...well not exactly tax free, but tax deferred at least.  Earlier in the year I mentioned a resolution that I'd declared for myself - to sell a high-end property that had built some equity via appreciation and re-invest in a multi-family via a 1031 tax deferred exchange. 

Here's a quick overview of how a 1031 works. 

A 1031 is an IRS code that allows investors to build wealth by exchanging properties while deferring taxes.  Any property may be exchanged for a "like kind" property.  Most real estate transactions fit this definition.  A rental property, for example, could be exchanged for a commercial or farm property. 

You'll need a "qualified intermediary" in order to execute a 1031 exchange.  In lay terms:  when you sell the property you're not allowed to touch the cash, otherwise the tax man is going to come knocking. 

When you sell the property, title is transferred to the buyer via the intermediary, and the proceeds of the sale are delivered to the intermediary.  At this point you have 45 days to identify replacement properties.  Within 180 days of the original closing you'll have to close on the purchase that you're making to complete the exchange.  

Here's the key: 45 days will go by like a flash.  If you haven't started the process of identifying the replacement property or properties before you close the sale of the property that you're relinquishing then you might find yourself in a squeeze. 

I'll talk a bit more about this in the near future....and discuss a project that I now find myself in the middle of.

...don't lose sight of the forest for the trees. 

Day-to-day volatility grabs headlines.  Money.com recently fielded in inquiry from a reader regarding the pros and cons of buying now in a buyer’s market vs. waiting for rates to drop.  Another story reported on the fact that mortgage rates ticked down a bit over the past week, down to 6.22 percent from 6.30 percent a week ago.  

But you’re a real estate investor, not a day trader trying to time the bond market, so be careful about letting the media push impact your decision making process.  One thing I like to do is look at long-term data series – a practice that helps me put the day’s headlines in proper perspective.  Take the interest rate example.  HSH Associates is a financial publishing company that provides some excellent historical information on a number of statistics, including national monthly averages for fixed rate and adjustable rate mortgages .  The chart below shows the monthly national average for 30 year fixed rate mortgages since 1986:

 
The Federal Reserve raised rates 17 consecutive times over the past couple of years responding to fears of inflationary pressures, so we’re not reading about record lows like we were back in ’03 and ’04.  

The green part of the series represents data points that are lower than the current rate, whereas the red data points are higher.  So yeah, there's a good bit of green over the past few years.  But when you look at twenty years of data you realize that in a historical context rates are still extremely low.  

I’ve used ARM’s before but right now I’m a fan of the 30 year fixed.  The spread between a 1 year ARM and the 30 year fixed can get up to 3 or 4 percent, but currently it’s contracted back to around half a percent.  And with national averages still hovering in the mid six’s long term investors should see a lot to like about locking in at these levels.  
 
 

I’ve stated in previous posts and articles that running the numbers and making sound assumptions about your potential investments is one of the keys to avoiding real estate investor burnout.  Real estate is a long term game and you can’t build a stable portfolio overnight.  This means you need some staying power, so if you end up packing it in after your first investment or two you’ll never get there.  

So in my view looking before you leap is the best way to keep your momentum as an investor, and that means having an idea about what to expect from an investment in terms of rate of return, cashflow and net present value.  

But analysis is like aspirin, or fine wine, or just about anything, for that matter.  A bit of it can make a big difference – but that doesn’t mean that a massive dose is a good idea.  More isn’t necessarily better.  

How do you strike the right balance?  Well that depends on the investor.  Personally, I’m an engineer by training and I love numbers; that’s why I ended up building this site.  I see the value in using a tool to catch all of those assumptions wrapping them into a cashflow projection.  Plus, I love to tinker.  But therein lies two danger – 1) becoming infatuated with the analysis and forgetting about the underlying uncertainties (no analysis is perfect) and 2) becoming infatuated with perfecting the analysis to the extent that you never get a deal done.  In other words: don't get paralyzed.

Both of these problems happen...probably more than you’d think.  

So...how to avoid these issues?  Again, it depends on the investor and your personality type, but I’d suggest the following rules of thumb: 

• Remember: your analysis is based on your assumptions.  Unless you have a working crystal ball you’re never going to get it all right.  Your analysis will give you your base case.  When you get your results ask yourself “is this target a good result?  Does the potential reward justify the risks?”  if the answer is “yes” then drive on and figure out how to make the deal work – don’t spend time fine tuning.  
• Analysis is a process:  I worked for a while in strategic planning with a major corporation.  We spit out huge, detailed plans.  And we never followed them.  Is this a bad result?  Well, not necessarily – the planning process itself is hugely valuable.  It forces executives to examine their assumptions, communicate their goals, and crystallize their thinking.  The planning process helps organizations to articulate their vision and set their course, even if they don’t follow the resulting plans to the letter.  Real estate analysis is similar: running the numbers will force you to consider the big questions around vacancies, rental rates, repairs, and other risks that you might not consider before jumping into the investment.  
• Evaluate the sensitivities:  Don’t just look at the final “answer” – look at the sensitivities to understand how much risk you’re taking.  Ok, you’re forecasting a 5% appreciation rate...but what if it’s 3%?  Or 8%?  The EquityScout tornado diagrams will help you do this, but if you’re running spreadsheets you can do the same thing manually.  
• Be honest with yourself:  There are two camps that you want to stay out of – the overly conservative camp that kills every deal that comes along by handicapping them with excess costs, and the rose-colored-glasses camp that tweaks all the variables up until they get the result they want.  Nervous Nellies do no deals, and the Pollyannas do bad ones.  
• Remember: once you’ve made your bed you’re going to have to lie in it.  A single fortuitous event (a upgrade in the neighborhood) or misfortune (a mold infestation or a disastrous tenant) will radically impact the performance of your investment.  You’re still going to have a lot of uncertainty to manage once you make your investment; the purpose of the analysis is simply to ensure you’re pointed in the right direction before you pull the trigger.  

