Does real estate deserve a place in your investment portfolio?
Does real estate deserve a place in your investment portfolio?
Paul Lewis never thought about real estate until his heater went on the fritz a few years ago. The repairman who came to fix the problem told Lewis that he owned 16 two-family homes in New Jersey, and he planned to buy two more each year until retirement so he could live off the rental income. It was the winter of 2000, and Lewis, a 34-year-old entrepreneur who had just sold MC2--an Internet security company he had started in his college dorm--was intrigued. The sale had left Lewis with a windfall of more than $1 million and no need to live paycheck to paycheck. He paid off his home's mortgage, created a small nest egg with a retirement fund and an education fund for his kids, and plunked down a chunk on high-tech stocks.
But after his conversation with the repairman, Lewis also decided to take a look at some rental properties. Before long, he'd entered negotiations to purchase three two-family homes not far from his own home in northern New Jersey. And then, just before the deals were finalized, a friend talked him out of them, citing the drawbacks of being a landlord: the pesky tenants! The leaky faucets! Besides, Lewis figured, why take a risk on real estate when his money had been doubling every year in the stock market? Instead of purchasing the homes, he bought stock in Sun Microsystems at $120 a share and BroadVision at $400 a share. Unfortunately, this was just before the bubble burst. Within a year, he had lost most of his windfall.
It may be of little consolation to Lewis, but over time, stocks have produced bigger returns than real estate. Between 1950 and 2000, median home values increased at an annual compound growth rate of 5.6%, while S&P 500 stocks rose 9.1%. Still, as Lewis learned the hard way, buying property can be a smart strategy for entrepreneurs who have money to invest and are looking to diversify. "Real estate is a nice way for entrepreneurs to offset private equity risk," says Larry Tekler, a Los Angeles-based investment counselor at Citigroup Private Bank who advises business owners. In recent years, as the post-bubble stock market fell, interest rates stayed low and the value of real estate soared.
Housing prices in New Jersey, for example, increased 26.1% between 2000 and 2003, while jumping 20% nationally--thanks in part to the lowest mortgage rates in 45 years. But, Tekler warns, interest rates are now expected to rise and real estate could cool off. There has even been talk that housing could experience a crash reminiscent of the tech bubble. But those worries seem to be unfounded, according to Rutgers University professor James Hughes, who recently published a study on the topic. While it's always possible for regions of the country to experience housing bubbles, he notes, the national market should, at worst, plateau or experience a slight decline, bolstered by factors like job growth and a generation of aging baby boomers buying bigger and better homes. At the same time, the so-called "baby boom echo" generation of twentysomethings should give rent prices a boost, as will the steady stream of Asian and Latino immigrants settling in states like New York and California.
If Lewis had understood all this in 2000, he might have put his money into the rental units instead of the tech stocks. But he didn't give up. He used the funds he had left to start a white-collar crime investigation agency, PG Lewis & Associates, that's a kind of CSI for crimes like embezzlement and blackmail. This year, Lewis expects the New Jersey-based company to generate $2.5 million in revenue. And now that Lewis is back on his feet, he's taking a different approach to investing. Most important, he's diversifying into different asset classes, like real estate, even if that translates into lower returns. "If I can get a return between 5% and 10%," he says, "I'll be happy."
Similarly, Jill Maurer, co-founder and CEO of SlickEdit, a software company based in Morrisville, N.C., is an entrepreneur who has found that investing in real estate can offer peace of mind. A recently divorced single mother, Maurer, 37, co-owns SlickEdit with her ex-husband and has two young sons. The elder, Kyle, who's seven years old, is autistic and requires in-home helpers, a pricey school, and medical care that isn't always covered by insurance. Needless to say, setting up a stable stream of income for his future is a big concern. Maurer is trying to do it with real estate.
She bought her first rental property on Florida's Amelia Island nine years ago for $84,000 and, after putting about $17,000 into renovations, sold it during her divorce in 2002 for $240,000. Now she's ready to get serious. She recently purchased a foreclosed one-family house in Raleigh that she found on a HUD listing. Maurer got a good deal on the property, which cost about $100,000, and she signed the house over to her LLC, a limited liability company that she created just for real estate investments. The LLC protects her from liabilities related to her rental properties and will make it easier to pass on ownership to her kids.
Housing prices in New Jersey increased 26.1% between 2000 and 2003.
Maurer opted not to take out a traditional mortgage and instead arranged a personal bank loan secured by the house, locking in a 30-year fixed interest rate of 6%. This kind of loan is generally available only to high net worth borrowers with excellent credit and an established relationship with a bank. Most important, since it's not a traditional mortgage, Maurer was able to put just 10% down without having to pay costly mortgage insurance.
Because demand for apartments in Raleigh has been low of late, Maurer's just about breaking even, but she expects that to change when interest rates increase and people become more inclined to rent. Right now, real estate makes up just a small fraction of Maurer's retirement portfolio, which comprises mostly mid-cap value stocks. "I'm still in acquisition mode," she says, adding that she hopes to take advantage of foreclosures stemming from increased mortgage rates. Rental income, she figures, is something her sons can't "mess up" after she dies. If they blow the rent money one month, she notes, there will be another check 30 days later. "I'm much more relaxed now," she says. "Knowing that Kyle's needs will be covered, I can take more risks with my business."
Of course, being a landowner isn't all rent checks and appreciation. "It can be a real pain in the ass," says Patrick Condon, founder and CEO of Denver's Finished Basement Co., which posted sales of roughly $5 million last year. Condon, who invests in real estate with his father and sister through an LLC, has had his share of tenant problems. Last year, his father had to fly to Florida to evict some "deadbeats" who hadn't paid rent in months. Plus, real estate can be illiquid. One of the homes Condon rents out in Wisconsin, for instance, is barely breaking even, and he's having trouble selling it.
While Condon's father had time to fly to Florida when a problem arose, not all entrepreneurs are as flexible. But there are options for people who want to take a more hands-off approach. Maurer, for one, has taken the hassle out of being a landlady by paying a rental agent a fee to fill vacancies and handle maintenance issues. And real estate investment trusts (REITs), which are traded on the stock market, are another alternative. Though REITs have outperformed company stocks over the past few years and are much more liquid than private real estate, they don't use as much leverage. Managers of REITs generally put more money down when buying property, so they don't give investors as much bang for their buck, explains Bill Landman, chief investment officer of CMS, a Philadelphia-based financial services company that caters to entrepreneurs. "My experience is that you do better in a private deal."
Some entrepreneurs, like Condon, just prefer to have more control of their investments. Though his real estate venture is more time-consuming than a plain old mutual fund or a REIT, he enjoys the hands-on aspect of being a landlord. "I own the dirt and the house," he says. "I don't know much about what's happening at GE or Microsoft, but I know what's going on in my neighborhood."