Investing Guide 2011: At home in America

Now may be the time to get in on the U.S. housing recovery.

Click here for the other four features in the 2011 Investing Guide.

Leave it to a real estate professional to put a positive spin on gloomy data. “We ring our hands over the fact that there’s 9.6% unemployment,” says Jed Smith, managing director for quantitative research at the National Association of Realtors (NAR) in the U.S. “That really says over 90% of the people have a job. The glass is 90% full.”

Such is the optimistic lens of the real estate industry. Home prices in some cities are still declining after a three-year-long plunge, but Smith sees signs of life in the market. Existing home sales are coming back, for one. In September, more than 4.5 million homes sold, up 10% on a seasonally adjusted basis compared to the month before. Inventory levels, which peaked at 4.58 million homes in July 2008, have fallen nearly 12%. The NAR even trotted out a long-awaited word when releasing these results in October: recovery. That recovery only applies to sales — not prices — and even Smith concedes this recovery is in the very early stages.

Still, the half-hearted vote of confidence from the NAR may be all the incentive some Canadian investors need to jump into the U.S. real estate market, as a number of trends are creating an enticing opportunity. Interest rates are low, facilitating cheap credit, and the loonie is near parity. The housing crash also pulled astronomical real estate prices back to earth. Prices in some cities are down approximately 50% from their highs, and the median price for all housing types nationwide is only US$171,700 compared to US$219,000 three years ago. Contrast that to Canada, where prices reached new peaks just this year, and some economists argue our real estate bubble is set to deflate.

Bargain prices aside, the U.S. market is still very shaky. Sure, sales may be up, but they’re coming off record lows in July. And housing inventory is still twice as high as in a balanced market. Sales of distressed properties have slowed down recently while all 50 states review procedures after learning that banks in some cases foreclosed on homes without even reading the paperwork. Foreclosures make up roughly a third of all homes on the market in the U.S., meaning a rebound will be delayed until the mess is sorted and the distressed inventory can be cleared out. The issue complicates an already difficult housing recovery, which will only occur once strong job growth returns and consumer confidence increases.

“On a national level, we see prices continuing to fall, certainly into 2011,” says Alex Villacorta, a senior statistician with California-based Clear Capital, which provides market analysis and risk assessments for the real estate industry. “But the future of the housing will start to differ considerably market to market.”

That means any Canadian scouting for deals has to know where to look, and be prepared to deal with further price declines and a slow recovery, whenever that may be. Quick flips are a dangerous bet in this environment. A less risky way to invest is to establish a rental property. That way, investors don’t have to wait for price increases before they start seeing a return.

The first hurdle is determining where to buy. Arizona, Nevada and Florida traditionally attract a lot of Canadians. In fact, Canadians are the No. 1 foreign buyers in Arizona. This is in large part due to the fact that the state is warm year-round, and real estate is dirt cheap. Phoenix was one of the hardest-hit cities during the crash, with single-family home prices down 53% from their 2006 peak, according to the S&P/Case-Shiller Home Price Index. A three-bedroom home in decent condition can sell for as little as US$75,000 in Phoenix today.

“If you’re prepared to hold on to a property for over five years, I don’t think you have any risk on the price side because they’re so cheap right now,” says Arnold Porter of Arizona for Canadians, a company that assists Canuck buyers. Porter, a Canadian who co-founded the company with his wife in 2007, argues that demographic trends actually favour Arizona down the road. Between 2000 and 2009, Arizona was second behind Nevada in terms of population growth in the U.S., and Porter believes retirees will continue to flock to the sun-drenched state. Unemployment, while still high at 9.7%, is lower in Arizona than in other Sun Belt states, and the home-price-to-income ratio has returned to its pre-boom level.

The logic is much the same for Florida, a now cheap real estate market with a warm climate to draw retirees and vacationers. Andrew McNeill, an urban planner with the City of Mississauga, purchased a condo in Sarasota this year after looking at as many as 40 other properties. Many of the foreclosed homes he checked out had been vandalized; some had the kitchen sinks and cabinetry torn out. He still found a bargain without resorting to a distressed property, however, and bought a condo at a 65% discount compared to its boom-era price. McNeill eventually plans to use the condo when he retires, and is renting it out in the meantime. He purchased through Florida Home Finders of Canada, a Toronto-based firm that presented him with listings in Florida and connected him with a property manager, so he didn’t have to find renters himself. “The rent that we’re getting means that even if the place never appreciates in value, it will pay for itself in seven years,” he says.

