The New Rules of Real Estate
Is it time to cash in? Or to double down before the next boom? The smart money says: Both. Here are the experts' top strategies for today's turbulent market.
(Business 2.0 Magazine) -- First, the bad news. In August the median sales price for existing U.S. homes slipped to $225,000, down from its record high, a year earlier, of $229,000. The 1.7 percent dip marked the first year-over-year drop in more than a decade, according to the National Association of Realtors. To many economists, that was irrefutable evidence that the nationwide housing slump is here to stay.
Now for the glass-half-full perspective. First, unlike the destruction wrought by the tech crash of several years ago, the housing downturn won't take a huge bite out of the value of American residential real estate assets, currently estimated at more than $20 trillion.
"Housing cycles end with a whimper, not a bang," says professor Joseph Gyourko, the Wharton School's director of real estate research, whose new study shows investors where to make safe real estate bets during a dangerous market.
Second, down markets in housing have always offered investors just as many angles to play as they might find during a boom - you just have to know where to look.
Thankfully, we've already done a lot of the scouting for you. On the pages that follow, you'll find plenty of ways to play the current market, whether your risk tolerance is low and you're looking for safe ways to preserve your nest egg, or you're an aggressive speculator who sees a downturn as the ideal time to shop.
No doubt you'll read plenty of doom-and-gloom stories about people losing their shirts in real estate during the months to come. Read on to make sure you won't be one of them.
Rule 1: Invest in Bubble-Proof Markets
New economic research suggests that big-city home prices will keep climbing - as long as incomes keep climbing too.
RISK LEVEL MODERATE
About the last place a prospective homebuyer might want to peruse MLS listings these days is in one of the country's most expensive markets, like San Francisco, where the median cost of a single-family dwelling has jumped 37 percent since 2003. (It's now more than triple the national figure.)
A couple of leading economists, however, think buyers shouldn't be intimidated, even if prices in these markets go into a slump. San Francisco, New York, and a small handful of other big cities may suffer dramatic swings in a downturn, but their long-term trends "are so strongly upward that if you're willing to buy and hold, it's a good strategy," says Todd Sinai, an associate professor of real estate at the Wharton School and coauthor of a recently released study called "Superstar Cities."
The same logic, Sinai says, applies in other inflated markets like Boston, Los Angeles, and Seattle.
So what are the criteria for bubble-proof status? Limits on the supply of new land and buildings factor heavily, but even more important are trends in household income. According to the study, prices are likely to keep climbing in cities where poor and middle-class households are being nudged out by rich ones. The phenomenon skews prices higher than the national average because more dollars are chasing fewer properties.
According to Joseph Gyourko, who coauthored the study with Sinai, living in these areas is akin to owning a scarce luxury good. "If you think of these cities as factories for high-income households," Gyourko says, "then the demand for luxury goods will continue to rise as long as you're creating rich people."
Another way to put it is that the growing wage gap between rich and poor Americans is being mirrored in real estate, and the income schism is especially exaggerated in wealthy cities with little new construction. On the opposite end of the spectrum are places like Las Vegas, which, despite the huge run-up in prices in recent years, is adding more than 30,000 new homes a year, and where the growth in wealthy households lags behind the national average.
Since the 1980s, the proportion of households in Vegas earning $110,000 or more a year barely grew; in San Francisco, it's jumped by more than 20 percent. The upshot? While Vegas could be looking at a price drop of as much as 13 percent, Sinai believes the Bay Area may not have one at all.
Investors who are catching on to the research aren't waiting. Ryan Lugbauer, whose partners own dozens of buildings in San Francisco, paid $670,000 in September for a single-family Victorian in the Inner Mission, a Latino neighborhood in transition. He plans to spend as much as $250,000 to turn the house into a duplex.
"It's a great time because there are fewer bidders," Lugbauer says. "Politicians here restrict development to a minimum, and it ends up driving up prices because the big earners want to live here. That's never going to change." Lugbauer thinks he could put his fixer-uppers back on the market for a combined $1.4 million as early as next year. - Paul Kaihla.
Rule 2: Buy Low, Rent High
To Redbrick Partners, slow real estate markets mean a fast path to profits by acquiring cheap homes and turning them into rental properties.
