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For the past three years, the stock market has been a lousy investment, while residential real estate, in most parts of the country, has been sizzling. With mortgage rates at 50-year lows and the median price of U.S. houses up 23%, to $163,600, since the beginning of 2000, many are wondering: Should I trade up to a larger house or invest in other residential properties? And how much of my portfolio should be in real estate?
That's not an easy call. Economists are debating whether we are in a real estate bubble, and financial planners are advising clients not to make large shifts into real estate now. "It would be a classic case of herd following," says Curt Weil, a financial planner at Weil Capital Management in Palo Alto, Calif. Already, prices in some places, including Silicon Valley, are turning south.
Even so, real estate can be an attractive investment--in moderation and integrated within a portfolio that also includes stocks and bonds. Including the value of your primary residence, you should have from 25% to 40% of your assets in real estate, says Dean Cherpitel, a financial planner in Overland Park, Kan.
That said, it's hard to fine-tune a real estate asset allocation the way you do stocks or bonds. A home, even in a hot market, is relatively illiquid--and transaction costs are high. So the first question is: Could you live in the house you buy if you can't flip it as fast as you would like?
In the long run, are you better off investing $100,000 in stocks or in real estate? The easy answer is real estate, if it's your primary residence. There's a strong case to be made for owning the biggest primary residence you can afford. With $100,000, you can place a 20% downpayment on a $500,000 house. If you can afford the mortgage payments, insurance, and taxes, and if real estate prices go up 4% a year over the next 10 years while stock prices go up 10%, you're far better off with the house, says Gerald Weiss, a financial planner in Dublin, Calif. At the end of 10 years, the house is worth about $400,000 after the mortgage is paid off, while the stocks are worth about $260,000. If you sell the house at the end of the period, the profits are sheltered from taxes, but the stocks are subject to capital gains taxes.
If you're acquiring rental properties, you're essentially going into business. Are you willing to be a landlord, or pay someone else to do it? Will you be able to collect enough rent to cover the mortgage, taxes, insurance, and maintenance? Figure wrong on that count, and the investment--even if it appreciates in value--could become a drain as you have to dip into other funds to cover the property expenses.
To avoid that, Weiss says when you invest in rental property you should aim for annual rental income to be about 10% of its market value. That's hard to do in hot markets. One exception: prime second-home properties in areas with strong appreciation potential.
Still, rental properties can be a valuable long-term asset. Weiss recently helped one client in his 30s develop an early-retirement plan based partly on rental income. The father of two works at a high-tech company with no pension plan. Weiss figures income from his rental property, a single-family home that generates $1,800 a month and has a $200,000 mortgage, will pay off the mortgage by the time he is 58, leaving him a steady income stream for retirement. "Rental income goes up with inflation and is usually steady compared to volatile stock investments," says Weiss.
Real estate economics may look attractive compared with stock market economics. But a couple of interest rate hikes could sour the real estate market in a hurry, too. Remember the investment lesson learned painfully over the past few years: Stay diversified. By Geoffrey Smith