portfolio isnt diversified properly. It also isnt liquid, and that can be a problem when people need money to retire. Those who are getting closer to retirement should consider liquidating in favor of stock or immediate annuities, Nowak says. You dont want to have to sell when you have to sell at fire-sale prices, which is a possibility for clients who wait.
Some clients may be better off getting real estate exposure without the risk, hassle and illiquidity that direct property ownership brings. For those clients, REITs are an obvious starting point.
Some clients are better off buying a REIT, though I think thats an area to be cautious of, Meehan says. REITs tend to correlate with the stock market. Its an asset class to diversify into [within] the equity world I dont think it acts as its own asset class.
In a rising market, REITs also have some of the same challenges as directly owned property. The REIT market is very volatile, down 75% between 2007 and 2009 which was terrific if you were in a rebalancing situation and then up 400% from that bottom, Haraway says. I handle REITs as maybe 10% of a portfolio. REITs tend to lead the other indexes and provide some diversification.
Along with volatility, REITs also carry interest rate risk, Altfest points out, and arent always available at favorable prices. Were value investors, and a lot of money is chasing REITs. Valuations are high and yields are low, he says.
Instead of (or in addition to) REITs and direct real estate ownership, Altfest suggests private partnerships, in which a group of people pool money to make a real estate buy and pay for its professional management.
We gave advice to someone who was very entrepreneurial and wanted to provide income to a community of [clients] who really wanted real estate as an investment, he says.
As targets for those private partnerships, Altfest likes shopping centers that are outside major real estate markets, but in areas with growing populations. Not the big-box shopping centers, he cautions. You want neighborhood shopping centers that are partially leased. Youre outside the biggest centers with tons of capital, you have the opportunity to lease it up and the prices are more reasonable. You can get a decent cash flow and have the chance to increase that cash flow while having the property managed by someone else.
Real estate-centered mutual funds, such as the Third Avenue Real Estate Fund (ticker: TAREX), are another choice. That fund, which Altfest says his clients use, owns real estate operating companies and stocks of companies that may not be in the real estate business, but have significant real estate assets.
Preferred equity investments are another way to get into the real estate market with greater liquidity and without management headaches. In a preferred equity arrangement, the investor loans money to the propertys primary purchaser, who uses the money to fund the purchase, either in addition to or instead of bank loans.
Look for an experienced real estate investment firm that is focused on preferred equity investing and has access to deals and the expertise to separate the wheat from the chaff, Altfest says. This can be a good opportunity if youre able to get one thats priced and structured well, he adds, noting that he likes short-term structures that return capital within two or three years and yield profits of 7% to 9% or more.
You can get a percentage of the profit sharing if the deal is a home run, and you can take control of the property if its being mismanaged, he says. The downside: A client could lose the capital if debt remains after the primary buyer loses his or her investment.
Which means, once again, that valuations are key. You want to look at the property for which youre providing capital. Altfest says. Is it expensive multifamily [dwellings] or something with better valuation where youre in at a low basis to the property? Conservative valuation is a good thing, because the equity owner is harder to wipe out.
For those clients who do want real property investments, the markets cyclical nature make a long time horizon critical.
The people who are really in real estate as a business model are typically doing well, says Steve OHara, principal at CLA Financial Advisors in Northbrook, Ill. They buy a house, have someone else make the payments for them, and then plan to use the income in 15 to 30 years. That can work.
There are other success factors, OHara adds. One is scale: As you build up your real estate portfolio, you learn something new and apply it across five, 10 or 20 properties. Invest once and you have the opportunity to mess up many [ways], he says. Do it 10 times and youll make fewer and fewer mistakes.
A capital cushion is important, too. People overestimate what theyre going to make from rental real estate. They think its going to be sunshine and roses, and if youre not well capitalized, it can get ugly fast, Nowak says. Capital of $8,000 to $10,000 per property can help protect a client from the financial impact of the unexpected.
Controlling for tenant problems also helps, which is why some business owners find profit in purchasing the buildings that house their firms.
In March, a client of ours acquired a large commercial property for his business and subdivided part of it into a rental, generating free cash flow of $10,000 a month, says David Demming Sr., founder of Demming Financial Services in Aurora, Ohio. The key is that it complements his business, rather than detracting from it.
Of course, if the business fails, owning the building could compound the trouble, and a firm that quickly outgrows its space may also have
So might a highly specialized business. One client of San Antonio advisor Ben Gurwitz is a veterinarian who is selling his practice and will likely have to sell the building with the business because the property is so specialized.
Other investors buy homes for family members to live in. Clients of ours were looking to buy an investment near their home for a sister with special needs. They had the opportunity to buy a place in a town home community four miles from their home. They rent it to the state, receive a guaranteed rent and have the sister live there, Weiss says.
Buying a home for a child or grandchild can serve as part of an estate-planning strategy, too.
I see clients who buy a place for their kid to live. They figure the child will be a good tenant and they can give it to the kid in fractional amounts over time, Haraway says.
CONTROLLING FOR RISKS
Once clients are established in real estate investing, Altfest says he looks to add value by protecting them from risk and liability.
We might give them advice about managing their risk from the standpoint of geography, other types of investing, insurance planning, cash flow planning and diversification. We make sure that they have thought through their insurance needs and structuring their investments correctly, he says.
There are tax planning strategies to execute for real estate investors, too. Im working with someone who has a low income and a rich balance sheet, Altfest says. The planning opportunities there are about being able to realize taxable income while the client is in a low tax bracket.
This might be a good time for a Roth conversion, for instance, because the client isnt paying a ton of income tax, he adds. Or it might make sense to realize some gains from an investment portfolio.
Did Weiss clients ever buy their daughters California property?
We talked about the importance of this project versus some of their other goals. By the end of the conversation, they decided against buying the house, Weiss says.
I would like to think that we kept them from making a mistake.
Ingrid Case, a Financial Planning contributing writer in Minneapolis, is a former editor at Bloomberg News.