Imagine 11 homes, 10 of which are $100K and 1 which is $1mil.

Imagine the $1mil home sells for $800K but several of the $100K homes sell for $100K. A “value weighted index” registers a 10% drop. An “equal weighted index” registers a 1.8% drop. Which is more “accurate?”

Imagine now that all of the $100K homes sell for $90K, but the $1mil home sells for $1.1 mil. The “value weighted index” registers no change. The “equal weighted index” would register a 9.2% drop. Which is more “accurate?”

Here are the two obvious flaws in the article.

First, appreciation isn’t two percent annualized on real estate. It’s closer to six percent annualized over the long term. Maybe the writers are biased by current data, but it sure seems like they cherry-picked a bias against real estate, because they have an eight percent assumption on the couple’s portfolio, which certainly is not reflective of recent data. If the authors want to use long-term projections for stocks in a ten-year future “what if,” then they should do the same for real estate. Even splitting the difference, i.e. giving a four percent allowance to real estate, makes a substantial impact on their calculations.

Second, what is this couple doing with their retirement home? Letting it gather dust while they visit it once or twice a year?

Let’s assume they have at least half a clue, and they put the home into rental service while waiting to retire. Now I don’t know if they can rent a $350K house out to a family for positive cash flow, but even if it’s an alligator as a full-time long-term rental, they only thing they’re really losing is the opportunity cost of using it occasionally. The couple is already paying principal, interest, taxes, insurance, and maintenance for a full year, even if they only use it a few weeks out of the year. If they rent it full-time prior to retirement, the tradeoff is opportunity cost for lost usage and paying a manager, while the PITIM is paid, at least partially, by someone else.

Now let’s assume that maybe the house is something that could be a resort or vacation rental. The opportunity cost is merely that they have to schedule their usage of the house carefully, while still getting much of the PITIM paid for, and they have to pay a manager.

In the event that the house is used as a rental, they get 1/27th of the house’s value as depreciation annually, which reduces their taxable income. If it is an alligator, they get business losses as tax credits. This is a powerful addition to their portfolio.

When the tax benefits of rental property are combined with a more realistic long-term appreciation assumption, the equation changes quite a bit. Perhaps they should buy that retirement home now, and rent it out for a while before they move into it.

Generally speaking, the Infernal Revenue Service defines two classes of real estate speculator, traders and investors, which are defined based on derivation of profit and holding periods, and differ in tax treatment. Traders derive their profit from the sale of inventory and buy inventory in order to sell it later, whereas investors primarily derive their profit from rental of the inventory. Speculators who do both should probably consult with a CPA and/or attorney in order to use separate entities for each activity, to take advantage of the proper tax treatments. Traders will have their entire profits from sales taxed as ordinary income, including the prospect of quarterly estimated payments and Social Insecurity. Investors have several advantages in this regard.

Investors have taxation advantages out the wazoo compared to traders. Rental units that are sold can have taxation of profit deferred provided they carry out a Starker Exchange, so named for a court case precedent. Essentially a third party holds proceeds while a replacement unit is found, hence the “exchange.” Investors can take depreciation on the units held in rental, as well as take losses. Sales of long-term holdings would be subject to capital gains tax rates rather than ordinary income (if it didn’t involve an exchange), and, within limits of time and total amount, the capital gains can be avoided if the unit is converted to personal use.

Wow. Let’s go through those one more time, in sequential order that an investor might perform them.

Ida Investor buys a couple of shotgun shacks that she then rents out. Each year, she takes depreciation on these units to offset her taxable gains from renting them out. When they get close to paid for, she Starker Exchanges them into twice as many units, avoiding the capital gains tax. When those four are close to paid for, she again does a Starker Exchange, but this time for a nice big house on the coast that she rents out to vacationers. After a year or so of renting out that beach house, she converts it to use as a primary dwelling, and if she then lives in it for a couple of years, she can take the limited capital gains exemption that applies to all owner-occupiers when she sells it. That is a lot of perfectly legal tax avoidance (not evasion, avoidance) on an investment.

Traders only have appreciation of the property as the source of income, which makes them vulnerable. Now is probably a great time for investors in real estate, not for traders, although their time will come again. That appreciation can come from buying actually distressed properties (repair and rehab) if the trader is especially stupid, from buying speculative properties in rapidly-appreciating areas if the trader is merely dull-witted, or from buying from distressed sellers, which is a totally different ball of wax. Distressed sellers will let their properties go for less than market value, and typically the properties only need cosmetic treatment. Many people call this activity “flipping” but one should be cognizant of the fact that some enforcement agencies describe certain mortgage fraud activities with the word “flipping.” Check out this story, which makes one wonder how many sub-prime foreclosures are related to out-and-out fraud, and I really doubt that those foreclosures, in particular, will impact consumer spending! LOL! I consider the “foreclosure flipper” to be a subset of the “buying from distressed sellers” crowd. Why? Because the banks have … other considerations, including regulatory impacts … that make the holding of REO properties disadvantageous. The bank will be there on the steps with a bid for the mortgage amount, and not a penny more, and that amount may be considerably less than market value. Even if the bank takes the property at the steps, they may be willing to sell the REO for less than the original mortgage, esp. if they initiate the new loan.

