So Where is the Investment Action?
by Jim Scott

This month I will review the investment market in rental homes and apartments. More on point, which investment yields the greatest return, commercial real estate or homes and condos? Both investments are very cyclical when it comes to return and risk. Where they differ is in the degree of risk and reward and in assessing what external factors influence them.

Timing Is Everything

People who invest in rental homes and condominiums are taking on more risk but also have the ability to make greater rewards than the traditional income property investor. There are real reasons for this. Far more investors can participate in this market; down payments for larger

income property are generally 35%, which sharply limits the number potential participants. The fact that almost anyone can invest in single units is both good and bad; it is easy for speculative fever to set in but panic-selling is even easier. If you do not think that has happened in this market you must have a very short memory. Those who invest in large income projects are

subject to market variations as well; the difference is larger projects are generally designed to withstand a financial storm. Setting aside until below the speculative boom downtown, the profitability of these vehicles is purely appreciation-based. It takes five to seven years to obtain a meager cash flow and even then the rate of return is probably less than a percent on equity. To make money you must obtain an annualized appreciation rate of over 15% if the investment is to be a winner. Fortunately, there is a get-out-of-jail card that comes with all San Diego real estate. If you can just hang on long enough, inflation will eventually right the ship. The voyage can be rocky; it is never fun covering negative cash flows and usually investors woefully underestimate actual operating expenses. If you bought after 1995 none of this would matter. The median price of County homes is now $472,000, a gain of $266,000 in the last five years. The point of this article is not the past. The real question is: will the median price be over one million in 2009?

Will It Always Be This Fun?

This is the third such carnival this writer has participated in and observed. The price increases during the periods of 1976 through 1979 and then 1986 through 1990 were just as spectacular. None of us ever thought about risk and kept drinking all night. The inevitable hangover

from both parties was just plain ugly. Even given favorable interest rates, it is hard to imagine the next five years being like the past quintet. Interest rates, while abating lately, seem to have nowhere to go but up. The Federal borrowing binge and skyrocketing deficits bode ill for the future of cheap money. Without the intoxicant of inexpensive mortgages, I doubt we will see anything on the order of the past five years. Also to be considered, during this period is that San Diego 's household income rose only two percent a year. There is nothing in the economic cards that would suggest that figure will increase substantially over the next five years, effectively precluding another price double. What worked five years ago may not work again no matter how much we wish it so or how fine our weather is. It is time to reassess the risk of purchasing this type of product.

Looking at Risk

I am not arguing against making such an investment. Rather, I am suggesting the risk-and-reward matrix has changed from five years ago. Still, entry-level real estate investments, over time, will always work in some fashion. No one ever lost a dime owning houses, condos and two-to-four unit buildings in San Diego as long as they had the financial ability to choose when to sell . If you possess the financial and emotional staying power you will always come up a winner—inflation, principal reduction and increasing population will see to it. There is always investment risk going forward given rising interest rates, terrorism, recession and a whole litany of bad things too numerous or depressing to mention. But I think risk is higher now, not so much because of the goblins listed above, but because the potential rewards are lower. This brings me back to downtown. As long as the collective body of downtown investors believes that prices will always move up smartly and without a serious interruption, there is no incentive to sell in order to avoid negative cash flows. This provides order and discipline in the marketplace and supports the price structure. Thus far price appreciation has been stellar buoyed by low variable interest rate loans and strong demand. The latter is driven both by the expectation of quick profits and the incredible quality of downtown living. I wish I had to courage to resume my old habits in this field. After a few recessions I decided to travel the stodgy real estate investment road. It is not that apartments and mobile home parks have not been profitable. Next month I will take a critical look at the other path.

Read Jim's back articles at www.sqre.com or call him for selected b ack issues, 619 920 9511

I welcome your comments; my email address is jimscott@sqre.com.

You can reach Jim Scott at his office, conveniently located in the heart of Mission Hills, at 1111 Fort Stockton Drive. Founded in 1982, Scott & Quinn is the oldest full service real estate firm in Mission Hills and is still locally owned and operated. Jim has been a homeowner in Mission Hills since 1976. He is married and has two boys. He can be reached at 296-9511, extension 100. Scott & Quinn features professional property management as well as 15 sales associates. Click here to see Jim's past Market Reports .You can also download Jim's 26 page research paper on San Diego County apartments.