Mountain West IRA – The State of Real Estate in 2008
By: Jon A. Galane
The opening of 2008 brings a new and vibrant market in hard asset investments. Following a year in which many real estate investors have seen decreases in their investments—even from purchases just six months to a year earlier—they contemplate what to do next.
Prior Tax Reform Influencing Real Estate Today
In October 1986, the passing of the Tax Reform Act of 1986 (TRA86) implemented massive changes to tax incentives and passive losses and tax shelters, all concerning real estate. So sweeping was this legislation that the Internal Revenue Code name was changed from IRC of 1954 to IRC of 1986.
There were several tax shelters in widespread use prior to TRA86. Tax shelters are defined as any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities. Generally, a tax shelter is a method that recovers more than $1 in tax for every $1 spent, within 4 years.
The complexity with this revealed itself in the 1970s when limited partnerships were opened and the nomenclature used was that these were “investments.” They were in actuality sold as tax shelters to the wealthy by hypothecating real estate as close to 100% as possible and creating a tax shelter for these individuals to use as a dollar for dollar write off against earned income.
This “investing to lose” mentality created “investors” who were really spending current, active income to create passive losses and avoid taxes on future income. Real estate values increased unreasonably, financing was loosened up and commercial and residential rental properties had loans on them to almost 100%. Stagnation and inflation skyrocketed and returns on investments went to double digit negative numbers.
Why do I start off prior to 1986 to discuss 2008? Well, let’s look at our current market situation. Lenders had been lending at or close to 100%. Generally, the mainstream press and real estate professionals had been touting a market that could not decrease, sighting increases over the last 4 years of 100% to 400% and no end in sight. So what happened in 2007 that changed all of this wealth creation?
As a person with a macroeconomic view it was exciting to see all investment markets having such robust growth after the passing of the Jobs and Growth Tax Relief and Reconciliation Act of 2003 (TERRA03). With capital gains cut to 15%, tax rates lowered 2% in all brackets, combined with the prior TRA86 of increased home mortgage deductions and a new depreciation system for real estate called “accelerated cost recovery system” or ACRS growth was there.
1031 Tax Free exchanges increased significantly becoming a popular way to defer capital gains and the recapture of unused depreciation. This technique assisted increasing an already robust market which the investor had no exit strategy in the case of quickly realized gains in a highly appreciated market. The exit strategy culminated as these highly appreciated properties were sold outside of the 1031exchange.
To help less affluent landlords, TRA 86 gave a $25,000 net rental loss deduction provided the home was not personally used for 14 days or 10% of rental days and adjusted gross income (AGI) was less than $100,000 with a phase out through $150,000.
Since the TRA 86 and TERRA 2003 we have seen unprecedented growth in investment markets including real estate. In an article I wrote in May of 2007 I discuss the growth of real estate investments from 1986 to 2006. I follow three types of real estate investments, 1st trust deeds with average returns of 10-12%, a combination of residential and commercial rental properties with 70% loan to value ratios and an annualized return of 40% between rents and asset appreciation, and more speculative raw land with an average annual return of 20%. Doing an asset allocation portfolio with 10% 1st trust deeds, 30% rental properties and 50% raw land I found that the hypothetical portfolio had a total annual return of 24.4% return on investment.
Predicating Future Returns
Let’s compare the above returns with that of an asset allocation model used in the financial markets. To find rates of return I looked at total returns from the 2006 Ibbotson Charts which chart stocks, bonds and cash markets from 1925 to present. Here is what I found. Cash produced 3.7%, bonds performed at 5.5% and the 30 Dow Industrial component stocks at 10.4%. So an allocation of 10% cash, 30% bonds and 60% stocks realized a total annual return of 8.26%
Now, you are asking yourself why is it I need to know all this. I want to know what is going to happen in 2008! Well, first one more important item to help you understand the future value of your money and investments. This is important to help with your retirement and other future planning. It is called the rule of 72. This rule tells us what the future value of our money based on returns on our investments that are tax deferred or tax free, as would be the case in IRA’s and Qualified Retirement Plans such as 401(k), 403(b), 457 and defined benefit plans. It is important to understand the advantages of tax benefits available to you now to keep more of your money in your pocket for future investing and income as well as capital appreciation of assets.