RISK LEVEL AGGRESSIVE
Jonas Lee spends most days driving slowly through unfamiliar neighborhoods. He may look lost - constantly leaning out the window, craning his head in contorted ways - but don't be fooled. He's doing the most critical part of his job: scoping out homes for his Washington, D.C., investment firm, Redbrick Partners, to add to its growing stable of rental properties.
Lee is doing more drive-bys than ever these days. A handful of housing markets, such as southern Florida and certain neighborhoods of Washington, D.C., are wildly overbuilt. Prices are dropping. And developers who raced to build new houses and condos during the boom are likely to soon be begging for buyers. "There's going to be blood in the water," Lee says. "A big pileup."
Where there's blood, there's opportunity. Redbrick creates and manages private investment funds made up of an unusual commodity - cheap houses, usually in working-class neighborhoods. The four-year-old company owns about 1,000 properties in urban enclaves in Eastern states: row houses scattered across Baltimore; townhouse-style homes in Hartford, Conn.; small brick houses packed around Philadelphia.
Lee looks for homes priced below $200,000 (some as cheap as $50,000), for a couple of reasons that any investor would do well to consider in a down market. First, cheaper homes are less vulnerable to sharp price declines. Second, they typically offer better overall returns from rental income than upscale homes. Redbrick fixes up its properties, rents them out, and occasionally snags a profit by selling them. Since its founding in 2002, the company has closed three multimillion-dollar funds.
So where is Redbrick prospecting now? No region has Lee more bullish than southern Florida - where the long-term prospects are attractive but, as Redbrick co-founder Tom Skinner puts it, the near-term fundamentals are "out of whack." It's a new market for Redbrick, and Lee, who has been scouting parts of Miami, Fort Lauderdale, and Fort Myers, predicts that buying opportunities will begin in early 2007. "The next couple of years will be ugly," he says, optimistically.
Lee says developers are offering condos in the region at 20 percent below appraisal value. Redbrick expects the discount to grow to 40 percent because developers lose money every day they own a property. Making the equation even more appealing is that rental prices are holding steady.
Lee and Skinner use a simple formula to calculate the overall return, or yield, of a rental property: rent divided by two divided by price. Lee says small landlords often overestimate rental income because they underestimate costs like maintenance, management, and vacancies. The advice Lee gives most often to aspiring real estate owners is to focus on a local market and get to know it really well.
"Just wait and watch," he says. "If you know the market, you'll know when an anomaly comes up." And, he adds, that's more likely to occur in the next two years than in the past two. - Paul Sloan
Rule 3: Own Where the Kids Are
If you want to become a landlord, it's time to go back to college - where housing demand is booming along with admissions.
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One of the many oddities of real estate investing is that the best time to plunge in is usually just when things are starting to go south - meaning now. While momentum is starting to carry the market down, home prices are still out of range for a lot of would-be buyers, which helps to buoy rents.
Further burgeoning the tenant ranks are the thousands of homeowners selling now in the face of rising interest rates. According to the National Association of Realtors, rents nationwide are expected to jump an average of 5 percent by year's end.
This explains why investment pros have begun pouring money into all kinds of rental markets. One of the hottest now is student housing. Michael Zaransky, co-founder of Prime Property Investors in Chicago, began investing in student housing three years ago when, he says, "we noticed that prices of apartment buildings in college towns were stronger compared with other cities and still trading hands at substantial profits."
Zaransky turned up several reasons that college-town apartment buildings are a smart bet.
First, inventory is shrinking: Public universities have suffered from continual belt-tightening in recent years, leaving most without money to upgrade or build out dorms and other housing units. Second, demand is skyrocketing: Colleges are starting to see a surge in admissions, especially from so-called echo boomers, the children of baby boomers.
For investors, that adds up to remarkably low vacancy rates near campuses. Prime Property owns 21 apartment buildings in five college towns in Florida and the Midwest, and Zaransky says "we are 100 percent occupied" - even during summer months. That's significant, considering the industry average of 90 percent for commercial apartment buildings. Prime Property also got remarkable rent increases in 2006, as high as 13 percent at its eight buildings near Purdue University in Indiana.
