KEEPING YOUR BALANCE
Wannabe Landlords Beware
by Jeffrey R. Kosnett

A short time ago I visited Donald Wood, president and CEO of Federal Realty Investment Trust. This REIT owns fancy neighborhood retail centers, often marked by a spiffy Whole Foods Market or Trader Joe's and, of course, Starbucks, Container Stores, spas and gyms, and more.

Federal is a fabulous success. At $52, its shares are up 60% in two years. That puts the current dividend yield at 3.9%, not much better than a CD. But if you bought Federal shares two years ago, the annual dividend of $2.02 is tantamount to a 7% yield on your cost basis.

A better-run company is hard to find, but are its shares worth the 60% run up? I doubt even Donald Wood thinks so. He confided he's no longer personally investing in as many REITs as he had been and that it's tough to find either stocks or properties to buy.

I've also spoken lately with a half-dozen individual investors who own rental houses, fixer-uppers, land and small office buildings. Their experiences are becoming mixed and they all tell how whenever they go to an auction or a real estate investors' meeting, the number of newbies and starry-eyed thrill-seekers is staggering. This tells me there is as much peril as opportunity now in the realm of investment real estate.

Warning signs

REIT results are one clue. In the first quarter of 2005, according to Prudential Securities, only six of the 90 REITs on its list made positive total returns. These are the pros, so if they're struggling, what's that tell you about the amateurs?

Watch the daily goings-on in real estate (big owners trying to sell) and the prices at which properties are listed and sold. You sense that only the smart or the lucky can avoid real pain.

The "cap rate," or net operating yield, on stuff like office buildings and apartments, is at a low point, down to 7% from 10% in just a few years. Now, a 7% yield sounds good. But that's a gross yield, the income after expenses as a percentage of the price you pay. We're talking about a $1 million office building (which realtors are definitely pitching to individuals or small partnerships) that produces $70,000 income. Clearly, if you could raise the rents or put a little money into small upgrades and attract higher-class tenants, your income would rise. If you could make $90,000 and the cap rate remains at 7%, your building would be worth $1.3 million.

But 7% cap rates are like 4% Treasury bonds: Lower than most experts think is safe or sustainable.

If the cap on that $1 million building goes to 8%, but you still make only $70,000 on it, the property's value sinks from $1 million to $875,000. If you put 20% cash down, which is common for this kind of an investment, you have already lost more than half of your equity.

The answer to this is to buy for $875,000 to begin with. But, because of the ardor to flip increasingly expensive properties, prices have yet to crack.

However, says Wayne D'Amico, an experienced real estate consultant, "Sellers are demanding cap rates that are not adequate to support the risk of most types of investments." Translated, asking prices are so high you have little or no margin for error, whether it be vacancies, zoning disputes, busted heating systems, crime scares, you name it. You'll have to take some losses and wait for a new boom to bail you out. If you have a bunch of profitable properties to diversify the risk, okay. If you do not, you will rue the day....

I won't say flatly no one should buy investment property at this time. But it's clearly not a great buyer's market. Too many would-be dreamers are up against smart, smug, well-financed sellers. Mortgage costs are beginning to climb. So are taxes, insurance and security.

Other ways to invest

If you're seeking alternatives to actually investing in property, one idea is to invest in a conservative, diversified real estate fund. Third Avenue Real Estate Value (TAREX) owns land stocks as well as some REITs, but they won't chase after obviously overpriced stuff. It's a long-term capital gains type fund; the dividend yield is 0.6%.

You can also buy an exchange-traded fund that represents a real estate index, such as the iShares Dow Jones Real Estate fund (IYR). It holds shares of most of the major REITs and some smaller ones and yields 4.5%; the advantage to it over REITs is strictly in the simplicity. It, like the REIT indexes, is down about 8% so far this year and isn't about to snap back, but if you're a long-term holder and don't want any active role in a real estate portfolio, it's the way to go.

I close with a book recommendation. Most real estate books are about systems and tax dodges and easy wealth. This one is not. It's called What No One Ever Tells You About Investing in Real Estate: Real Life Advice from 101 Successful Investors (Dearborn Trade Publishing, $18.95) Rob Hill, the author, is a friend, a real estate lawyer from Nashville with enough hands-on experience to know success can mean walking away and holding on to your money. There are odd stories -- Rob's favorite is the one about the tenant who turned out to be an armed tax protester wanted by the FBI. But, mainly, it's slices of real life in real estate.

Tread carefully.