Investment Consult: Have real estate prices peaked?

February 21, 2003

For the past three years, real estate has been the best-performing part of many portfolios. Are the good times over?

 

Investment Consult

By Lewis J. Altfest, CFP

Have real estate prices peaked?

• Real estate, especially housing prices, seems vulnerable.

• Rents for commercial real estate are declining in many markets.

• Real estate will continue to be a great long-term investment.

 

While the stock market has lagged, real estate has been hot in many areas of the country. Many people have seen the value of their homes skyrocket.

If you're among them, congratulations—but keep your feet firmly planted on the ground. Although some experts are optimistic that home prices will continue to rise in 2003, I see strong signs that the run-up in prices may be coming to an end. Losses could become common over the next several years. The growth in prices has reached a risky level, as has investors' enthusiasm for bricks and mortar. That goes for both residential and, to a lesser extent, commercial real estate.

It's not hard to understand why real estate soared. The government's monetary policies have contributed to a decline in mortgage rates, making it cheaper for people to borrow and allowing more of them to qualify for a loan. At the same time, many investors have lost confidence in the stock market and shifted more of their assets into real estate. Demand for homes has increased, and prices followed suit.

But real estate in general, and housing prices in particular, now seems vulnerable, for the following reasons:

• Household debt as a percentage of income continues to be at historically high levels.

• Expensive real estate has lead to an oversupply in some markets. Prices in Chicago, Dallas, and New York are already showing signs of softening.

• Rents for commercial real estate are declining in many markets. In New York, asking prices are sharply lower than they were two years ago.

• The Federal Reserve Board, in my opinion, has been deliberately reducing long-term interest rates to, among other reasons, help cushion the impact of stock-price declines on household wealth. But as the economy rebounds, the Federal Reserve will likely raise rates. This will make it more expensive for banks and other lenders to borrow money and will result in higher mortgage rates for businesses and consumers, in turn dampening prices for all types of real estate.

Still a good bet

The good news is that despite these short-term problems, real estate will continue to be a tremendous long-term investment. When held over many years, it almost always appreciates and provides significant capital gains when it's sold. Moreover, the returns on real estate usually don't correlate with those of the overall stock market, which makes housing, office space, and, in many cases, raw land excellent tools for diversifying your portfolio.

Besides capital appreciation, the great tax benefits real estate offers add to its long-term appeal. Business owners can take a depreciation deduction on the building they own. And, like homeowners, they can write off property taxes and mortgage interest.

The IRS is especially kind to homeowners who sell a principal residence: Gains are taxed as capital gains only if they exceed $500,000 for couples filing jointly, and $250,000 for singles. You're entitled to one exclusion every two years, as long as you and your spouse used the home as your primary residence during that time. This tremendous tax benefit is why some people buy a rundown home, fix it up, live in it for two years, and then "flip" it. The outcome is investment nirvana—a large, tax-free gain.

Given that lure, you may be tempted to sell your home now, while prices are still strong. Keep in mind that if you've owned your house for decades in an area where real estate has appreciated strongly, your gains may bump up against the tax-free limits. To help possibly avoid this, you can reduce your gains by adding back to your original purchase price the cost of any home improvements you've made—additions, remodeling projects, central air conditioning, water filtration systems, landscaping, etc. This assumes they're still part of the home and property. But keep good records of these improvements, along with receipts for major purchases; if you're audited, you may need them to support your calculations.

Unfortunately, if you sell a home that was purchased during this latest real estate bonanza, there's no guarantee you'll have a capital gain, and, if you lose money, the IRS generally won't let you write off anything. You can deduct some losses, though, if you used part of the home for business, converted it to a rental property, or acquired it as an inheritance or gift and immediately put it up for sale.

What to buy and sell

If you're selling your home and plan to buy another, consider postponing your purchase if doing so wouldn't significantly impair your quality of life in the meantime. That way, you may benefit from falling prices. In New York, some people who have sold their co-ops and apartments are renting for now. That could turn out to be a smart contrarian move.

In addition, this could be a perfect time to sell that vacation home you don't use much. You could command top dollar or close to it, then invest some or all of the proceeds in the stock market, where prices remain rather depressed.

But if you own shares of a real estate investment trust (REIT), hold onto them. Apartment REITs in particular will do well when interest rates rise, because the number of people who can afford homes will decrease. In fact, any "equity" REIT—those that rent out and sell their properties—will benefit from a strengthening economy.

I've always liked REITs for the diversification they provide, without the hassles associated with limited partnerships. For more information, see "REITs: solid dividends and gains," Sept. 9, 2002.

The author, a fee-only financial planner, is president of L.J. Altfest & Co. (www.altfest.com), a financial and investment advisory firm in New York City. The ideas expressed in this column are his alone, and do not represent the views of Thomson Medical Economics. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

 

 

 

Lewis Altfest. Investment Consult: Have real estate prices peaked?. Medical Economics Feb. 21, 2003;80:23.

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