To pick the best towns, Zaransky offers investors a handful of market-research tips. First, check the supply: Find out how much of the available housing is university-owned. Next determine the ratio of university-owned beds to students. Zaransky prefers a ratio of 30 percent or lower. Last, he says, look at projected enrollment growth for the next 10 years, favoring schools expanding their student ranks by at least 2 or 3 percent a year.
A word of caution, however, before you start prospecting houses or apartment buildings for your college-bound son or daughter. As Ralph Block, a real estate strategist at Phocas Financial, notes, it's a high-priced game in which most investors pool their money with others through private partnerships, with a typical minimum of $100,000. Being a college-town landlord comes with a unique set of headaches too.
"This business is very management-intensive and has unusual risks," Block says. "College policies regarding student enrollment can shift, and it can be very difficult to forecast fickle student demand."
There's another option for the risk-averse: buying shares in one of several publicly traded real estate investment trusts that are focused on the student market. Block's favorite is American Campus Communities, which trades for $26 a share. Since 2004, shares of ACC have returned 50 percent. - Carleen Hawn.
Rule 5: A, Always. B, Be. F, Foreclosing
Fast-rising default rates and widely available market data have made it easy to become a real estate closer. Here's how to cash in on those leads.
RISK LEVEL HIGH STAKES
Two years of interest rate hikes and flattening home prices have put the squeeze on homeowners who gorged on debt during the boom. Now they're struggling to keep up with ballooning payments or, worse, losing their homes to creditors. In September alone, more than 112,000 U.S. homes fell into foreclosure - a 63 percent jump from September 2005, according to RealtyTrac.
Ideal market conditions, in other words, for a niche group of real estate investors - foreclosure gurus who deliver panicked homeowners fast cash in return for property acquired at enviable discounts. They used to go door-to-door and staple ads to telephone poles. Today, though, an array of new online services like PropertyShark.com and Foreclosures.com is making a once-shady business more respectable - and teaching a new class of investors how to turn hard times into sweet profits.
Take 37-year-old John Cordero. From 9 to 5, he's a broker for a financial-services firm in Burlingame, Calif. In his spare time? Relying on Foreclosures.com for good leads and guidance, Cordero has purchased and resold nine houses in some stage of foreclosure since 2003. What Cordero calls a hobby is looking more and more like a dream career: Foreclosure sales have so far padded his net worth by $700,000.
Websites haven't changed the basic rules of the game, of course; they've simply sped it up and invited more players. Here's what several pros consider essential knowledge for rookies.
1. Find diamonds in the rough from the comfort of your desk. Many sites update foreclosure listings as soon as they're available, and often include the amount owed and the estimated value. Some even mention code violations or complaints against previous owners.
"It's stunning," says Bill Rohlfing, who does about half his business of acquiring "shell" buildings in Harlem through foreclosure. "I'd be doing hours and hours more work if I didn't have PropertyShark." Other sites provide useful hand-holding for first-timers.
2. Time your attack. Don't even consider attending public foreclosure auctions, which are typically controlled by banks and other big lenders. Small players get their best shot by scouting a property right after it goes into default, when there's a brief window to negotiate directly with the owner.
"The whole idea is to get the property before it goes to the [auction] table," Rohlfing says. After spotting a default notice online - the first stage before the formal auction process - he goes into action.
"First I call the lawyer who represents the owner to ask if there is a way I can negotiate with the owner before it goes into auction," he says. The typical answer is a firm no, but Rohlfing takes that as his cue to try to do it anyway, preferably in person.
3. Make the owner your partner. Currying favor with the owner is another way a small player can get the necessary leverage to strike a quick deal. Cordero, for instance, often promises to solve the owner's immediate problem by covering enough mortgage back payments to get the loan out of default. Then, in exchange for the deed to the property, he provides the owner with an apartment, rent-free, while he refurbishes the house. When he sells the home, Cordero cuts the owner a check for a portion of the profit - usually 10 to 20 percent. - Carleen Hawn.
Rule 6: Put Your House on the Block
Need cash fast? An online home auction probably won't fetch the best price - but for sellers in dire straits, it will get a deal done ASAP.
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Last spring, Curtis Burttram found himself in a bind. His wife was battling a serious illness, the couple was sitting on two small rental properties near their home in rural Albertville, Ala., that they didn't have time to manage, and prices in the area had begun to slip.