Banking on price appreciation is not the wisest approach. Prices in some Florida cities are still falling. Tampa Bay is down 4% in the past year, while Miami has barely moved. Same goes for Phoenix, nearly 3% since January. “If you’re going to buy in the U.S., don’t buy in areas poised to have further drops,” says Don Campbell, president of the Real Estate Investment Network in Calgary, which offers analysis and tips to its members. “Buy in the cities where the recession is starting to come off, which is in Houston, Dallas and Washington, D.C.”

Indeed, when the Milken Institute ranked 200 U.S. cities in October based on job creation and economic growth, nine of the top 20 locations were in Texas, largely because of the state’s business-friendly climate. Tucson, Ariz., and Phoenix finished at 77 and 117 respectively.

The uncertain economic outlook has kept David Aroeste away from the Sun Belt. The Vancouver resident and real estate investor instead purchased four houses in Kansas over the past year, where he feels the market has stabilized. The midwestern state was also never subject to the extreme boom-and-bust cycles seen elsewhere. Like McNeill, he is not overly concerned with further price drops since all four of his properties are generating rental income. “If your cash flow is really good, then it doesn’t matter if your price drops a bit,” he says.

Aroeste conducted a lot of research before purchasing his first investment property. He recommends anyone looking to purchase in the U.S. spend at least a week in the desired city investigating properties and getting to know the neighbourhoods, amenities, employment opportunities, and crime rates.

There are many things Canadians need to be aware of before buying. Credit is tight in the U.S., and very difficult for foreign investors to obtain. Most buyers end up taking out a line of credit domestically. Canadians should budget for a property management firm, which typically charges 10% of gross rental income. Property management firms are obliged to withhold 30% of any rental income generated by foreign investors and turn it over to the Internal Revenue Service, but Canadians can skirt around this issue by electing to file a tax return in the U.S. The marginal rate in most cases is substantially lower than the 30% withholding tax.

Condo investors should pay particular attention to the condo corporation’s reserve fund. Some buildings, beset with foreclosed units, are grossly underfunded, and current owners will have to make up the shortfall. American condo corporations typically aren’t as well funded as their Canadian counterparts to begin with, as McNeill learned when purchasing his investment unit. In fact, when he showed the closing documents to family members who happened to be lawyers, they advised him not to sign. “For someone from Ontario buying in Florida, it’s a little unnerving,” he says. McNeill hired an independent lawyer who assured him the condo corporation’s finances were typical for Florida, however. He also says there were relatively few foreclosures in his building and most units are occupied, meaning a shortfall is unlikely.

If the hassles of owning property in the U.S. are too much to contend with, investors can gain exposure to the market in other ways. Real estate investment trusts have made a surprising comeback this year. The record number of foreclosures has driven many former homeowners back to the rental market, boosting the fortunes of REITs that own apartment complexes, such as Equity Residential (NYSE: EQR), up nearly 50% this year. Investors can also save themselves the trouble of investigating a multitude of individual companies and opt for an exchange-traded fund that tracks REITs. The iShares Dow Jones US Real Estate ETF (NYSE: IYR) is up 26% year-to-date, outperforming the Dow Jones industrial average. And the awkwardly named iShares Cohen & Steers Realty Majors Index Fund (NYSE: ICF) is up nearly 30%.

For investors with a bigger appetite for risk, CBI Group Investments in Alberta operates two funds to purchase distressed homes in Arizona and turn them into rental properties. Through the Arizona Acquisition Fund, which launched last year, CBI has raised close to $14 million from Canadian investors and purchased 65 homes, nearly all of which are rented out. “There has been a massive over-correction in price,” says Jarrett Zielinski, vice-president of property acquisitions, “particularly in our target market, which is entry-level homes.” The fund aims to purchase up to 175 houses, and liquidate the portfolio five or six years from now.

The condition of the real estate market at that time is still anyone’s guess. Campbell says that given the bleak economic outlook, investors in U.S. real estate ultimately need to hold on for the long term, especially those who purchase directly. “If you’re thinking of buying a property you’re going to have in your family for 25 years, the next couple of years are going to be a good opportunity for that,” he says. “Just go in with your eyes open.”