Real Estate Investing: A Risky Proposition?
Real Estate mania of today recalls memories of late 90's stock market mania, as well as the real estate bubble of the late 1980's. Is it different this time around? How should a prudent investor view real estate now?
(PRWEB) June 19, 2005 -- Listening to the buzz around summer picnics and the
office water cooler this year, it won’t take long before discussions turn to the
red hot real estate market. There is no doubt about it, real estate as an
investment has been on a tear for several years now. Many people seem to believe
real estate is the miracle investment of the 21st century – guaranteed high
returns with little or no risk. However, the truth is that there are no miracle
investments – never have been, never will be. Despite all the hype, risk and
return continue to be well correlated in the investment world. Higher returns
still equate to higher risk of loss. Real estate is no exception. Prudent
investors need to carefully consider the risks before jumping on the real estate
bandwagon.
Don’t get me wrong. Real estate deserves a place in most
individual financial plans. After all, as a “hard asset” it is very unlikely
that a given piece of property will ever be worth nothing. Further, the long
term track record of real estate investments does support the position that real
estate is somewhat less volatile than alternative investments such as the stock
market. Over the long run, real estate has demonstrated slow but consistent
growth, roughly paralleling the overall inflation rate in the economy, and there
is no reason to expect that similar returns shouldn’t continue long into the
future.
However, before investing in real estate, one should recognize
and accept that real estate prices in any given market can and do occasionally
turn downward. Sometimes markets collapse dramatically, with owners unable to
sell properties without incurring severe losses. History has shown that
downturns can be prolonged, with prices taking years to recover. One needs only
think back as far as 1990 to recall the damage that can be wrought by real
estate price deflation, particularly on individuals with low down payment or
negative amortization mortgages. Real estate market collapses in the past have
usually followed periods of rapidly increasing prices and rampant speculation.
For example, the 1990 real estate collapse was preceded by a period of rampant
speculation and “real estate mania” not unlike that which we are experiencing
today.
Arguments which suggest that real estate will keep going up and
up forever are simplistic and inherently flawed. Such arguments are almost as
absurd as the talking heads on CNBC in the late 1990’s who argued that stock
prices would keep going up because “the rules had changed” in the “new economy”.
As many people became painfully aware, the rules of investing had not changed in
the 1990’s and they have not changed today. In the opinion of nearly all
rational financial experts, real estate prices cannot and will not keep
increasing at 15% per year forever.
Many experts will point out that
real estate market collapses have historically been less severe on a percentage
basis than stock market downturns. While this is true, the impact of even minor
downturns on real estate investors can be severe. This is because real estate is
most often purchased using leverage. Leverage refers to the purchase of an
investment with borrowed money (mortgage). The effect of leverage is that both
gains and losses on the investment are magnified dramatically. Consider the
following two examples:
The Smith family has $25,000 to invest. They
choose to invest in the stock market by purchasing mutual funds. If the stock
market rises by 10%, the value of the Smith family’s investment will increase by
$2,500. If the stock market falls by 10%, the Smith family will lose $2500 on
their investment, leaving them with an investment worth $22,500.
The
Jones family also has $25,000 to invest. They choose to use the money as a down
payment to purchase a $250,000 investment property. In two years, the value of
the property has increased by 10% and the Joneses’ decide to sell their property
for $275,000. The gain represents an increase of 100% on their original cash
investment. Not a bad rate of return. However, should home prices drop by 10%
(as home prices in NJ fell in 1989/90), the value of the $250,000 house will
fall to $225,000. In this event, the Joneses have lost 100% of their original
$25000 cash investment. Worse yet, if the Jones’ had purchased using “no money
down”, they would be $25,000 in the hole.
Although the Joneses’ property experienced the same price fluctuations
as the Smiths’ mutual fund, the effective gain or loss on their original $25,000
cash investment was dramatically magnified by the leverage of their mortgage.
This important source of risk is often ignored by individuals considering real
estate investing.
Are we predicting a major
stock market crash? By no means. It is impossible to predict precisely when, or
even if, any investment bubble will burst (or even begin gradually deflating).
We are not even suggesting that investors avoid real estate investing at this
point in time. What we do suggest is that investors should not ignore the
valuable lessons provided by the stock market crash of 2000/2001 and the real
estate collapse of 1990. We should have learned from these experiences the value
of a well diversified portfolio of investments. We should have learned that
mania in investing is a sure sign of danger ahead. We believe that prudent
investors would be wise to discuss with a professional financial planner (such
as Frontier Financial Planning) the proper role of real estate investments in a
well diversified, risk managed portfolio.
Frontier Financial Planning,
located in Somerville NJ, provides retirement, estate, and small business
planning services to residents of Somerset, Middlesex, and Hunterdon
counties.
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Source : http://www.prweb.com/releases/2005/6/prweb252492.htm