Reluctantly, Burttram put the pair of two-bedroom homes on the market - where they sat for six months without an offer. Increasingly desperate, he took a flier on a new strategy. He listed one of the houses on an online home-auction site called RealtyBid.com, a new eBay-like service for home sellers.
After a two-week bidding period, not only did Burttram have four bids, but he got his minimum asking price of $11,500, just $500 less than his original listing. (You read that correctly: You can nab a three-bedroom house in the area for less than a Chevy Cobalt.) Three weeks later he closed the sale. Then he listed the second home, and it closed just as fast.
The auctions wound up saving him money - and incalculable stress. "It's a different approach," Burttram says. "But it accomplished what we needed in a fast and hassle-free way."
With 39 percent more properties nationwide sitting on the market than last year, Burttram is one of a growing number of motivated sellers looking to move their homes fast in slow markets. While eBay also offers residential property listings, its auctions aren't legally binding - buyers' only risk is receiving negative feedback if they pull out of a deal.
RealtyBid, on the other hand, is one of the first online services to require buyers to sign on the dotted line. The service has already handled more than $200 million in residential real estate transactions, and RealtyBid CEO Tony Isbell expects that figure to triple by the end of 2007.
Here's how it works: First, you need an agent to list your home. (The good news here is that you can negotiate the commission, since the agent won't have to do any legwork to sell it.) For a $100 fee, you get your house listed for 14 days, a yard sign, and a marketing e-mail blast sent to agents in the county where the house is located. As with eBay, you set a starting price and a minimum reserve. When the reserve is met, the agent sends a contract to the winning bidder, who must sign papers and send back a 5 percent deposit.
Bear in mind, Burttram's story is the exception, not the rule. Homes on RealtyBid often go for as much as 20 percent below asking.
"Sometimes it makes sense to take less money to get that money immediately," says Glenn Mayernick, a New York real estate agent who recently helped a couple sell their house - originally listed at $440,000 - for $340,000 on RealtyBid and has sold 10 houses through online auctions in the past year. Isbell, meanwhile, is taking the model a step further: He just launched Condobid.com. Michael Lev-Ram.
Rule 7: Target the High End
Everyone thought John Vatistas was nuts. But he's proving why the slowdown is an ideal time to start an upscale real estate brokerage.
RISK LEVEL AGGRESSIVE
During the recent boom, few housing markets in America drew more pure speculators than Phoenix and its desert suburbs. Developers put up more than 280,000 homes in the region between 2000 and 2005, and median home prices shot up by 79 percent.
And one bubble helped to inflate another: There are more than 38,000 real estate agents in the region - with just 48,000 homes for sale now, as the market slides back to reality.
While thousands of agents are expected to drop their licenses, one entrepreneur is turning the great agent shakeout into a thriving niche business: a real estate brokerage tailored for high-end clients and luxury homes. Last year John Vatistas, who'd been running a mortgage and title firm in Phoenix, invested $17 million in just such a startup.
"People asked, 'Why are you doing this in a bad market?'" Vatistas says. "They thought I was nuts."
He and his investment partner didn't think so. Vatistas figured that a weak market was a perfect opportunity to poach top agents. He also reasoned that higher-end homes are surprisingly resilient to market swings, compared with the pain that houses in the middle of the market typically suffer.
So Vatistas began raiding Coldwell Banker branches (two have closed in the area) and other firms and hiring away their best agents. In all, he lured 232 agents - including Sandra Baldwin, who had been Coldwell's top producer in Phoenix for 16 years running - to join his startup, Equitable Real Estate. Just one year out of the gate, Equitable has chalked up $600 million in home sales.
Vatistas estimates that Equitable's home-sale transactions will hit at least $1 billion in 2007, and that the company will be profitable by then, in part because it has no debt and owns most of its offices.
He also is not worried about new online services like PropertyShark and Trulia that are displacing agents. "In the Phoenix area, that's happening at the low end," Vatistas says. "We don't compete there. But the high end of the market is intensely relationship-driven and, I think, more resilient in a downturn."
