REAL ESTATE FROM THE GROUND UP Tax reform has clipped this inflation hedge, but property investments still offer steady if unspectacular returns.
By GARY HECTOR REPORTER ASSOCIATE Wilton Woods

(FORTUNE Magazine) – AN EXECUTIVE at a semiconductor company in Silicon Valley spent more than a year looking for a new home. By September he finally found something he liked, a four-bedroom, ranch-style house in San Jose that listed for $325,000. Unfortunately a lot of other people liked it too, so the owner asked prospective buyers to submit sealed bids. He got six, all above his asking price. The long-searching executive won the house with an offer of $340,000. The sizzle in housing prices persists most strongly in small enclaves along the California coast, where houses are selling for 20% more than a year ago. Investors in other real estate markets, especially those looking at commercial property, are likely wondering where the steak is. ''The markets are dicey,'' says Stephen Roulac, managing partner of Roulac Real Estate Consulting Group, ''but the opportunities are out there.'' ''Out there'' means the East Coast and the West Coast. Experts are talking about a ''bicoastal economy,'' with prosperous pockets in between, such as suburban Chicago and Atlanta. Though another 1970s-style price spiral is unlikely, real estate in these areas is expected to keep pace with inflation, which Fortune forecasts will rise to 5.5% in the coming year (see The Outlook). Knowledgeable investors recommend shopping centers, apartment houses, and industrial properties such as warehouses, but warn that office buildings and hotels will remain overbuilt for at least the next five years. You can buy property directly or you can invest in a variety of real estate securities. By far the most rewarding -- and the riskiest -- way to invest is to own real estate directly, whether it's a vacation condo in Maui or a warehouse in Baltimore. The minimum investment is high, normally $25,000 or more, and managing property yourself is time consuming. Moreover, tax reform has taken some of the joy out of being a property owner. Income or losses are deemed ''passive'' by the IRS and can be used to offset gains or losses only on other passive investments, such as limited partnerships. (People who earn less than $100,000 a year and who manage their own properties can use up to $25,000 in losses to shelter other income, and those with adjusted gross incomes of up to $150,000 can deduct losses in lesser amounts.) Securities -- including mortgage-backed bonds, real estate investment trusts, and limited partnerships -- are generally easier to buy and sell than property, and their tax treatment is less complicated. But they fluctuate more in line with interest rates and stock prices than with the value of the underlying real estate. Right now Fortune expects that interest rates will decline next year and that the stock market is likely to be in for a rugged 12 months, making these securities potentially mediocre performers. ''We remain bearish,'' says Karen Knudson, director of real estate research for Bailard Biehl & Kaiser, a San Mateo, California, investment manager. ''At one point we recommended that investors put 40% of their assets into real estate. At our low we recommended just 5%. We are now at 10%.'' Yet even Bailard Biehl has been shopping for bargains recently and agrees that real estate securities belong in a diversified portfolio. Cautious investors find mortgage-backed certificates an attractive alternative to bonds. The certificates, known as pass-throughs, are backed by pools of residential mortgages; the interest and principal the homeowner pays flow through to the investor every month. The safest are GINNIE MAE, FANNIE MAE, AND FREDDIE MAC PASS-THROUGHS because the mortgages are guaranteed by the Government National Mortgage Association, the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corp. They recently yielded about 10%, nearly one percentage point more than ten-year U.S. Treasury bonds. You can buy individual pass-throughs from your broker with a $25,000 minimum investment, but you can more easily buy Ginnie Mae mutual funds, where the minimum investment is $1,000. The risk in mortgage-backed securities is that, as with all fixed-income investments, prices fall when interest rates rise. But the investor can also be sandbagged by falling rates, because in that case homeowners refinance to pay off higher-interest mortgages. Then your certificate matures long before its due date, and the capital you thought was safely tucked away for the long term falls on you like an avalanche to be reinvested -- just when rates are lower. To get around this problem, investment bankers have segmented pools of single-family mortgages into classes of maturity, assigning the homeowner's mortgage payments to the shortest maturity first, then to the next