Let’s use the rule of 72 in our asset allocations models from above. First the financial market allocation. Divide 72 by the rate of return of 8.26% this equals the years to double. 72 / 8.26% = 8.7 years. So if you had invested $250,000 it would be $500,000 in 8.7 years, $1,000,000 in 17.4 years. Second the real estate markets 72 / 24.4% = 2.9 years. The same original $250,000 investment is worth $500,000 in 2.9 years, $1,000,000 in 5.9 years, $2,000,000 in 8.8 years, $4,000,000 in 11.7 years, $8,000,000 in 14.7 years and $16,000,000 in 17.6 years. The amount in real estate is 17 times greater than the financial markets in the same time period.
Let me just give you one assignment to see what would happen to your investments if they were all taxable at current federal tax rates. This is called the rule of 103. This works the same way, taking our real estate example 103 / 24.4% = 4.22. Take a moment to calculate your personal portfolios and see just what the actual cost of not doing proper retirement and tax planning is costing you, you may have a bit of a surprise.
What Happened in 2007?
Well, not a tremendous amount of shocking news in 2007. The stock market remained strong and right on its historical average. After five consecutive years of double digit real estate growth we saw real estate take a needed breather from all of the upward pressure. Sub-prime capital markets collapsed under the weight of lending beyond people’s means, with little or no equity to insure buyer responsibility.
Job growth is still strong; inflation remained stable although it looks as though we are starting to see an increase which needs to be watched closely in 2008 due to the devastating effect high inflation can have on your current lifestyle and future value of investments.
CPI and consumer confidence remained stable and retail sales during the holiday season I believe will be up a very predictable 2-3%. After five consecutive years of double digit oil prices and energy cost increases I believe we will see stabilization and possibly even lower energy by the end of 2008. Crude oil, which climbed more than $35 a barrel this year on Middle East tensions, rising demand and supply disruptions, closed the year at $95.98 down from $99.29 after the dollar strengthened.
Oil and the dollar usually move in opposite directions because a rising currency reduces the appeal of commodities as an investment. The dollar, which fell against the euro for a second year, appreciated the most in more than two weeks on a report that home sales unexpectedly increased last month.
Our safety remained in-tact with no terrorist attacks on our soil. Congress finally passed the alternative minimum tax patch for 2007, known as the “Tax Increase Prevention Act of 2007” saving over 69,000 Idahoans thousands in taxes this year. So except for the sub-prime collapse, overall a pretty economically boring year after all.
Why did my real estate values go down?
I believe this is truly a matter of perspective and psychological market conditions. In Ada County year-to-date through November 2007, single family home sales saw an average price increase of 2.06% with a median price drop of -1.32%*. Granted the number of homes sold has decreased -32.66% think of this as stable prices with lower trading to use market terms.
I find the information available quite interesting on new home sales. Year-to-date average price changed a robust 8.22% up and median up 1.77%.* As an interesting side note the Dow Jones Industrial Average went up just over 8% in 200 also. Considering that newly constructed homes sold went down by -51.93% in 2007 prices still continue to increase. I believe statistically this is very encouraging forming what I would call a soft U curve landing in the real estate market leading to a much more reasonably robust rebound than the national prognosticators may be anticipating.
A home is an emotional heart warming purchase and should never be looked at as an investment but a place to raise your family and give you warmth, comfort and security when you walk in the door each day. If you looked at your home as an investment opportunity where you would move in, borrow all you could and sell for a tremendous gain after two years (meeting the personal residence capital gains exclusion) then you may have looked at the wrong side of the investment equation.
I just have to relay one anecdotal situation which happened in the last year. I was at a Christmas party in December 2006 for a major financial services firm. One of the investment advisors was outwardly upset because his home was worth $30-$40,000 less than when he purchased it a year earlier. His analysis was that it was the fault of the market and that he read that the market would not go up for the next five years.
