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updated 3/16/2005 2:12:14 PM ET 2005-03-16T19:12:14

You've heard the conventional wisdom: Don't think of your house as an investment. Think of it as a place to live. But how can you not think of it as an investment when it has been such a good one lately?

The median existing home price in the U.S. rose to $189,000 in January, up 10.5 percent year-over-year. Indeed, homes nationwide have appreciated an average of 8 percent annually in the past three years. That compares to a three-year average annual return in a typical diversified stock fund of just 5 percent. Homes in metropolitan areas on the East and West coasts have risen at a faster clip — doubling in the past five years in many markets.

Can this continue? It turns out that caution may be in order for 2005. The good news is that purchasing or owning a house remains one of the best investments you can make over the long term. Historically, the real estate market often spurts, then pauses, and sometimes even declines slightly. Prices have never really plummeted on a national basis.

Troubling signs
Yet for three years, home-price appreciation has been running far ahead of rates of inflation, wage increases, and national economic growth. The kinds of growth chalked up since 2002 are likely unsustainable, in the view of most analysts who follow the housing market. That doesn't mean home prices will crash, but they might retreat some in your region, especially if they've risen extraordinarily fast in recent years and if a downturn hits your local economy.

Even barring that, as interest rates rise (and long-term rates have spiked in recent weeks), fewer people will be able to afford current home prices. That may lead to flatter real estate prices even if demand stays robust. Overall, national home sales have cooled a degree from 2004's hottest levels, according to the National Association of Realtors (NAR). And luxury home prices in several markets, including Boston and Chicago, actually dipped in the last three months of 2004.

A few troubling signs of a real estate market top are emerging: An increasing percentage of home financings are done with adjustable-rate mortgages (ARMs), which indicates people are stretching to afford the homes they want. If rates rise quickly, buyers with short adjustment periods may face higher rates sooner than they expected. “That sets people up for a problem if something goes wrong,” says David Kelly, economic advisor to Putnam Investments.

Timely guidelines
Another worrisome trend: NAR reports that 36 percent of home sales in 2004 were second homes. Of those, the number of people reporting that they made the purchase primarily as an investment climbed from 20 percent in 1999, to 64 percent in 2004. That's a sign a lot more speculative buyers have come into the market, and that could be fueling a real estate bubble in some areas.

If you're thinking about putting more of your assets into real estate in 2005 — whether you're a first-time buyer, looking for the retirement home of your dreams, or still think you can make good money investing in real estate — here are some guidelines for maneuvering in what's likely to be an overheated market this year.

First, realize that you may be getting in late. “The best real estate investing was done three to five years ago,” says Geordie Crossan, a financial planner in Westlake Village, Calif. When it comes to the purchase of a second home, he advises clients to consider whether they're already overexposed to real estate in their portfolios — much the way investors were overexposed to tech stocks in 1999. “If your real estate holdings are more than 75 percent of your total equity, you need to look at building up some other assets,” he says.

‘Not an ideal strategy’
More second-home buyers today are blurring the lines between vacation and rental properties, justifying the purchase by planning to rent it out and figuring it’s sure to appreciate. But if you're really looking for an investment property, do the math. Rental income minus expenses should produce a positive cash flow, says Gayle Henderson, an agent with RE/MAX Excaliber in Scottsdale, Ariz. “Some buyers are willing to live with a shortfall if they think prices will appreciate rapidly, but that's not an ideal strategy,” she says.

Another good rule of thumb: In the research phase of shopping for a new home, compare prices of comparable properties that are for rent and for sale. If the local market is getting bubblicious, it may be far cheaper to rent than to own. In that case, if you expect to sell in less than five years, it may be worthwhile to rent. This could be especially true if you're vacation-home shopping. For your primary residence, long-term, it's always better to own, says Kelly. “Just be very patient and make sure you're buying something that is actually worthwhile.”

How so? The old maxim — find the worst house in the best neighborhood — still applies, real estate agents say. “Location just can't be substituted,” says Henderson. “In a premium neighborhood, chances are you have less risk of loss and more opportunity for gain.” Look for excellent schools, good public services, and low taxes, even if you pay more for the house because of them. A paper soon to be published in American Economic Review, finds that property values are rising fastest in communities with strict zoning laws and well-organized neighborhood groups, mainly because that keeps available supply of new homes down.

Buyer’s traps
Looking for a deal? Avoid buyer's traps, like finding a fixer-upper that isn't worth fixing up. A lot of houses, particularly old summer houses, were built to a minimum standards and don't have “good bones,” says David Groom, president of Groom Construction in Swampscott, Mass. He says many families overinvest in renovations. “Sometimes it just gets silly,” he says. “People buy a house for $800,000 that needs $500,000 of work when even if it's fixed up beautifully, it's only going to be worth $1 million.”

If you venture into a fringe neighborhood, to get more for your money, be sure you plan to be there for a while. “The discounts can be very compelling,” says Lucien Lidji, an associate broker with Prudential Douglas Elliman, in New York. “When a residential neighborhood is really new and not established, that's where you're taking the most amount of risk, even if your reward can ultimately be much greater.”

Most important for investing in real estate in 2005: Make sure you have a few months worth of emergency funds on hand to carry the property even if your income dips or prices teeter. And don't feel rushed to buy just because mortgage rates are expected to rise this year. Remember, if that happens, it would likely lead to lower real estate prices, offsetting to some extent the higher interest rates. Keeping your cool is an asset.

Get educated
Also, it's understandable that home buyers would hope to enjoy in the future rates of return similar to today's. “Buyers are much more investment conscious,” says Lidji. “That's because they're paying so much and they're taking money out of other investments in order to buy the house they want to live in.” Many are even borrowing from their 401(k) plans to fund that first home purchase, he notes.

Still, if thinking of your home as an investment is practically unavoidable in this real estate market, try to make sure your decisions are sound. “If you start feeling the urge to overinvest in real estate,” says Putnam's Kelly, “stop feeling and start thinking.” As the bull market in residential real estate shows signs of age in 2005, that advice is worth heeding.

Copyright © 2012 Bloomberg L.P.All rights reserved.

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