Excluding fraud, trading houses is a tough way to make a living, and is dependent on either finding the valuation mismatch (distressed seller and cosmetic improvements) or logistically navigating the maze of getting more value out of improvements than one spends on them. The “day trader” of real estate, who buys and sells speculative properties in rapidly-appreciating areas but does nothing to add value inbetween, really only exists for a few years of each real estate cycle, and (thankfully) goes extinct with regularity.

There is one type of trader that is of special interest, and that is the “sweat equity livinum” trader. If I were young again and knew what I know now, this is what I would do: buy a home that needs minor improvement, live in it while I perform the necessary work, stay long enough to get the capital gains exemption, and then move. Rinse, repeat. If a young person is reading this, this is a good way to increase your income over time, because you’re gonna need a place to live anyways …

Investors get more than just rental income and favorable tax treatment, they also get the benefits of leverage and long-term appreciation. Yes, long-term appreciation. If you visit the OFHEO Home Price Index page, which differs from the S&P C-S Index in that it includes all Fannie and Freddie data rather than just 10 or 20 cities, you can download 32 years of truly nationwide data. And just what kind of innumerate crackpot calls a 10-city index “nationwide?” Wait, I know the answer to that question! See other posts in the Real Estate category for an in-depth discussion of the merits of various Home Price Indices, a discussion notably lacking at “brand x.”

All real estate is local, and being the best real estate investor in 1991 Boston or 2007 Detroit is gonna be about as pleasant as being the best gold sector fund manager in 1982. Go figure. But on average, over 32+ years, home prices have appreciated +6.2% annually in the U.S., with min, max, and median annual appreciation of +0.3%, +14.8%, and +6.0%. This +6.2% annual average sucks compared to stocks, but beats the long-term returns on gold pretty easily, and is better from a risk-adjusted standpoint, as well. Real estate is a smoother appreciation ride, because even the worst downturn in local real estate price levels can’t compare to the haircut the S&P took from 2000 to 2002 or the one gold took from 1980 to 1982, and nationally, from the standpoint of an actual, honest-to-goodness nationwide index (10 cities? Gimmeafrickinbreak!), there has not yet been a year of nationwide annual price downturn in the last 32 years, which is something that stocks and gold cannot say. Even assuming one might be coming, does anyone aside from the usual f-, er, suspects, think it’ll be comparable to a 10%+ correction or bear market in global stocks? Before we get into a discussion of specific real estate market locales, I’ll head it off at the pass: MOVE! Same suggestion that one should give a sector fund investor when their favorite sector is out of favor …

During the appreciation of stocks, one gets a dividend. During the appreciation of gold, one gets to pay storage charges, security charges, or paper carrying charges if in the futures markets. During the appreciation of real estate, one gets to receive rents, take depreciation, and pay property taxes, insurance, and maintenance.

Stocks have their own quantifiable metrics for those that make the best longer-term trades, what is comparable to an investment in real estate. One might think of the rent to price ratio as the real estate’s P/E ratio. Just check to see what similar properties are renting for and divide that by the purchase price to find the ratio, on a monthly basis one probably should look for rents that are more than 1% of the price, or annual rents that are more than 12% of the price. Less than that, and one almost definitely has an alligator to feed, or has to throw in a lot of initial equity.

Aside from the metric of rents to purchase price, which can be used to determine what neighborhoods or nearby cities are good ponds to fish from, one should get comfortable with the basic structure of a real estate investment that generates cash flow.

It would go something like this: Determine a competitive rental rate for a target property. Adjust the rate for vacancies, which can be determined by surveying other investors in the area, or guessed at, but remember that inaccurate guesses pay of here just as well as in the stock market! Perhaps a semi-annual turnover in tenants with four weeks vacant in-between, that’s a rate of 4/104 or 3.8%, or an adjustment factor of 96.2%. Now subtract the costs of property taxes and insurance from the adjusted rents. If the property is financed (which it should be, unless there is a mortgage rate to appreciation mismatch of proportions heretofore unseen), subtract the debt service costs of principal and interest. Determine what others charge to manage the properties, and subtract that from the adjusted rent as well. Even those who self-manage should be paid for it. The last major item to be charged is a maintenance allowance, which should approximate the anticipated costs over the course of holding. Bottom line, a well-purchased property should generate at least some marginal positive cash flow after all the expenses are factored in.

