The three myths of condo investing

Don't be sucked in by these three myths of condo investing.

August 20, 2005: 1:35 PM EDT

NEW YORK (MONEY Magazine) - The growth in condo-investing mythology may be more worrisome than the risk of overbuilding. Here are three whoppers that need reality checks.

MYTH: Get in early and you'll be guaranteed a profit.
Remember the lust for Internet IPOs? Ordinary investors bid up the stocks of hot little companies that hadn't even registered their first sale yet. Today's version is a preconstruction condo, where investors jockey to get into a project not yet built, certain the units will jump in value when completed.

But getting in early doesn't guarantee riches anymore. That's because developers have caught on to the demand and are now selling preconstruction properties at market prices, says Kimberly Kirschner, a Miami agent who specializes in new condos.

Also, developers are requiring buyers to reserve their units earlier -- as much as three years in advance. That's an awfully long time to assume a hot condo market will continue to boil.

So when it comes to preconstruction, skip that line. Instead, buy an existing unit. While preconstruction purchasers can wait up to three years with very little to show for it at the end, you can collect 36 months of rent to put toward paying off your mortgage and building equity. If prices continue to appreciate, great. But that's a cherry, not the whole sundae.

MYTH: Creative mortgages lower your payments and guarantee positive cash flow.
New twists on adjustable-rate mortgages and interest-only loans can make condo investing seem like a lark. But some of these things could slaughter you if prices fall when you have to sell.

The riskiest is called an option ARM, which features several payment choices each month, including a standard interest-and-principal payment, an interest-only payment and an interest-only minimum payment that's so low it doesn't cover the month's interest charge. The unpaid interest is rolled into the principal, meaning that -- yes -- you're charged interest on your unpaid interest.

Fort Lauderdale resident Bruce Palmer, 50, recently signed up for an option ARM that cuts his monthly payment on a $417,000 investment condo by $500. As a result, his two-bedroom in Fort Lauderdale should generate a profit of $350 a month.

Palmer, a commercial pilot, says he sees the risk. Paying the interest-only bare minimum means his mortgage is growing, not shrinking. If local prices were to drop, his loan balance could exceed the condo's value.

But Palmer is confident, building a war chest to snap up properties. "If I could leverage more," he says wistfully, "I would."

Gary Eldred, author of "Make Money with Condominiums," worries about such sunny thinking. Most condo investors should avoid option ARMs, he says, and either put down more money to lower the monthly payment or consider buying -- gasp -- a less expensive unit.

Whatever your choice, Eldred says your expected rent should cover at least 70 percent of your total monthly costs. Tax write-offs on condo losses can help close some of that gap, he notes. (Up to $25,000 in losses, excluding mortgage-principal payments, can be charged against total income of less than $150,000.)

And he argues that rising rents should, over time, cover the rest. (With condo prices soaring, Eldred predicts that condo rents will follow as would-be buyers get priced out and rent.) More cautious investors would want their rent to cover 100 percent of carrying costs or more.

MYTH: You should buy in your backyard, where you know the landscape.
Too few condo investors recognize one of the best reasons to buy: It can help diversify your real estate holdings so that your portfolio doesn't rise and fall solely on hometown economics and events. (Even if property is a relative bargain in your area, buying wisely elsewhere can make more sense than buying too much property locally.)

New York City attorney Richard Savitt, 40, never thought about all this 18 months ago, when he abandoned hopes of investing in Big Apple condos and bought in Philadelphia instead.

"We just thought New York prices were crazy," he explains.

But it sure looks wise now. Savitt and four partners bought four one-bedroom condos, each around $300,000. Similar units now list for as much as $450,000.

To help you determine where to invest, take the average price at which units are selling in a city and divide it by the annual rent the average apartment there generates. That will produce a price-to-rent ratio. The lower the better. Houston, Atlanta and Philadelphia, for instance, still look relatively good, while New York City and San Francisco do not.

In Minneapolis, Chris Cowen and four other condo investors who've become pals gather at a bar for their fortnightly meeting. Jahn Dyvik, a 42-year-old engineer who sold his Porsche Boxster to help fund more condo buys, says lower prices in neighboring St. Paul make that city the better bet.

The rest of the group is sticking with Minneapolis, where they think prices will rise faster. Two others have also sold their cars. All have home-equity loans.

Where are prices headed? Cowen's not sure. The long-term case for condos looks good, but all the building out there makes him nervous. "People have unrealistic profit expectations."

Not him, of course. "No one has a crystal ball. But the condos I've bought are going to go up."