PROPERTY
Get Real About Real Estate
by Jeffrey R. Kosnett

For Derrik Dyka, the biggest obstacle to successful real estate investing isn't a meltdown in property values or tenants who wreck an apartment or don't pay their rent. "It's overconfidence," says Dyka, a 34-year-old Minneapolis investor who turns old apartments into new condominiums. If you're expecting to cash in on the 21st century's first gold rush without breaking a sweat, it would be wise to take Dyka's words to heart. The margin of error for making money in real estate is closing fast.

It's not surprising that real estate tempts so many Americans today. Over the past five years, home prices have soared and rags-to-riches tales abound. But so much real estate has become so expensive that Real Estate Research Corp., in Chicago, reports that many real estate pros say now is a better time to sell than buy. As San Diego real estate investor Chuck Wise observes about the area where he operates, today's buyers are like "lambs being shorn."

Of course, that doesn't mean that all deals are doomed to fail. But it does mean that it's time for would-be investors to pay more attention to the perils of owning property, not just the potential profits.

Watch your cash flow

The most common entree into real estate investing is the single-family house. Investors bought almost one-fourth of all homes sold in 2004, according to the National Association of Realtors. If you're one of those buyers and your income from that property (after taxes) exceeds your expenses by $100 or $200 a month, you're in good shape (see "21st-Century Landlords," Dec. 2004).

But because prices and property taxes are so high in many areas, and there's so much competition for attractive rental properties, it's increasingly difficult to find deals that generate enough income to more than cover your expenses -- what's called positive cash flow. In areas such as the leafy suburbs of New York City and Boston, where a modest three-bedroom house can easily cost $600,000, there's no way you can collect enough rent to cover the steep property taxes and payments on a $500,000 mortgage. Figure monthly out-of-pocket expenses of more than $3,000, if not $4,000. The pool of renters who will pay that much is small.

So be ready to set your sights lower and get your hands dirty. Instead of a well-located home in pristine condition, look for a fixer-upper off the beaten track for maybe $150,000 that you can rent for $1,000 a month. The numbers work if you're willing to spend weekends, say, painting the walls and, if you're capable, making repairs that would otherwise require professional help. The hidden profit from home improvements is why "ugly real estate often makes more money than the nice stuff," says Kelley Pace, head of Louisiana State University's real estate research institute.

Mind the cap

You can quickly figure out whether a house or condo is likely to generate positive cash flow. For more complex properties, such as a small office building or retail space, check the cap rate, a single number that can tell you if you're overpaying.

The cap rate -- cap is short for capitalization -- is a property's net operating income as a percentage of its price. The figure is real estate's version of a bond yield. If a property sells for $500,000 and generates net income of $50,000 (rents minus expenses), the cap rate is 50,000 divided by 500,000, or 10%. The lower the cap rate, the more you pay for each dollar of annual income.

In 2000, the average cap rate on commercial property in the U.S. was 10%. Since then, because of relentless price appreciation, the average cap rate has sunk to 8%. That alone suggests that wringing further gains out of commercial property is unlikely.

If you want to invest in a commercial property, aim for a purchase price that results in a 10% cap rate. But remember that the cap rate also depends on how much you collect in rent. Ask the broker for details about the tenants' leases, including how rents compare with those of other nearby properties and when the leases are up for renewal. The property should come with an information packet that is more like a stock prospectus than a real estate agent's fact sheet on a single-family house. If necessary, hire a property inspector. Then take all the information to a lawyer who specializes in real estate. If you have any doubts about the property, walk away.

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