Most of the money he invested went, literally, to building Equitable's brand - a big factor in holding onto wealthy clients. Vatistas and his partner, Scott Barker, spent $12 million building or renovating five offices in Scottsdale that feature flat-panel screens displaying area maps, and the flagship location has a $35,000 glass sculpture behind the front desk.
But fancy digs aren't the only inducement Equitable has offered converts. It allows its agents to keep as much as 95 percent of their commissions, compared with only 75 to 80 percent for top agents at most Phoenix-area firms.
The basic strategy, Vatistas adds, would be easily exportable to other markets that have had huge explosions in both housing inventory and prices - and tension between top agents and real estate franchises.
Nearby Las Vegas and Southern California share some of those characteristics, but Vatistas says he has his hands full in Phoenix. "The population here is going to grow 50 percent in the next two decades," he says. "My firm is going to stay small and ride that wave." - Paul Kaihla.
Rule 8: Be a Landlord of Last Resort
It's a new twist on an old strategy: Buy property from struggling companies, and then lease it back to them at a premium.
RISK LEVEL HIGH STAKES
Jeff Hayden preys on smallish companies on the brink. Not because he's a vulture investor seeking to turn around a struggling business. He just wants its real estate. And he wants it cheap, so he can then rent it back to the company for a juicy profit.
His strategy is a new twist on what's known as a buy-to-leaseback - a deal that's long been used by big companies such as Walgreens that want to get real estate off their books and raise cash. Plenty of investors are glad to have healthy, household-name companies like Walgreens (Charts) as tenants, so they purchase their properties and then lease them back. But Hayden is striking deals with companies that big real estate investors ignore, and his approach could mark the emergence of a wide-open multibillion-dollar opportunity.
Hayden, who runs a three-man startup in Los Angeles called Asset Funding Group, compares himself to Michael Milken, who created the junk bond industry that offered access to capital to companies with lousy credit. The leaseback play, Hayden says, is real estate's version of the same notion. "We finance high-risk clients, and we get higher returns," he says.
After a little more than a year, AFG has kicked the tires of 200 companies, and done deals with seven - five of which are old-guard manufacturing firms in the Rust Belt. These companies aren't just getting crushed by low-wage competition from China, they're also struggling with rising interest rates, which have hiked up their costs and crimped their ability to borrow.
But they still have one prime asset - the property their facilities sit on, often acquired generations ago and now worth several times the depreciated value listed on their books.
The harsh economic realities for Rust Belt companies have created some eager customers. One is Hastings Manufacturing, a nearly 100-year-old piston-ring maker based in southern Michigan that ran into extra-hard times by straying into product lines that didn't work out. Hayden swung a deal last year to buy Hastings's land for $2.6 million - 21 percent below its appraised value of $3.3 million. (On Hastings's books, it was valued at $275,000, minus recent building improvements.)
It was a win-win transaction: For Hastings, it brought much-needed cash and time to find a buyer. Private equity firm Anderson Group snapped up the business for $9.1 million, and put in turnaround specialist Fred Cook as the CEO.
He overhauled it and trimmed operations, and the company is again making money. "I don't mind the rent payments," Cook says. "If I'd had to buy Hastings plus its land, it would have cost me an additional $3 million."
For AFG, it's an even sweeter deal. It collects a market rent of $264,000 a year and, factoring in the steep discount it got on the land, earns a return that Hayden, who won't disclose details, says is 50 percent higher than what traditional leasebacks make.
The risks, of course, are greater when dealing with businesses on the edge. But it's not as perilous as it sounds. For instance, bankruptcy laws offer investors some protection, as they give landlords preferential treatment compared with other creditors if a tenant goes into Chapter 11. The court cannot suspend or renegotiate a rental agreement; it can only order the tenant to continue paying the contractual rate or move to new digs, which is generally prohibitively expensive.
Hayden estimates that small to midsize companies are collectively sitting on $200 billion worth of real estate. And the market is bound to grow as globalization continues to swell the ranks of companies hungry to trade their land for cash, creating even more opportunity for niche players like AFG and others angling to get into this business. "I get calls every week from people who want to get into the market," Hayden says. - Paul Kaihla.
Rule 9: Go Green
New tax credits and rebates are making solar-power conversions as smart as redoing your kitchen.