shortest, and so on, to protect your original yield for the term you have chosen. These designer securities are called collateralized mortgage obligations (CMOs) or real estate mortgage investment conduits (Remics). You can buy pieces of a mortgage pool with average maturities of as little as two years or as long as 16 years. The securities can be fixed-rate, floating-rate, interest-only notes, or principal-only certificates. REAL ESTATE investment trusts (REITs) also provide income, but because they trade like stocks you get a chance for capital appreciation as well. You buy them from your broker just like stocks. Mortgage REITs invest almost exclusively in commercial mortgages, although some older ones may own a few properties acquired through foreclosure in the 1970s. Equity REITs own property directly. REITs pass on the interest on the mortgages or the rental income from the properties as dividends to the shareholders. They cannot pass the tax benefits of investing in real estate through to their shareholders, but they are exempt from the corporate income tax as long as they pay out 95% of their income in dividends. As a result they tend to be high-yield stocks and appropriate for people who want high income. Edward Caso, an analyst at Goldman Sachs, favors the nation's largest mortgage REIT, ROCKEFELLER CENTER PROPERTIES. It holds the mortgage on $1.3 billion of Manhattan's finest midtown real estate and pays a dividend of more than 9% that has been growing 1% to 3% annually. This REIT has a wrinkle that is unusual for a mortgage trust. About half the leases on Rockefeller Center come due between 1994 and 1997, and the landlord has agreed to pass on some of the higher-lease income he may be able to command from new tenants. Says Caso: ''This is a tremendous play on New York City real estate.'' Because equity REITs own property rather than the mortgages on it, they are likely to perform better than mortgage REITs should inflation rise sharply. Equity REIT portfolios include rental properties and land that is under development. Some of the trusts specialize by region or by type of property, and they range from highly leveraged to almost debt free. The least risky are obviously those that invest in existing properties that they have paid for entirely or largely with cash. Equity REITs pay modest but growing dividends, currently averaging 7% for conservative trusts. Though analysts expect equity REITs to fare well over the next few years as the building binge of the early Reagan era subsides, they were not world beaters last year. An index of the shares declined 12.3%, vs. a 2.4% rise for Standard & Poor's 500-stock index. Since the October crash they have risen 11%, vs. the S&P's 20%. Kenneth Campbell, editor of Realty Stock Review in Montvale, New Jersey, recommends trusts that operate smaller shopping centers. They tend to resist the drag of a recession because they are usually anchored by discount stores. Campbell likes FEDERAL REALTY INVESTMENT and NEW PLAN REALTY TRUST in the Northeast, IRT PROPERTY TRUST in the Southeast, and BRE PROPERTIES, which owns apartments, offices, and malls, mostly on the West Coast. For those who believe that the Texas economy will recover, Burl East, an analyst with Alex. Brown & Sons, recommends WEINGARTEN REALTY INVESTORS. It is a Houston-based shopping center specialist whose properties remained more than 90% leased during the state's economic downturn. The company is conservatively run -- it pays cash for most of its properties -- and the REIT yields just over 6%. SIMILAR to REITs, but with more complex risks, are public limited partnerships, which you can buy from your broker or a real estate syndicator. Some have units that are traded on exchanges just like stocks, so you can usually get your money out whenever you want. Tax reform eliminated much of their appeal as shelters, and now many of the partnerships concentrate on producing income rather than write-offs. In the past high front-end fees -- up to 40% of the total investment -- injured limited partners, who were then insulted by mediocre performance. Respected syndicators like JMB REALTY CORP. of Chicago, BALCOR CO. of Skokie, Illinois, and KRUPP ASSOCIATES of Boston may flourish in the new world of making money rather than writing off losses. But most investors should wait until they can see several years of solid performance under the revised tax rules before plunging into new partnerships. With the current oversupply of apartments, offices, and other commercial buildings, new construction is more of a crapshoot than ever. But if you are a contrarian, one prudent way to wager on a building surge is to buy stocks of well-known commercial property developers such as ROUSE CO., a Columbia, Maryland, builder of shopping centers; FOREST CITY ENTERPRISES, a Cleveland shopping center builder; or KOGER PROPERTIES, a