Not many real estate brokers will tell you what I am about to tell you:

1. Most of the data you’ve been fed about housing price changes is grossly misleading
2. Housing is not the great investment that the NAR (National Association of Realtors) wants you to believe

Let me give you some typical examples of the information that is out there on the subject of housing prices and the problems with this information. While the information is usually true in some way it is often misunderstood, and sometimes that is the intention.

Example #1

Two days ago the Tribune ran an article, “Home sales, prices decline statewide; city not as bad”, which stated that the median Chicago condo price in March rose 8% over last year. So what do you think that means? That condos in the city have appreciated 8% in this lousy real estate market? I don’t think so.

All it means is that the median price of a condo which sold in March was 8% higher than the condos that sold a year ago. But that doesn’t mean that the value of condos went up. More than likely it means that the mix of condos which sold this March is skewed more towards expensive condos. Maybe this year there are more 3 bedroom condos being sold and fewer 2 bedroom condos.

Example #2

According to the Tribune’s Real Estate Market Pulse, in Lakeview between 12/1/2002 and 2/28/2003 the median home sales price was $320,000 vs. $245,500 one year prior. Some people would look at the Lakeview data and conclude that housing in Lakeview appreciated by over 30% in one year. However, this is that median problem again.

Example #3

In late 2006 and early 2007 the NAR ran an ad campaign that stated, among other things, that “Housing is a great investment, with average home valuations increasing 88 percent in the last 10 years”. That works out to 6.5% per year on average (keep that number in mind for later). Of course, this 10 year period just happened to coincide with the most outrageous 10 year period of housing appreciation in the nation’s history, for which we are now paying the price. Unfortunately, they’re implying that home buyers can expect that appreciation going forward, which is absurd. This self-serving information appears to be intentionally misleading. But isn’t that the point of advertising?

Example #4

In late 2005 the Tribune published a map showing home price appreciation for each of the Chicago communities and some of the surrounding suburbs. One of the communities they highlighted was Uptown, where they claimed home prices had appreciated on average by 9% per year over 10 years, which is huge. In addition, they showed the 1996 price of a home (presumably the average?) as $121,918 and the 2005 price of a home as $265,000.

This example is interesting because not only does it suffer from the median or average problem that I’ve already addressed, but it also suffers from a math error that seems to recur throughout this map. The percentage change is wrong. For Uptown, given those home prices the average appreciation rate (if you can call it that) actually works out to 8.1% per year.

The Correct Way to Analyze Housing Price Trends

Fortunately, there is a more robust way to track housing prices. The S&P/Case-Shiller home price index tracks repeat sales of homes so that they can really tell if homes are appreciating and by how much. This index has been calculated for 20 metropolitan areas and Chicago is one of them, going back to January 1987. For each metropolitan area they calculate the index for low, middle, and high price tiers, along with a composite index.

The Chicago metropolitan area is defined broadly to include the counties of Cook, DuPage, McHenry, Kane, Kendall, Lake, and Will. In this area the pricing tiers are defined as:

• Low - Under $227,766
• Middle - $227,766 - $348,054
• High - Above $348,054

Here is what the data shows:

There are several points to note in this graph:

• Data for the individual tiers are not available prior to January 1992
• The lower priced tiers have appreciated more rapidly than the higher priced tiers. This makes sense in light of the “innovations” in subprime lending that spurred growth at the lower end of the market.
• The Chicago housing market peaked in September 2006, right around the time that the NAR came out with their great investment campaign. Since then prices have declined 9.1%. I guess it wasn’t such a great investment after all.

