Tuesday, May 24, 2005

The Globe and Mail: Mania over real estate spurs fears of a crash

The Globe and Mail: Mania over real estate spurs fears of a crash

An interesting story about what some believe to be a Real Estate bubble in the US.

My thoughts on this subject are not new. I believe there are several local housing bubbles, but not a national bubble (mirroring Alan Greenspans view - or perhaps he is mirroring mine!). The problem is that we don't know if there is a bubble until after it has popped. Just like with the Nasdaq in 2000 everybody thought prices could continue to rise even though they were completly disconnected from reality.

Don't get me wrong, I am not saying there will be a drop in real estate prices in the bubble areas (Orange County, San Diego, & other places mentioned in the article), I have no idea what will happen with prices. I thought homes were overpriced last year and they increased by 20%, thus confirming that I have no predictive ability (as if you needed confirmation).

Everyday I get a call from someone wanting to start investing in real estate and I tell them that I think its a great idea. Of course I preface this by explaining the difference between investing and speculating. If you are purchasing a home solely because you believe the price will be higher in a few months (the greater fool theory of real estate) and you can sell it to someone else for a profit, you are not investing - you are speculating. There is nothing inherently wrong with speculation; our society could not succeed without speculation, however do not call it investing. An investment is something that you can reasonably expect to get a return on over a reasonable time frame. To me there are two basic ways to make money in real estate:

1) Buy a property at a reasonable price, preferably a depressed price and fix it up (adding value to it) - then either sell it or rent it out.

2.) Buy a piece of property for rental purposes, but in doing so make sure that you have cash flow that is at least break even. Not break even on an interest only loan, but break-even on a fully amortized loan (including taxes, insurance, etc).

I believe rental real estate can be a wonderful way to build a net worth, but only if done wisely. I always say that there is no other investment like real estate. What other investment is purchased for you (the bank) and paid off by someone else (the renter)? There is no other investment like this.

Imagine a 35 year old purchasing a few pieces of property and getting enough rent to cover expenses - if they have a 30 year mortgage it will be paid off by retirement and they will have an income stream that they won't outlive and one that will rise with inflation (rising rents), this is smart investing.

The problem today is that this type of real estate investing is getting more difficult as more and more people are doing it and bidding prices up to levels that don't make sense. In addition, many of these people have no reserves (which is a must in real estate) and no idea how to fix a toilet (another must if you want to be a landlord). Real Estate can lead to riches, but like anything it must be done over time and you must be patient and smart with your purchases. Buying real estate because it is going up is not a good reason to buy.

I can help you evaluate a potential deal if you are in the market, but be aware that I am quite conservative - i will apply the Graham and Dodd principles when evaluating a deal, it has to make sense and provide a reasonable level of safety.

Are we in a bubble? I don't know. Does it matter? Not really, if you are living in your home for the long term you have nothing to worry about, but be careful with your ideas of buying property.

Scott Dauenhauer, CFP