As a side note, when you lose money in an investment it is never the markets fault. Markets have a tendency to never do as you wish!
As an investor with 25 years experience I couldn’t resist, I asked him if he would like to make a little wager as to the values in real estate in Ada County in the next year. He accepted and the agreement was that a combination of average and median home values would be higher by December of 2007 than December of 2006.
Did I win this wager? Yes I did, because combining the two values created a 1.32% gain. Now had I made the bet one month earlier I would have lost, funny, could have gone either way. But what did he as a homeowner do wrong? Well, never invest in something you are emotionally involved in, don’t worry about what you can sell for and keep your home separate from your investments.
Contrarian Real Estate Investing
Let’s go back to the plight of real estate investors in the past couple of years. I am what might be termed a contrarian value investor. What does this mean? Is it really important what you can sell your investment for? No, not unless you overpaid to begin with. I believe that all of the gains in your investments happen or don’t happen the day you buy the investment. As the ultimate living contrarian investor Warren Buffet would say, “if there is greed be fearful and if there is fear be greedy.” Let’s look at a couple of other contrarian investors.
My favorite is a gentleman you may have heard of by the name of Thomas Edison. Thomas Edison discovered a little thing called the light bulb. His strength was that be was cautious on the buy side, he didn’t even discover the system to carry the electricity to the bulb, but he figured if he could discover the inexpensive part he could use the knowledge developed by others to carry power to his investment. His difficulty was he failed to produce a return on his investment 10,000 times. He finally got it right and opened a little company named General Electric.
Now in 2006 GE reported consolidated net earnings of $20,829,000,000.** By the way that is one year’s net earnings. GE is the eighth largest economy in the world with only 7 countries ahead of it in revenues. If Edison were alive today do you think he would worry about what he could sell his investment for? Probably not, after all he invested in what he loved and believed in.
Look at what you’re investing in, not emotionally but are you going to enjoy visiting, managing, and doing. The results come in time, all quality real estate investments will go up; there is just no way to predict in what time frame. It may be one month, one year or one decade. If you are contrarian and buy while there is fear and are prepared to hold for up to ten years to sell into greed your patience will be returned in aces and spades.
If you wish to wait because you don’t believe it’s a good time to buy because you can not sell for what you think will be the price you want or because you believe prices are decreasing you may miss the contrarian opportunity that exists now and buy as the market is increasing. The stress involved with hoping the market goes up rather than buying low and selling high becomes inherent.
Idaho census figures were released on the day I was writing this article and we are the number four state in population growth. Those people will need places to live and do business. In time excess inventories will be used. A sellers market will reign again and contrarian investors will have bought right having not worried about when to sell. Investments take time like a child or flower to grow and develop.
Flipping real estate, no money down buying and buying into a sellers market is not investing but more akin to gambling or speculating. If you have assets and time to carry a speculative investment then you may weather the storm of an election year, the back end of an expanding economy.
If you buy right and are ready to hold, the economy in the next 12-24 months will not affect your decisions. With my crystal ball not working I cannot give you a definitive answer on what will happen to real estate in 2008. Although I feel safe in saying Idaho is a wonderful place to live and invest with tremendous long term returns.
*Intermountain Multiple Listing Service Statistics.
**2006 General Electric Annual Report
Copyright © 2008 – Mountain West IRA
Jon A. Galane is a retired Vice President, Sales Manager and Financial Advisor with Morgan Stanley. Mr. Galane is a principal of Mountain West IRA in Idaho the only locally owned and operated self-directed IRA and retirement plan administrator in Idaho. Mr. Galane has been a local radio talk show host on Retirement Planning and is a published author on a subject he coined as “Mixed Portfolio Theory.”
Mr. Galane is a freelance writer for various publications and is available for lectures on various subjects concerning economics, retirement planning and buying real estate and alternative investments in self-directed IRAs and retirement plans.
For more information on self-directed IRAs, opening a self directed IRA account or booking Mr. Galane for a lecture please contact Mountain West IRA at (208) 377-3311.