Can You Live with Your Investment in Real Estate?

Physician's Money Digest, July 2005, Volume 12, Issue 10

Owning a home is the American dream. Justask those Americans who contributed to therecord sales in 2004 for new and existinghomes. Housing industry economists expectanother very strong year for housing in 2005. So, what'sfueling this growth?

Janet Leavitt, realtor with Coldwell Banker PrestigeProperties in Escondido, Calif, says there are two drivingforces: baby boomers and attractive interest rates."Boomers are progressing into their second or thirdhome, whether it's for vacation or retirement,"Leavittsays. "And interest rates, relatively speaking, are extremelylow. Today's younger homeowners are used to nothingbut low interest rates. They don't remember 18%."

Even the forecast that the real estate bubble mayburst is not deterring many people these days. Accordingto the April 2005 McDonald Financial Group AffluentConsumer Confidence Index, 60% of affluent Americansagree that a real estate bubble does exist. However, 37%of survey respondents said they were still more likely toput their money into real estate rather than stocks, bonds,or mutual funds during the upcoming months.

Wall Street Journal

But buying a home is really more of a lifestyle issue,says Mel Cutler, senior portfolio manager for CutlerCapital Management. Investing in real estate is somethingelse entirely. And whether you're investing inmutual funds or real estate, doing your homeworkbeforehand is key to a successful investment. Because asJonathan Clements notes in his column,real estate doesn't always go up.

Maintenance Matters

A home's value depends a great deal on how it'smaintained, and that means the inside as well as theoutside property. Dave Tibbetts, president of AtlantaDecking & Fence Co (770-781-4641; www.atlantadecking.com), points out that before a buyer or guesteven steps foot inside your home, they've alreadyformed an impression.

Enhancing your landscape, he says, can add 15% to70% payback. A well-kept garden, pathway, and fence,as well as a freshly painted front door give a prospectivebuyer an early indication of how well the home has beenmaintained. In contrast, if the front lawn and backyardare neglected, the inside is likely to be neglected too.

Stuart Rider, an Arizona-based contractor and developerwith more than 30 years of real estate experience,says that real estate is not rocket science. "For the averageperson, real estate is the single-best sure thing on theplanet,"he notes. According to Rider, the key for homeownersis to keep their residences state of the art."You've got to keep it maintained so that if you're goingto sell, there's no deferred maintenance,"he explains.

Rider also points out that the most profitable thing ahomeowner can do is expand. "For every square footyou add on, you double your money,"he says. "I canadd space on all day long for about $125 a foot. So forevery $1 I put in, I get $2 back."

When it comes to the inside, experts urge cautionbefore spending money on expensive remodeling projects.Leavitt explains that if you own a one-bathroomhome and put in a second bathroom, you'll probablyreceive back more for that extra bathroom than the actualcost of the improvement. However, if you put in acombination swimming pool/spa/outdoor entertainmentcenter, you may not even recoup half of the investment.

"It's the added functionality for a family,"Leavittsays. "The pool/spa complex may have added value toyou, but it may have a negative value to others. Whenyou bring things up to a level of function, you can getyour return. But when you go over the top, you canlower the return because you've gone beyond the functionalrequirements of most families."

According to Rider, kitchens top the list of homeowners'priorities. "The new fad is spending $35,000on the kitchen,"he points out. "The problem is you'renot going to get $35,000 back. But if you add 2000square feet onto your home and remodel the kitchen,then the remodeled kitchen will probably sell the biggerhouse a lot faster."

Diversification Benefits

Real estate investment trusts (REITs) allow investorsthe chance to pool their capital and invest in hard assetsin real estate with limited liability. They're vehicles thatallow investors to have ownership in real estate withoutthe hassle of maintaining it.

Cutler Capital Management specializes in investingin REITs. Mel Cutler, senior portfolio manager, explainsthat one of the main reasons people invest in REITsrather than hard real estate is for liquidity. "If you buy apiece of real estate and decide you need to liquidate, theprocess of selling, especially if it's commercial real estate,could take 3 months to a year,"Cutler says. "WithREITs, you can have your money in 3 days."

REITs also allow for portfolio diversification, thecornerstone of a successful investment strategy. Theaverage physician-investor might be able to invest in asmall apartment building or become a partner in a smallshopping center, but that isn't real diversification, Cutlerpoints out. "All real estate is not equal,"he warns.

Cutler notes that REITs are typically characterizedby the nature of their real estate investments. For example,there are REITs that focus on apartments, hotels,industrial complexes, or large shopping malls. Someapartment REITs even specialize in geographic locations,which makes it easier to achieve diversification in yourinvestments. But as with any investment, it's importantto do your homework.

"I've spent my whole life looking for the free lunch,and I haven't found it yet,"Cutler admits. "And there'sno free lunch in REITs. Some REITs have cut their dividendsbecause the underlying property has suffered."Apartment REITs fall into that category. Cutler explainsthat with interest rates so low, more people have beenable to buy homes.