RISK LEVEL AGGRESSIVE
Considering a remodeling project to boost the value of your home? Before you drop $40,000 or more on a new kitchen or master bath, consider the newcomer on the renovation block: a rooftop solar-power system that not only will lower your overhead costs and insulate you from a volatile energy market but will likely add just as much to your home value over the long haul.
The technology has come a long way in the past 30 years. And what's starting to be good for contractors is looking sweet for homeowners too. For starters, today's solar systems are far more efficient than their commercial predecessors, and most are warranted to last 25 years.
More important, the federal government and some states are offering serious incentives that can slash the price of installation (typically over $40,000 gross for a full system) in half. In California and New Jersey - the first states to allow so-called net metering, whereby homeowners are credited for electricity they generate beyond their own use - going solar can pay for itself in several years.
Home systems are still rare, so their value is difficult to assess, but home appraisers follow this general rule of thumb: Half the gross cost can be recouped in the home sales price as soon as it is installed.
True, that's well below the recovery rates for kitchens and bathrooms (which range from 70 to 90 percent), but your kitchen doesn't pay the power bills. And solar's ability to lower energy costs also adds value. A study in Appraisal Journal found that for every utility-bill dollar saved annually because of an improvement, you gain $10 to $20 in property value.
So if you can zero out a $1,000 annual electric tab by installing solar, you'll get back $10,000 to $20,000 in home value.
Whether it pencils out for you depends foremost on where you live. California and New Jersey lead the nation in offering financial incentives, but states like Arizona, Colorado, Nevada, and New York are ramping up fast.
Another determinant is your typical electric bill. "If it's under $100 a month, people just put in solar because they want to be part of the solution," says Mike Hall, VP at Borrego Solar in Berkeley. "When you get to $100 to $150 a month, the financial arguments start to take hold. Anything north of $200 a month is a no-brainer." - Michael V. Copeland.
Rule 10: Go Small
Seeking shelter from a stormy market? Tiny homes offer just enough at the right price.
RISK LEVEL MODERATE
Admit it: You've fantasized about paring your life back to the bare essentials. No more crushing mortgage. No more worries about market uncertainty. Jay Shafer created a business that's all about making those wishes come true. He's the founder of Tumbleweed Tiny House Co., a Sebastopol, Calif., business that designs and sells tiny dwellings - about 150 square feet - that squeeze a desk, kitchen, bathroom, and bedroom into a floor plan smaller than most living rooms.
The homes sell for about $40,000; a set of blueprints for do-it-yourselfers, $850. Shafer has sold 10 houses so far, and "I'd like to think business will grow as the overall market gets worse," he says. The appeal of his homes, he adds, stems from a child's desire to "build your own fort or a tree house." For some homeowners right now, that might not be such a bad place to be. - Todd Lappin.
MAKING THE RENT PAY
Redbrick's formula for evaluating rental properties.
(RENT ÷ 2)/PRICE = YIELD
RENT: Divide annual rental income in half to account for the cost of vacancies, maintenance, insurance, and taxes.
PRICE: The full price you paid for the property, including closing costs.
YIELD: The return on your investment. In today's market Redbrick looks for 5 to 7 percent.
Note: Redbrick says this formula works best for properties worth less than $250,000.
NEW WAYS TO BUY AND SELL
The latest real estate websites go beyond just searching the listings.
Maps the nearest schools, eateries, parks, and government offices. Sister website HouseValues.com also offers valuation estimates.
In addition to foreclosure listings, offers demographic and zoning data and toxic- and tax-lot maps.
Lets buyers tap into a nationwide home search engine. Additional crime-rate and school-performance data round out city profiles.
Forget the "Zestimates" for home values. The site is best at culling neighborhood "comps" that help buyers and sellers handicap prices.
BUYING AND SELLING
Helps homeowners sell their property directly through listings on Google Base and other major classified-ad websites.
Buyers and sellers put their business up for auction, with agents bidding to offer the highest rebate or lowest commission to do the job.
A real estate agency that does most of its business online, charging sellers a flat $2,000 fee and rebating buyers two-thirds of its commission.
A clicks-and-bricks agency that offers reduced commissions to sellers and rebates 20 percent of the commission it receives as a buyer's agent.
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