Speaking of investments, how has Chicago real estate performed as an investment? Case-Shiller provides comparisons of various asset classes such as stocks, bonds, commodities, and housing over the last 10 years, which has been a stellar time period for housing. I won’t bother to show you how Chicago real estate compared to stocks because we all know that stocks haven’t done that well during this time period. However, comparing Chicago real estate to bonds is a different story:

Basically, over this time period, you would have ended up slightly better off had you invested in bonds vs. Chicago real estate. However, there is a bit more to the story:

• The average appreciation of Chicago real estate from January 1987 to December 1998 was 3.7% per year.
• Starting in 1999 people thought they were rich (remember the tech bubble?) and they went on a home buying spree. In addition, this is approximately when subprime lending really took off.
• From January 1999 through the peak in September 2006 the growth rate jumped to 8.3% per year.
• To put all these percentages in perspective Robert Shiller (of the Case-Shiller Index) analyzed home prices going back to 1890. For the first 100 or so years of that time frame his data shows that the average appreciation of homes, after adjusting for inflation, was….are you ready for this? Zero!

Nevertheless, someone will always say “But I’ve owned my house for 3 years and my equity has doubled”. OK…but that has to do with leverage, and in the good ol’ days that leverage was 5:1. Since then it has sometimes been infinite. So if your house appreciates by 20% and you are leveraged 5:1 then your equity doubles. Of course, leverage works both ways. If your home depreciates by 20% then you are wiped out, and this has happened to a few people lately. It happened to me in New Jersey in 1993 (actually, I lost double my equity). However, if you like leverage, you can leverage investments in stocks, bonds, or commodities as well. It’s a great way to lose your ass.

OK. So why is a real estate broker telling you all this? Shouldn’t I be convincing you to buy, buy, buy? For one, I am sickened by the self-serving analysis of the real estate industry and I want to set Lucid Realty apart from this madness. Secondly, I want to make a really important point: Your house is not an investment. It is a place to live. Don’t buy a home primarily because of some perceived investment opportunity. You may or may not realize it. Of course, I’m not suggesting that you shouldn’t try to find the best value when shopping for a house. After all, that’s where we come in. It’s just that some people make the mistake of letting the perceived investment opportunity overshadow other considerations. Let me put it another way: what kind of investment is your car? And before answering that remind yourself that you don’t (normally) sleep there at night.

If you want an investment, there are plenty of much simpler ways to invest your money. And if you want a real estate investment then look to income producing property that you subject to rigorous financial analysis. In the meantime, if you want a place to tuck your kids into bed at night or have a group of close friends over please give us a call.

With interest rates down and the real estate and stock markets declining everyone is trying to figure out how to invest their money to increase their returns. I’ve been scouring the planet looking for opportunities in tax exempt municipals, CDs, and even my life insurance policies. Naturally, some people are looking at income producing properties as a possible alternative - especially since prices are believed to be down.

But how do you evaluate income producing properties? As you might expect there are numerous techniques that might be used. Some people might just look at them in terms of their belief of the underlying value of the building. Does it appear to be fairly valued, given the location, amenities, and condition of the building? However, as someone who has been a stock market investor for decades I tend to look at investment properties in terms of the return I can earn on them and how that compares to other alternatives available to me.

Calculating the Rate of Return

In order to calculate the return on income producing properties one has to first determine their Net Operating Income, which is basically the sum of all sources of income minus the sum of all expenses. For example:

Notice that depreciation and mortgage payments are not included as expenses for this analysis. The reason for this is that depreciation is a non-cash expense and mortgage payments are part of the financing decision, not part of the property valuation decision (this is actually the same way you value businesses).

Once you have your Net Operating Income (NOI) you can divide it by your purchase price to begin to get an idea on the return you can expect on your investment. This is known as the Cap Rate, which is short for capitalization rate. If you pay $500,000 for a rental property and your annual NOI is $25,000 then your cap rate is 5%. However, that’s still not the return on your investment. Why not? Because over time you can expect to be able to raise rents and the value of your property should appreciate. For instance, if you can raise rents by 3% per year and if the property can still be sold in the future at the same cap rate at which you bought it then your return will be boosted by 3%. In other words, with a 5% cap rate and a 3% average annual rent increase your total return is now 8%. You can trust me on this or you can contact me to get the mathematical proof, which I would be more than happy to provide.

At this point it’s a good idea to start thinking about how you would finance the deal. If you are going to get a mortgage then you need to compare your mortgage rate to the cap rate on the property. If the cap rate is lower than your mortgage rate then that means that your investment is going to provide a lower return on the money you are borrowing than that money is costing you - in the short run. In other words, you are probably going to end up running negative cash flow in the early years before you can raise the rents sufficiently.