Figures released last week indicated a contraction both in housing starts (lowest level since 1997) and in median sales prices.  Median prices fell in 73 metro areas in the final three months of 2006.  These results on the back of one of the strongest housing booms in U.S. history.  The sober view is that concern is not unwarranted.

Glance at today’s USA Today, however, and you’ll get the idea that everything is rosy; unless you dig into the article you might come to the conclusion that some positive numbers have been release.  The main headline on the front page of the Money section (three of our columns - use your imagination if you're looking at the online version): Realtors expect home price recovery.  The first quote is from David Lereah expressing optimism that a “discernable improvement in both sales and prices” is already upon us. 

Real estate professionals will know who David Lereah is, but some investors might not.  Lereah is the Chief Economist for the National Association of Realtors®.  The NAR is the industry group charged with keeping the real estate market moving, keeping prices on the rise – and most importantly ensuring that sales volume stays high, which means more commissions flow into Realtors® pockets. 

A statement from Lereah isn’t "news", it’s a sales pitch.  Lereah is just doing his job – trying to convince homebuyers (and investors) that everything is rosy.  The problem is that consumers will read an article like this one – prominently published by a high volume national news source like USA today, and mistakenly conclude that it’s news. 

So what does it mean to me?  Two things to consider as an investor.

• Consider the source.  It’s fine that the National Association of Realtors® has a voice in the press, but don’t give their forecasts and vies the same weight that you’d give to an impartial market expert.  The NAR has a point of view that they’re trying to sell. 

• Look at the underlying numbers.  Even a bad article like this can yield some information.  National median sales price for an existing single family home is down 2.7% nationwide from the same period last year – so instead of trending upwards with inflation (the natural path) the market has entered into a quantifiable correction.  Ask yourself “is this enough.”  What’s your view on your own area. 

• Be skeptical about some “information” you get from the popular press.  I note that on the same page of the USA Today they have a color photograph of the new Ford Edge HySeries prototype SUV, a fuel-cell plug-in hybrid that the paper refers to as “pollution free”.  This is simply wrong.  A car that you plug into your wall to recharge runs on electricity, and the vast majority of electricity in the United States is produced by power plants that burn hydrocarbons – primarily coal and natural gas.  Electricity isn’t free, and it can’t be produced unless you burn something, which creates pollution.  Fuel cells run off of hydrogen, which in itself is clean, but is produced as a by-product of natural gas – again, a hydrocarbon. All cars pollute – it just makes us feel a bit greener if the pollution is coming from the smokestacks of a remote power plant or hydrogen facility instead of the tailpipe of the car we’re driving.  A tangent from the topic of real estate?  Perhaps – but for me it’s a clear example of the fact that the press will simplify issues until they’re simply wrong – and that’s dangerous for an investor.  

Glance over at Wall Street and you’ll find some troubling indications on the health of some of the lenders.  We know that foreclosures are on the rise and that there are looming concerns about interest rates, but seems that the analysts are taking notice. 

New Century Financial Corp (NEW) took a big hit late last week on the back of news of  an unexpected fourth quarter loss .

New Century Financial focuses on sub-prime lending, the market that is taking a disproportionate share of the blow being dealt to financial institutions by rising default levels.  Sub-prime lenders get a lot of scrutiny from watchdog groups and consumer advocacy organizations - and rightly so; this is a market that is prone to abuse.  But inarguably sub-prime lenders provide a service to the real estate community by offering options to potential homeowners who otherwise would be unable to purchase a home.  Look for liquidity to be negatively impacted as these companies get clobbered – which will impact homeowners as they try to refinance adjustable rate mortgages that they entered into back in rosier days. 

So what does it mean to me?  Well a lot of real estate investors have jumped into risk/complicated loans during the easy-money days, with they expectation that they would either a) sell the property or b) refinance in the future.  Well refinancing will get harder if the current trend continues; they very companies that started the trends in sub-prime lending and exotic mortgages are on the brink of leading the market towards tightening lending standards.  Take a look at your situation and decide whether or not you need to take action. 

See also:

• Option ARMs in the news
• Mortgage choices for investors

I found this quote on the Actvity splash page.  I thought it was pretty cool...

• Aoccdrnig to a rscheearch at an Elingsh uinervtisy, it deosn't mttaer in waht oredr the ltteers in a wrod are, the olny iprmoetnt tihng is taht frist and lsat ltteer is at the rghit pclae. The rset can be a toatl mses and you can sitll raed it wouthit porbelm. Tihs is bcuseae we do not raed ervey lteter by itslef but the wrod as a wlohe.

In my unscientific survey everyone polled could read this without a pause. 

I could try to make some tortured analogy to tie this to real estate investing but I won't try; there are worse sins than the occasional irrelevant post. 

BankRate.com's real estate advisor Steve McLinden does an excellent job covering ethical considerations of flipping houses for a profit. 

Property flipping has gotten a black eye as of late from shady practices that have victimized first-time buyers, at-risk communities, and the reputation of the real estate industry as a whole.  The matter hasn't been improved by the proliferation of quick-money real estate courses and goofy reality television programs like Flip this House and Flip that House (yes, these are two different programs - just another indication of the general public's manic appetite for all things real-estate related).