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With the Stock Markets in Turmoil,

Real Estate Offers Steadier Returns

 

By RAY SMITH

Staff Reporter of THE WALL STREET JOURNAL

 

 

Looking for steadier returns? Ever think about being a landlord?

 

With so much volatility in the stock market, now might seem the ideal time to buy and rent out a house or small apartment building. While stock markets were reeling for much of last year, the real estate world had another good year. Investors in apartments received an annual return on their investment of 10%, the National Council of Real Estate Investment Fiduciaries estimates. During the same period, the Standard & Poor's 500-stock index fell 12% and the Dow Jones Industrial Average was down 7%.

 

Compared with the stock market, investing in real estate may seem about as exciting as watching grass grow. But it remains one of the most popular investments for small investors. Around 10 million individuals or married couples own single-family houses used as rentals, according to a U.S. Census survey in the mid-1990s, the most recent data of the sort. The survey found more than seven million individuals own multifamily properties. Indeed, 85% of apartment properties with two to four units are owned by individuals, according to the National Multi Housing Council, a trade group.

 

The current low-interest rates are giving a big boost to real estate right now. First, it makes buying a lot easier for investors who borrow money. Second, real-estate returns appear even more attractive at a time when yields for some bonds have sunk below 5%.

 

That is the good news. The bad news is that a lot of real-estate pros think real-estate prices could slip in the next six months. In other words, the property you buy now could be worth less by midyear -- not a good first step toward earning healthy returns. At the same time, layoffs are rising because of the recession, and as a landlord the last thing you need are tenants having a hard time making rent payments.

 

Even in once-hot northern California, where one would expect prices on houses and small apartment buildings to have dropped precipitously because of layoffs in the high-tech industry, "value is really hard to find," says Stephen Lefkovits, principal of Joshua Tree Residential LLC, an investment firm with a focus on smaller multifamily communities. He has been looking for rentable properties with between 20 and 80 units in the San Francisco Bay area since August without great results. "Sellers' pricing hasn't really adjusted from last year," when the market was in better shape, he says.

 

Eventually, sellers will get more realistic about prices. "I would sit on my wallet a bit," says Susan Hewitt, president of Cheshire Group LLC, a New York-based real-estate investment company. "There will be better deals within the next six months or so."

 

So what do future landlords do now? Research -- something you should be doing anyway. After all, this is an area where it is impossible to have too much neighborhood knowledge. Rental demand can be hurt if your property is on the wrong side of the railroad tracks or if it is in the wrong school district.

 

Start by studying towns where you want to invest. How fast is job growth? More jobs mean more renters. Are any new supplies of rental properties likely to hit the market? After all, you wouldn't want to buy an aging apartment building and then have a new apartment complex open across the way, especially since new complexes often offer renter incentives to fill up.

 

Regional apartment associations throughout the country are a good place to get information on vacancy rates. Another source is Reis Inc., a New York-based real-estate research firm, which reports vacancy rates for various markets across the country. Baltimore, Fort Lauderdale, Fla., Washington, D.C., suburban Maryland and Philadelphia have the lowest forecast vacancy rates across the top 50 apartment markets from 2001 to the end of 2003. Meanwhile Austin, Texas, Charlotte, N.C., Memphis, Tenn., Orlando, Fla., and Raleigh-Durham, N.C., are all forecast for high vacancy rates, so buyers should be wary in those markets.

 

Some of the best rental values are found in neighborhoods starved for investors. Robert M. Kligerman, of Scarsdale, N.Y., started buying small apartment buildings in East Harlem 20 years ago, while working as a commercial real-estate broker. He slowly worked up to buying 50-unit apartment buildings, at one point owning 150 properties in the Bronx.

 

Mr. Kligerman looks for neighborhoods that have nearby shopping and strong public transportation. "On the surface," he says, "a Bronx investment appears to be a risky proposition, but when you scratch the surface, it quickly becomes evident that there is really strong stability in those neighborhoods."

 

How do you avoid overpaying for a rental property? The broad rule of thumb is that real-estate investors expect at least a 10% return on their investment. But actual returns, and how you get them, vary widely by market. In tight markets, such as San Francisco, much of your gains will come through appreciation of the property. But in markets with plenty of new construction, as in Dallas, expect much slower appreciation. In slow-appreciation markets you have to make doubly sure the property is generating enough rent to give you good returns after paying maintenance and taxes.

 

Before you start looking seriously to buy, you should obtain a financing commitment from a lender. That way you can strike quickly if you find a bargain.

 

Expect to fork over a hefty down payment. If you are buying a home that you intend to occupy, lenders will let you put as little as 5% down. But it is a different story with rental properties. Lenders know it is easier for you to walk away from a sour deal, and they typically demand 20% down, says Jay Brinkmann, an economist with the Mortgage Bankers Association of America, in Washington.

 

A lender might require more money down if the property is in a market where there are already a significant number of available apartments -- yet another reason to avoid those high-vacancy markets. Another factor: the type of rental property. "Lenders look at whether or not it's a seasonal rental, like a beach house, a condo, a ski resort," says Mr. Brinkmann. "A seasonal rent stream is not as guaranteed. You could have high demand one year fall off next year."

 

Write to Ray Smith at ray.smith@wsj.com

 

Updated January 28, 2002 11:06 a.m. EST