Last Updated: May 4, 2009
Real estate prices are low and mortgages are cheap. However, such circumstances don't always make for a good investment, according to FPA member, Rich Arzaga, owner of Cornerstone Wealth Management.
According to Arzaga, a cheap house is just that — a cheap house. While many experts are touting that now's the time to buy real estate for investment purposes, Arzaga is taking a more practical and prudent approach to current conditions. "The adage that a good real estate investment is based on fundamentals has not changed, and does not necessarily make a cheap house a good investment," he said in a release.
First, cheap is not a fundamental of investment real estate. In evaluating any income property, the bundle (or stream) of benefits potentially delivered by a good real estate investment include cash flow, tax benefits, amortization and appreciation. "While cheap real estate might help increase cash flow, it is simply a feature of the real estate cash flow analysis and not a direct benefit for investors," he said.
Another mistake investors make in today's market is "they assume that appreciation will make the investment perform well; that simply breaking even is acceptable because the value of the investment will grow substantially over time," he said. "If an investor decides to ride appreciation and break even on cash flow, which seems to be a popular yet ill-advised approach, the investment will disappoint if there is a zero annual cash flow on equity and a nominal return on appreciation, even when leveraged up with debt," he said. "In the case of leverage, a property with 50 percent debt and a 2 percent appreciation rate is on track for a 4 percent per year growth of capital, not what most investors expect when they take on the risk and reward of real estate investment ownership."
Arzaga also noted that one of the most underestimated assumptions of real estate investing is the actual cost of running the business. "Often missed is the total cost of ownership, which includes maintenance reserves, entity creation and maintenance, leasing, vacancy and bad debt, and about a half dozen other expenses frequently missed in the calculation." For most people who believe they are breaking even, they actually end up carrying the property for many years. "The number of foreclosures lining the streets is a combined result of the under anticipation of the impact of interest rate djustments and the underestimate of total ownership costs,"' he said.
Another potential misconception? That prices are so cheap today that in the next year or two, home prices will have to shoot up and that is where the money will be made. Thinking this through rationally, there is no reason to believe that the value of property is going to increase dramatically in the short-term, or that prices will not dip further. Don't mistake the real estate market for the stock market where stock prices can fluctuate dramatically. It simply does not work that way. It is not plausible to expect that type of quick growth in real estate, where the average family will not be in the position to chase the cost of that type of growth.
"Yes, interest rates are attractive. Home prices are attractive. And for those seeking real estate to occupy as their first home, or to move up, or even move away, this could very well be the best time in the recent past to get into a property that is suited to their liking and financial condition," said Arzaga.
For those who see these same milestones as a reason to invest, however, cheap doesn't mean good investment. "Real estate investing is an important investment decision and a long-term strategy, and must be thought out carefully."
Find a financial planner who can help you determine whether real estate should be a part of your financial plan.