Prospering in the housing bust

William Rivas welds panel clips at Turnberry Place in Las Vegas earlier this year. The skyrocketing costs of materials and labor have toppled some high-profile luxury condominium projects, turning the market skittish. Jae C. Hong / AP file
/ Source: Forbes

Gillette Edmunds has made good money in real estate — by knowing when to sell. Edmunds owned six investment properties: single-family homes in southeast Denver he'd purchased for around $70,000 apiece. He was leasing out the houses for an average of $700 a month, amply covering mortgage payments, property taxes and maintenance costs. Then the Denver residential market seemed to get too frothy, and before something bad happened, he dumped the homes for two or three times what he'd paid eight years before. Edmunds, who has retained his personal residence, reinvested the profits in real estate investment trusts. And indeed, the Denver market began to slide.

Brilliant timing now that everyone is talking about a housing bust, right? Well, he bailed out of housing in 2001 and 2002, when it was roaring elsewhere, particularly on the coasts. Look at Denver's early dip as a precursor of what seems finally to be occurring in those other markets. Denver's housing sector dropped early because the telecom industry fell apart.

Sure, sure, all real estate is local, and not every place goes down at once. Timing in markets is more art than science and can fool even the pros. Diane Saatchi, a leading real estate broker in New York's high-tone Hamptons, figured the market there was near peaking — two years ago. She sold three modest rental properties for a combined $2 million, nearly three times what she'd paid ten years before. Alas, the Hamptons market then rose another 20 percent in value, though now it finally is weakening. Quoting 1920s tycoon Bernard Baruch, Saatchi says: “I made my money by selling too early.”

So this time it seems real. Evidence abounds that the national housing craze is nearly over: higher mortgage rates (6.2 percent on a 30-year fixed loan, up a percentage point from a year earlier), slumping orders for homebuilders, rising inventories of unsold units, like Miami's glut of empty condo projects.

The National Association of Realtors is projecting that prices around the country will rise only 5.7 percent this year, far down from the 12.5 percent gained in 2005 — and the Realtors are just about the only commentators putting out bullish forecasts. This may portend a market where prices collapse, plateau or merely descend a few notches. What's clear is values won't advance at a double-digit clip anymore.

Regardless, like Edmunds, you can prosper in such a world. But it will take some work and some know-how.

As a first step, figure out how much investment reward a property is generating compared to other properties, and also versus other types of investments. That involves calculating what's called a “capitalization rate.”

To get a house's cap rate, compute the net rental income. This is what's left of the rent after operating expenses like property taxes, insurance, utilities, maintenance and rental agent's fee. Divide this sum by the property's market value. This percentage return corresponds to the coupon on a bond or the earnings yield on a stock (a stock trading at 20 times earnings has an earnings yield of 5 percent). To simplify: You should sell when the cap rate is low.

The right time to take profits may be never, if it's a beloved primary residence. But if you're into the real estate solely for the money, bail out when the cap rate dips below the rate of return offered by competing investments.

No competing investment is entirely comparable — any investment has advantages and disadvantages peculiar to it. But it's worth starting with a comparison to the yield to maturity available on Treasury notes. The ten-year Treasury yields 5.2 percent. Disadvantages of Treasury: no inflation protection, high taxes. Advantage: extremely high liquidity.

The stock market these days has an earnings yield of 5.6 percent (S&P 500 earnings divided by index value). Stock liquidity is high. Tax treatment is roughly as good as that on rental real estate. Stock dividends and long-term capital gains are taxed (for the moment) at 15 percent. Net rental income is ordinary income taxed at up to 35 percent, but in computing the net you can write off depreciation. The effect is something like the break on dividends.

Now here's the unavoidable fact about real estate, especially residential: In almost any hot market, its cap rate is low. Suppose you wanted to rent the 940-square-foot bungalow at 1149 Grant Avenue in Venice, Calif. Since L.A. rentals are plentiful, this tiny house will gross only $2,200 a month, or perhaps $1,450 after operating expenses. Built in 1940, the house has two bedrooms, one full bathroom and a narrow kitchen. Elsewhere this would be a slightly shabby starter home.

But the famous surfing scene at Venice Beach is a mile away, so the market value of this house is $730,000. This makes for a slim cap rate of 2.4% — measly, but about par for Los Angeles. "Rents are nowhere near where they'd have to be to provide adequate income for a new buyer," says Bruce Huntley, who manages 1,500 apartments in the area. Prices in Venice are up threefold since 2001, while rents have only edged up with inflation. Sell and put the money into stocks and bonds.