"For what you're paying in rent, you can own ahouse. So apartment REITs have suffered because theiroccupancy rates have been down."In contrast, Cutler'scompany has recently become interested in student andmilitary housing, two narrow areas.

"Today, students coming from middle-class homeshave their own room and maybe their own bathroom,"Cutler says. "They don't want to live in something less.We've found a significant upgrading of dormitories inalmost all colleges."The same is true with militaryhousing. Facilities that were built during World War IIare now being rebuilt.

"REITs are like any other investment,"Cutlerstresses. "You should know something about the company,know something about its management, and thenlook at the REIT financial statement to see what theyown and where it's located."

Government Assistance

Stephen Wayner is a real estate attorney withBayview Financial Exchange Services (866-903-1031;www.bayview1031.com). He is also one of only 170 certifiedexchange specialists in the United States. Waynerpoints out that the US government offers Americans avaluable device: Section 1031 of the Internal RevenueCode. This device can save taxpayers and investors hundredsof thousands of dollars.

Here's how it works. Section 1031 allows buyers andsellers of commercial property and real estate investmentsto defer capital gains taxes by rolling the proceedsfrom one sale into another investment property of equalor greater value. But despite the large volume of commercialand investment real estate bought and sold inthis country, Wayner says that the 1031 exchange is anunderutilized tax and investment strategy.

"The purpose of Section 1031, which was first enactedin 1921, is to keep the economy spiraling upward,"he explains. "For example, if I were to sell a piece ofproperty for $300,000, the thought process is that Iwould take my money and buy something more expensive,maybe something for $400,000. That keeps oureconomy growing."

There are some basic rules that apply to a 1031exchange. The first rule is that the property being sold orrelinquished must be property that was used as aninvestment or for a trade or business. The second rule isthat the property being purchased must also be investmentproperty or property used for a trade or business.It must also be like-kind property.

Popularity question:

"When it comes to real estate,"Wayner says, "anytype of real estate qualifies as like-kind. I can exchangean apartment building for a piece of raw acreage—that'sthe beauty of the 1031 exchange."Why don't more people take advantage of Section 1031?Wayner says it's because they don't know about it.

"If there were 100 people in a room, all of theminvestors in real estate, and you asked me how many ofthem know about Section 1031, I would say about5%,"Wayner explains. "I think the public is just startingto find out about Section 1031, and they're kickingthemselves in the pants and asking why their CPA didnot tell them about it."

There are considerable advantages afforded by a1031 exchange, including both federal and state taxdeferrals. There are also important timing rules and regulations,and the exchange must be coordinated by aqualified intermediary; that individual will serve as themiddle man and hold the money being paid by the purchaserof your property until you find a suitable replacementproperty. If you're considering a 1031 exchange,the best way to ensure that it's done properly is to consultwith a certified exchange specialist.

Franchise Opportunities

If you really want to become a land baron, youmight want to consider investing in franchise condominiumcommunities. Epcon Communities (614-761-1010; www.epcongroup.com), believed to be the country'sonly franchisor of condominium complexes,began franchising in 1995 and now has 100 franchisesin 27 different states.

So what is a franchised condominium community?Tom Rothrauff, vice president and general manager ofEpcon Communities, says the concept is similar to aWendy's or McDonald's. "We have developed a homebuilding concept,"Rothrauff explains. "We build singlestorycondominiums. And we will provide you with atested and proven product."

Epcon provides franchisees with blueprints, manuals,and instructions for setting up the condominiumcomplex. Sales and marketing tools provided includeprint, radio, and television ads, as well as direct mailmaterials. Franchisees will also receive instructions forsetting up their sales office as well as instructions forhow to stage a grand opening.

"We have manuals for every phase of constructionand national accounts with suppliers to provide us materialsand services at prices lower than somebody could geton their own,"Rothrauff says. The company also has anintranet for new franchisees to reach out and learn fromothers who have already established their communities.

Who's investing in these communities? Rothrauff saysthat about 55% of franchisees have some type of buildingexperience,ranging from customhomes to mallsand offices. However, 45%of franchisees have no buildingexperience. What makes it possible for the nonexperiencedfranchisees is that everything is kept simple. "Wehave only four product models, and we don't encourage alot of options,"Rothrauff explains. "That makes it feasiblefor people without experience to get up and running."

What's the cost to get up and running? Rothrauffsays prospective franchisees will need approximately $3million to $4 million. "The total cost of the communitymight be $13 million to $15 million, but you never needto borrow that much,"Rothrauff says. "You get arevolving line of credit to build the homes and you borrowon that credit. Then, as you close homes, you'll freeup that financing."

Banks will require approximately 15% equity as adown payment, and seed money is needed to get somethings up and running. As such, Rothrauff suggeststhat it's best if prospective franchisees have about $1million in liquid assets to invest. He also adds thatEpcon Communities completed 2100 units in 2004and anticipates completing between 3500 and 4000units this year.