I assume you would probably like to know what cap rates look like in Chicago right now. As I periodically check on cap rates in different Chicago neighborhoods, I’ve decided to share the results I recently came up with for rental properties currently on the market in Bucktown. The chart below shows the distribution of cap rates for 22 rental properties currently on the market in Bucktown:

These rates are estimated based upon very incomplete information from the MLS system so please take them with a large chunk of salt. When determining the cap rates on any property you might be considering you should insist on complete documentation of all sources of revenue and expenses.

At any rate (no pun intended) the cap rates vary between 2.8% and 7.1%. In evaluating possible purchases you would have to ask yourself why the available properties have such differences in cap rates. Perhaps the properties with lower cap rates also have below market rents and you will have the opportunity to raise those rents. Or maybe those properties are just overpriced. Once you have determined the cap rate of a property you can add to it your own assumption regarding annual rent increases.

Tax Benefits

But wait, there’s more! There are also tax benefits in owning rental properties. You can depreciate the portion of the purchase price attributable to the building on your tax return each year so this provides you with annual tax benefits that you need to consider. However, this starts to get complicated and this is where you really need to talk to an accountant because:

• There is this thing called recapture of depreciation when you sell a property that has been depreciated and you will end up giving back some, if not all or more than all, of the tax benefits you took over time. However, there is value in the fact that you had use of the tax savings, interest free, in the meantime.
• There are limits to how much depreciation you can take in any given year if you are not a “real estate professional“.

Do You Want to be a Landlord?

There is just one more thing to consider before investing in income producing property. You need to ask yourself if you really want to be a landlord. When the hot water heater ruptures at 2 AM who are your tenants going to call? Who is going to fix the broken shower head?

And how much is your time worth? Take another look above at the components of your operating expense in the chart above. There is a line for management expense because either you are going to hire someone to do it or you need to consider the value of your time - unless of course you work for free, in which case you should contact me.

Note: If you are thinking about investing in real estate give us a call and we can provide you with information that is more targeted to your particular situation. Also, please keep in mind that all of the above information is not guaranteed to be accurate and before investing in rental properties you should seek the expert advice of an experienced accountant and maybe even an attorney. This post is intended for general circulation only and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. It should not be regarded as an offer to sell or as a solicitation of an offer to buy property.

Knowledge is power, so they say. As a professional who realizes the importance of education and staying current on trends, I dedicate a few hours each day to my continued real estate education.

Last week, I read an article that made me feel embarrassed to be a real estate broker. The article “33 Professional Etiquette Tips” was published in the March 2008 Illinois REALTOR magazine and gives “professional etiquette” advice. While I do not think that it can hurt to remind people of the common courtesies of doing business, I found some of the tips pretty basic. Basic, as in behaviors that should have been learned by young adulthood.

Here are a few of the points:

“1. Don’t answer your phone—or check your Blackberry—during a closing. This is the time when everyone’s efforts and hard work come to a successful conclusion. Show all parties involved the respect they deserve by focusing on the closing.”

Do my peers need to be reminded how to use common sense or common courtesy? I mean come on! Does any adult need to be told not to talk on the phone during a business meeting? When I was in corporate America, no boss ever had to tell me not to answer my phone in a meeting. Doing so probably would have gotten me disciplined. Why do real estate agents just need an extra reminder?

“3. Please pronounce who you are correctly: REAL-TOR, like DOC-TOR. (Not REAL-A-TOR or DOC-A TOR!)”

Is comment even necessary for this one?

“6. Spell-check your remarks in the remarks section of the MLS.”

How about being reminded to use spell check? We are supposed to be professionals’ people. Business 101, wait is that English 101? Check your work!

“19. A buyer’s broker was eating a sandwich while walking through my listing. I politely asked her wait until leaving my listing to finish the sandwich.”

