(MCT)—With housing prices so low, buying a home or rental property may sound tempting. But is it a good investment? This week, Jonathan Lederer, a wealth management adviser in Sacramento, California, offers his advice.
Q: With home prices dropping and so many foreclosure sales, it seems like a good time to invest in real estate. But what are the risks long-term? How do you compare investing in “real” property vs. something like REITs or other real-estate stocks or mutual funds?
A: With the home prices low in much of the country, some consider residential real estate an attractive investment.
In fact, a recent Wall Street Journal featured an article, “It’s Time to Buy That House,” that said the combination of reasonable price-to-rent ratios and historically low mortgage rates makes this a good time to buy a home or purchase residential rental property.
If you are looking to purchase rental property, I strongly recommend that you first project the internal rate of return (IRR). To do this, you need to estimate the annual rental income and then subtract the annual mortgage expenses, property management fees, property taxes and other costs. When calculating the net operating income each year, be sure to do it on an after-tax basis, as you can frequently deduct rental income, mortgage interest and depreciation expenses.
Finally, you need to estimate the net sales proceeds at the time you expect to sell, then discount all of these projected cash flows back to the present. It would also be wise to determine the expected IRR under several different scenarios, such as strong appreciation, no growth and declining prices.
Once you have forecast your expected return on the rental property, the next logical step is to compare this rate of return with those of other investment opportunities. At present, one can earn an annual yield north of 4 percent on publicly traded REIT funds. Since geographically and economically diversified REITs are highly liquid (i.e., they can be bought and sold online with a click of a mouse), astute investors should demand substantially higher rates of return on residential property, which is illiquid and highly dependent on local economic conditions.
Considering that one can currently purchase certain corporate bond funds at yields greater than 8 percent, I would require at least a 10 percent IRR before purchasing residential rental property.
When forecasting cash flows on a rental property, remember some structural head winds that may continue to pressure residential housing. First, considering the glut of houses-turned-rentals, it is not always easy to find renters in a timely manner. Moreover, it may be difficult to raise rents unless the economy improves substantially.
Finally, the economic situation today is much different than in the early 1980s, when California housing prices began to gain roughly 6.5 percent a year for the next 25 years.
©2011 The Sacramento Bee (Sacramento, Calif.)