The final benefit calculation gets complex in a hurry, even in a theoretical exercise like this one.

Assume a low-to-mid-market home that rents for more than enough to cover its costs. It then appreciates at +6% annually over the long term, and the tenant is paying down the principal, which adds to the equity growth. Meanwhile, the property throws off 1/27th of its acquisition price annually in depreciation benefit. Working with 20% down on a 7.2% non-owner-occupied 30-year amort, the early years of the mortgage each pay off about 0.8% of the purchase price annually, and the depreciation benefit is 3.7% of the purchase price annually, so a typical annual benefit might be 6.0% appreciation + 0.8% payment into equity +3.7% depreciation = 10.5% of purchase price, which is insane when based on 5:1 leverage (20% down). This, of course, includes no cash flow benefit.

It is the prospect of this type of gain that will encourage the real estate investors to seize opportunity in the current turmoil. It is also this type of gain that makes REITs so profitable on a total return basis.

While my focus in this post has been on the individual rental real estate investor, it should be remembered that perhaps the best reason for owning a small business is to pay off a chunk of commercial real estate while earning a living. If you’re reading this, and you’re a small businessman who leases his real estate, take a re-assessment of whether that’s a bright idea.

The main barrier to entry in the real estate investing market is knowledge, followed closely by the increased activity level. There are liability concerns, privacy concerns, and an education process that has to be gone through in order to be successful at real estate speculation, and some of these things are unique to real estate as opposed to futures, bonds, or stocks. All that said, real estate speculation can be very profitable, and the real question one has is whether or not it is suitable to them.

Seriously, one fraud ring accounted for over a hundred subprime foreclosures, mostly of the “don’t even make the first payment” variety that the bearmongers moan about the most! How many fraud rings would it take to make a serious dent in the increased foreclosure run rate that’s been making headlines? How many of these fraud rings are there?

This information is quoted directly from pages 25 and 26 of the OFHEO HPI 2Q07 data release.

14. How does the HPI differ from the S&P/Case-Shiller® Home Price indexes?

Although both indexes employ the same fundamental repeat-valuations approach, there are a number of data and methodology differences. Among the dissimilarities:

a. The S&P/Case-Shiller indexes only use purchase prices in index calibration, while the all-transactions HPI also includes refinance appraisals. OFHEO’s purchase only series is restricted to purchase prices, as are the S&P/Case-Shiller indexes.

b. OFHEO’s valuation data are derived from conforming, conventional mortgages provided by Fannie Mae and Freddie Mac. The S&P/Case-Shiller indexes use information obtained from county assessor and recorder offices.

c. The S&P/Case-Shiller indexes are value-weighted, meaning that price trends for more expensive homes have greater influence on estimated price changes than other homes. OFHEO’s index weights price trends equally for all properties.

d. The geographic coverage of the indexes differs. The S&P/Case-Shiller National Home Price Index, for example, does not have valuation data from 13 states. OFHEO’s U.S. Index is calculated using data from all states.

For details concerning these and other differences, consult the OFHEO HPI Technical Description (see www.ofheo.gov/Media/Archive/house/hpi_tech.pdf) and the S&P/Case-Shiller methodology materials (see http://www2.standardandpoors.com/spf/pdf/index/SP_Case_Shiller _Home_Price_Indices_Methodology_Web.pdf)

Also note that a recent paper, “A Note on the Differences between the OFHEO and S&P/Case- Shiller House Price Indexes,” measures the incremental impact of various methodological and data differences between the two price metrics. That paper can be downloaded at http://www.ofheo.gov/media/pdf/notediff2.pdf.

Differences are predominantly in the value range covered and in the geographic range covered.

The value at which the OFHEO will start missing transactions is $417,000, so it is weighted towards above-average, average, and lower-valued homes. Because the S&P index includes higher-valued homes, and is weighted by value, it has two influences that focus it on values well above those most “Main Streeters” would consider for purchase. The 2005 census estimate (see the Census FactFinder) shows the 2005 estimated median value of owner-occupied homes at $167,500 with a small margin of error (+/- $322), so only the upper end is excluded, the heart of the batting order is well-represented.

The S&P 10-city index, the favorite of the bears precisely because it is so limited and focused, comprises the following cities and surrounding metro areas: Boston, Chicago, Denver, Las Vegas, L.A., Miami, New York, San Diego, San Francisco, and Washington D.C. The total number of housing units in the 2005 census estimate is 124,521,000, and are there any guesses as to what percentage of total national housing is represented by those areas? Fannie and Freddie data comprises about 40% of all housing stock.

Your mileage may vary, but I am sticking with the OFHEO data as being still imperfect, but more accurate, than the 10-city S&P data favored by the bears.