That is just wrong. What did the brokers’ client think? How could the broker be effective at answering questions or pointing out the features of a home while her mouth was full of food? The fact that the broker had to be reminded by the listing agent is pathetic.

“27. Delete the expletives from all of your communication.”

When I was old enough to talk my mother taught me not to swear. Now, I’m human, and of course I swear on occasion. But not in writing! Common sense tells me it’s a bad idea.

“34. When showing a property and the seller is home be sure to thank the seller before leaving home. Many sellers expect this courtesy and are offended when they discover the agent and his/her client have left without saying a word.”

The last point is my favorite, or is it the least favorite? To express gratitude. Again, something I was taught as a child. Do adults really need to be reminded? Uttering the words “Thank you” is not only simple, but so effective. Again, it is called common courtesy.

What scares me the most about the article, in addition to the fact that it was even written, is how much many of the real estate agents in the industry today need to read and heed the advice.

Ever wonder why there aren’t corn or soybean fields in The Loop? Probably not. I think you know why. There is a fundamental concept in real estate that dictates that land should always be put to its highest and best use. It make sense, right? Why would you utilize a precious resource in a less than optimal way?

However, there is this 22 acre tract of land in Chicago that has always mystified me. Right on the edge of Lincoln Park, at 2011 N. Southport, 4 miles and 9 minutes from downtown, there is a steel plant. It’s the A. Finkl & Sons Co. factory, complete with scrap metal processing and smelters. (Curiously, they think they are located in the Near North Side.) For the longest time, every time I drove by that place, bounded on the East by really expensive housing, I couldn’t figure out why that place was there. Surely a steel plant is not the highest and best use of that property and surely Chicago could use more housing close to downtown. So I always figured that the Finkl family had some irrational attachment to the steel business.

Well, I have subsequently found out that it’s not the Finkls that are irrational, but actually Mayor Daley. You see, according to this week’s Crain’s Mayor Daley has this campaign to keep manufacturing jobs in the city and has refused to change the industrial zoning of this tract of land, which would raise the value of the land from $29 MM to $80 MM. Hence, $51 MM of economic value is being wasted and this all seems to run counter to the mayor’s other goal of affordable housing.

The article goes on to talk about how Finkl has been threatening to move out of the city entirely if the zoning is not changed and how certain financial subsidies are being discussed. Sounds like more waste to me.

What I don’t understand is what is the magic about manufacturing jobs that the mayor wants to preserve them. All I can say is that it sure is a good thing that the mayor wasn’t around 100 years ago because today Michigan Ave would be lined with liverys and horse drawn buggy shops surrounded by cornfields.

It looks like the Chicago real estate transfer tax increase has gone into effect as of April 1 to help bail out the CTA. Why homeowners have to pay for public transportation is beyond me but what the heck. You and I are already paying to bail out everyone else these days so what difference does one more bailout make? I just wish someone would bail me out of something. I would like a government subsidy for my gasoline bill or maybe for my monthly phone bill.

In case you haven’t heard, this tax increase amounts to an additional 0.3% that the seller has to pay. So, to use round numbers, on a $1 MM house that’s an additional $3000. So let’s review the total taxes now involved in buying our theoretical million dollar home:

• State tax paid by Seller = $1000
• County tax paid by Seller = $500
• City tax paid by Seller = $3000
• City tax paid by Buyer = $7500
• Total tax = $12000

As the guy who I bought my first home from used to say, “that’s a lot of jingle”. It’s almost as much as a typical real estate agent might make on the deal. And regardless of who pays the various transfer taxes in the example above it raises the cost of homeownership for all of us because everyone is a buyer and a seller at different points in time.

What’s really surprising about this development is that I just didn’t hear anyone outside the real estate industry complaining about the issue. The ordinance was passed unanimously by the city council without debate so they must not have heard many complaints either. Perhaps people just didn’t focus on it because it’s not a tax they get hit with every day - only when they move, and people often don’t think about moving until they start thinking about moving.

The real estate industry launched a valiant effort to stop this tax but despite their massive clout it looks like they didn’t even slow the process down. I guess you just can’t stand in front of a moving train.