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Why Property Investors Must Learn to Diversify

By Lynnette Khalfani

From Dow Jones Newswires

NEW YORK -- Location. Location. Location.

Anyone who has ever bought or sold a home knows that the right location is the number one rule of real estate.

Those purchasing property for investment purposes also would be wise to remember this mantra: Diversification. Diversification. Diversification.

With the stock market gyrating daily, more people are seeking assets that can bring some stability to their investment portfolios.

Real estate can act as a hedge against inflation. It offers significant tax benefits: in addition to depreciation write-offs, in most cases the sale of investment property held for at least a year is taxed at capital gains rates -- now a maximum of 20%, far below the top income tax rate of 39.6%. Real estate also offers the chance for capital appreciation, and it is not correlated with the stock or bond markets.

Best of all, though, real estate can generate significant cash flow -- often far more than equities. Consider: The average company in the Standard & Poor's 500 Stock Index has an annual dividend yield of 1.1%, compared with a 7% average yield for real estate.

Sound tempting?

Well, before you plunge forward, it's important to consider the drawbacks associated with real-estate investing.

For starters, real-estate investments are far less liquid and typically require a much longer holding period than stocks or bonds. Also, there can be a relatively high cost of entry in real-estate deals. In an economic downturn, real-estate prices can really take a hit, as happened in the early 1990s. And finally, valuations sometimes can be difficult to establish. Who's to say how much that five-acre parcel of land in the country is worth if there are no bidders? Remember: A piece of real estate isn't worth what the broker says it's worth, but what a buyer agrees to pay for it.

Crunching the Numbers

In addition to carefully weighing these disadvantages, real-estate investors should do some serious number-crunching.

Jed Abrams, a real-estate attorney with Lent & Abrams in Manhattan, says he is always surprised by the number of people eager to buy a piece of property, but clueless about the true cost of acquiring and holding such an investment. Mr. Abrams says that when he walks many would-be investors through a laundry list of bank fees, closing costs, transfer taxes, brokerage commissions and required escrow amounts -- to name just a few expenses -- "it's shocking to them."

His advice: Real-estate buyers "should really know what their budget is," and make sure that the rental income to be generated will be sufficient to cover the property's mortgage (including principal and interest), taxes, insurance and operating expenses.

OK, so let's assume you are ready to delve into the world of real-estate investing. Perhaps the most important thing to keep in mind is the hallmark principle mentioned above: diversification.

"Many people think owning a duplex somewhere is doing well," says Leo Wells, president of Wells Real Estate Funds in Atlanta.

But Mr. Wells and other real-estate pros say that to become a successful real-estate investor, you must diversify five ways: geographically, by tenant, by tenant industry, by lease term and by property sector. Don't make the mistake that most real-estate novices commit when they buy a single piece of property and count on that investment to balance out their portfolios.

The idea is to spread out your risk as much as possible, because "no matter how smart you are, you won't be able to predict which areas will remain strong 10 years from now," says Mr. Wells, whose company has $1 billion in real-estate investments.

Cutting Out Responsibility With REITs

If you don't want the headache and responsibility of personally managing a real-estate investment -- that means collecting rents, dealing with leaky faucets and screening tenants -- your best bet is to hire a professional property manager or buy real estate through a real-estate investment trust.

REITs are publicly traded companies that own portfolios of real-estate investments, including apartment buildings, shopping malls, hotels, offices and industrial buildings. As exchange-listed entities, REITs have volatility like other stocks, but they more closely resemble mutual funds than individual companies. The reason a REIT makes sense for most real-estate investors is the same reason a mutual fund does: You probably don't want to manage individual properties any more than you want to spend your days and nights looking after the 100 or so individual companies in your mutual fund.

Most REIT income is derived from rents, and REITs are required to distribute at least 90% of their earnings to their shareholders every year. Mr. Wells's company is one such REIT. It builds and manages suburban buildings that will be occupied by Fortune 500 companies that agree to 10-year leases. Investors essentially act as the bank, putting up the money for construction. Mr. Wells pays the investors a 7% to 8% annual dividend, and the investors own the building. When the building is sold, investors also get any capital appreciation. The company's typical investment size is in the $10 million to $20 million range, but an individual in the Wells Funds can invest as little as $1,000 to $2,000.

Residential or Commercial?

