Wednesday, February 8, 2012

A Crazy Idea, Right?

There is a house about a block away that used to go for 250K but right now can be had for just $50,000. I almost bought the thing recently for the Pass the Test offices. But, turns out, the village government says no--it's a residence, not a commercial property. At first I was disappointed, but the more I think about the opportunity, the more I question the very premise of this investment. I mean, even if I wanted to just buy the place and rent it out to some tenants for a few years before selling it--is there really any merit to this investment, even at 1/5 its recent market value? We've gotten so used to thinking of real estate investing as "smart" that we seldom question the merits at all. So, let's think outside the box a bit. Rather than buying $50,000 worth of real estate outright, let's say I bought $50,000 of Real Estate Investment Trusts (REITs) instead. Sound crazy? Kind of, but let's make sure. As with the rental property, I'm going to use as much leverage as possible. So I put down $25,000; TD Ameritrade fronts me the other $25,000, and--bang--I own $50,000 worth of investment property tied to real estate. Like the rental property, I now owe interest on the amount I borrowed, and, the margin interest is higher than what I would pay on the rental property . . . but not as much as one might think. Since the rental house would be an investment property, I'd be lucky to borrow the money at 6.5%. The current rate of interest I'm paying on my margin account is about 8.5%. Yeah, but mortgage interest is tax-deductible, you say. Uh-huh; so is margin interest. Okay, you say, but I'd be "cash-flow-positive" on the rental house, to the tune of about $400 a month. Well, let's assume that no repairs are required for the first several years--the best-case scenario. After factoring in the mortgage and the fix-ups required just to get the place livable, I'm going to yield about $4,800 in rental income on a property that cost $50,000 to buy and $20,000 to fix up. I'm into this property for $70,000 and my best-case-scenario is a yield of about 6.8%. With the REITs, I can buy a diversified portfolio exposed to office buildings, shopping centers, apartments, etc., and, getting a yield of 6.8% is not going to be a problem with real estate investment trusts. Not to mention, the chance of a suspended dividend is no greater than the chance of a deadbeat tenant, and I don't have to make expensive repairs to my REIT portfolio, ever. So, the REITs seem to match up well in terms of the income piece--just as dependable if not more, and no chance of any repairs wiping out the cash flow. What about the capital appreciation side--which investment is likely to appreciate more over time? Nobody knows, but why would I be a better real estate investor on one non-diversified holding compared to, say, a dozen different real estate investment trusts with the biggest talent in the business managing office buildings, shopping centers, and apartment buildings from coast to coast? Here in Chicago I see Sam Zell out and about occasionally--you're telling me I'm better off buying a fixer-upper in Forest Park than buying shares of Equity Residential (EQR) and coming along for the ride that Sam and his team of real estate professionals are already offering me?
I'm not a CPA or a CFP, and I do need to analyze the interest-rate spread between mortgage and margin interest. But even if I have to pay 2 points more on the margin versus the mortgage interest, I'm thinking I'd probably make a bigger capital gain over time on the REITs and would probably enjoy an equivalent income stream year after year . . . all without ever having to run credit checks, interview tenants, or replace water heaters after they've blown and flooded $5,000 of brand-new carpeting. So, yes, it does seem like kind of a crazy idea. Which is why I plan to stay where it's safe--in the stock market.

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