Should You Invest in Real Estate Now?

Every first-year law student quickly learns that all their seemingly good questions are relegated by their professors to one thoughtful, albeit frustrating, response: "It depends."

I believe the frequently asked dinner-party question, "Is now a good time to invest in real estate?" deserves a similar fate.

Depends on what?
It all depends on what you mean by "time" and "invest."

Timing the market is for speculators. In The Intelligent Investor, Ben Graham advises that there is nothing wrong with speculation -- just do so only with money you can afford to lose. Also, be honest with yourself and admit that you are speculating. Don't try to small-f fool yourself by calling it "investing."

Investors don't substitute timing for thinking. Every opportunity must be analyzed based on its own merit. So what is the most important determinant of real estate value?

Rent!
No, not the musical. I'm talking cold, hard monthly cash flow. This is the only tried-and-true metric that ensures a worthy real estate purchase.

Surprisingly, most people believe that their home is an investment. But unless they plan on renting out rooms, turning it into a quaint bed and breakfast, or using it in some other manner that generates income in excess of total expenses, it doesn't qualify as an investment.

Homebuying decisions tend to be made with the heart, not the mind. There's absolutely nothing wrong with that. Just know that anything you pay above the rental value of your property is either speculation or indulgence. Treat any premium paid for homeownership as either a slightly favorable gamble at a blackjack table, or a speculative art purchase.

How the pros do it
Think of it this way: Homebuilders such as Toll Brothers (NYSE: TOL  ) , Lennar (NYSE: LEN  ) , and D.R. Horton (NYSE: DHI  ) would have great difficulty renting their housing inventories at rates above their carrying costs. If they could, they would simply convert to a Real Estate Investment Trust (REIT) and instantly solve all their problems.

However, these companies aren't looking for rental income. Homebuilders, like most real estate speculators, count on rising home prices, or at least prices that don't decline. The market has finally dispelled the long-held belief that property values only go up. Higher rents are the only factor that ensures higher prices.

In contrast, apartment REITs, such as Equity Residential (NYSE: EQR  ) and AvalonBay Communities (NYSE: AVB  ) , derive their income from historically stable monthly rents. The model is quite simple. Rents cover the operating expenses of the property, mortgage costs, and administrative expenses. Most of the remaining profits are returned to shareholders as dividends. These returns can be quite attractive at times. For example, Equity Residential currently boasts almost a 5% yield.

REITs don't rely on property appreciation to generate profit, and neither should the intelligent real estate investor.

So the next time you're at a dinner party and the conversation turns to real estate, take the time to explain the difference between investing and speculating.

Will the other guests get it? It depends.

Further Foolishness:

Fool contributor Andy Louis-Charles is an active real estate investor. Feel free to email him if you'd like to rent a room; sorry, no pets over 200 lbs. The Fool has a disclosure policy.


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  • Report this Comment On July 14, 2008, at 7:50 AM, kakrae wrote:

    You made a small mistake in your article:

    Lennar (NYSE: WCI)

  • Report this Comment On January 14, 2009, at 3:05 PM, michaelroe wrote:

    I completely agree with Ben Graham. An intelligent investor is the smart buyer not necessarily a risk taker as most view them. Smart investors use data to make an informed decision. Unfortunately, most of the "get rich in real estate" schemes bank on the on the heart of the consumer..everyone wants to be financially secure. People pay thousands to have their heart strings pulled, which really aggravates me. If you want to read an honest book on the process I recommend "The Pizza Delivery Millionaire" by Rick Vazquez. Apart from being entertaining it shows how any one can really become financially independent if not free.

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