It's tough to say how well real estate will fare in any given year. But a study by Lend Lease, an Atlanta real-estate management and advisory firm, shows that, historically, real estate has experienced far fewer years of negative returns than stocks and bonds. Since 1934, returns for real estate have been negative 5% of the time, versus about 25% of the time for stocks and bonds, according to Lend Lease, which manages about $50 billion in real-estate investments for institutions and private clients.

The fact that real estate fared well most years was little solace to those hurt by the real-estate market downturn in the early 1990s. At that time, the residential and commercial real-estate markets both suffered as homeowners were forced to sell middle-class and high-end residences at substantial losses and changing tax laws wiped out many benefits for real-estate investors.

Now, some people worry about the impact of the recession on the real-estate market. But others note that real-estate remains one of the last standing legs of the economy. Also, the weaker economy has made it easier to jump into the real-estate investing game by spurring 10 interest rate cuts by the Federal Reserve in 2001.

"Funds are very available," and investors can now "borrow money for 30 years at a fixed rate of interest at incredibly low rates," says Michael Morrongiello, general manager of SunVest Corp., a real-estate and mortgage investment firm in Sonoma, Calif.

Still, Mr. Morrongiello adds that "in general, investor loans are going to carry a little higher interest," than loans for a primary residence, because statistically there are more delinquencies and problems with investment properties.

While funds for real estate are plentiful, the challenge "is to find deals that make economic sense," says Scott Mollen, a real-estate attorney with Herrick Feinstein LLP.

On the commercial side, Mr. Mollen says retail strip centers and shopping malls have added appeal for those seeking diversification. "They're viewed as being closer to a mutual fund, given their multiple tenancies," he says.

Sam Blumenstein, vice president of commercial and residential development for LoanGiant.com, the Internet arm of World Wide Financial, views the commercial end of the market as "still very volatile," especially in the wake of the Sept. 11 attacks. But "the key is the tenant mix in any existing piece of property."

Value in Low-End Residential

Mr. Blumenstein favors low-end residential real estate. "Redeveloping urban centers is becoming a viable option," he says, adding, "It's a little bit more of a risk, but by the same token, the returns are better."

For example, Mr. Blumenstein, who is based in Southfield, Mich., says that in the Pontiac and Detroit areas of his state, the residential market is booming. Investors sticking "under the $250,000 range are doing very well," and reaping double-digit returns, he says. For example, LoanGiant.com is backing the development of a 120-unit condominium complex in Pontiac. The average price of the units is $130,000, and most are spoken for. Mr. Blumenstein says 10 out of 50 condos are being sold to investors, whereas a few years ago a similar development in the area might have sold one out of 50 units to investors.

If you're a bit squeamish about going into urban areas that may be on the cusp of a turnaround, Mr. Blumenstein offers another strategy.

He points investors to areas poised to benefit from an influx of intellectual capital or economic development that is already taking place. For example, he cites Jersey City as a place that stands to gain from the "brain power" moving into New Jersey as a result of the Twin Towers' collapse. The destruction in downtown Manhattan forced many Wall Street companies to relocate into Jersey City or beef up their existing presence there, producing a "ripple effect," says Mr. Blumenstein. "They'll need another Starbucks, a cleaners, a grocery store, etc. -- all of which provide opportunities for investors," he says.

He recommends that investors pick up commercial properties two to three blocks away from the main hub where development is taking place -- and where real estate is a bit cheaper. "Your fringe area might not grow at 20%," says Mr. Blumenstein, "but it'll still grow."

Finally, the pros say that real estate isn't an area that you should jump into unprepared. Mr. Morrongiello, of SunVest, now turns a pretty penny "flipping" real estate -- or buying properties, fixing them up and quickly reselling them.

He recently bought a home in Glen Ellen, Calif. -- a rural, hamlet community in Sonoma Valley's wine country -- for $315,000. After pouring $240,000 into the home, he resold the house four months later for $777,000. But Mr. Morrongiello acknowledges he could have done a lot better earlier in his investing career if he had set aside a cash cushion to cover unexpected expenses.

"I'm not afraid to admit that I've made a lot of mistakes," he says. "If I had to do it all over again, before I bought buy-and-hold properties, I would first accumulate a nice nest egg."

Email your comments to rjeditor@dowjones.com.