Jacksonville, Florida, developer of suburban office parks. Kenneth Campbell also suggests smaller companies with large land holdings in rapidly growing areas. Among his favorites are LENNAR CORP., active on the east coast of Florida; LEISURE TECHNOLOGY CORP., with land holdings primarily in southern New Jersey and California; and STANDARD PACIFIC, a master limited partnership with 6,600 building lots in California and a 12% yield. For those with the time to manage property themselves, investing directly in real estate -- either as a single owner or in partnership with others -- probably will be far more rewarding than owning real estate in securitized form. Tax reform has stripped away most tax benefits from owning real estate for investors earning more than $100,000 a year, but you can still deduct the mortgage interest on your home or a second home. Don't count on renting out that vacation house for part of the year, though. Congress has made that too much of a headache. Owning rental property such as single-family homes, condos, or buildings with two to four rental units can generate deductions for interest payments and depreciation. Unfortunately, the breaks aren't as enticing as when the top tax bracket was 50%. If your interests range beyond condominiums and less expensive rental property, seek out other local investors and form a private limited partnership to share the costs and risks of acquiring larger holdings. Says Lawrence A. Krause, a San Francisco financial planner: ''We are getting more and more requests for this kind of investment.'' For the past 12 years, Sylvan I. Feder has been successfully organizing partnerships for friends and associates in San Mateo, south of San Francisco. He and his partner, Janice B. Beiser, consider real estate more a steadily appreciating asset than a tax shelter, and none of the dozen partnerships they have put together were designed solely to shelter income. As general partners, the two accept substantial personal risk. They guarantee the repayment of all loans and lend the partnerships money when necessary. Says Feder: ''The only time we get money out is when there is a profit.'' Their first partnership bought a mixed-use apartment building in San Bruno that rented residential and professional units. They paid $160,000 for it in 1977; three years later they sold it for $326,500. Late in 1986 their most recent partnership bought a 16-unit apartment building in Menlo Park for $1.3 million. It is on the market now for $2 million after the partners put $100,000 into improvements. Says Feder: ''We invest only with people we know. No strangers.'' Their latest pool, which owns the Menlo Park building, has just ten investors, who put up a total of $500,000. They include Feder's doctor, his accountant, family members, and a former banker. He and Beiser put their own money into each of their partnerships. At $115,000 apiece, they are the largest single investors in this one. Feder cautions: ''This is a risky business. Only people who have income they don't need to live on should invest. If all our partnerships went broke tomorrow -- which they won't -- our investors could afford to live comfortably.'' John R. White, honorary chairman of Landauer Associates, a New York real estate consulting firm, suggests that you concentrate on small apartment houses and storefronts in clean, stable downtown areas. His advice is to stick close to home, where you know the market, and look for a well-built property in a good location. Real estate professionals agree that these private partnerships help a small investor profit from big opportunities in his locality. The biggest advantage of joining a small partnership is its hometown flavor. The developer, usually the general partner, knows the area; the banker extending the loan knows the developer; and neither is likely to skip town if a project flounders. Partnerships often require a big initial investment: Some ask for well over $25,000 as a minimum stake. For many investors, that is a considerable amount of money to risk on a one-shot deal. In their early years partnerships can function as tax shelters, generating losses that can be used to offset passive income. As a limited partner you are not liable for any commitments that exceed your investment, but you do run a risk that the gain at the end may prove as insubstantial as the Cheshire cat. For this reason, keep these projects to no more than 5% or 10% of your total portfolio. Any developer who has survived more than one business cycle can tell horror stories of the big deal that cratered when the market went soft. One survivor is R. George Latham Jr. of Roseville, near Sacramento, who creates limited partnerships to develop properties and then sell them. Latham raised $400,000 for his first partnership in 1979 to acquire raw land he thought he could sell at a profit. But he held on too long, ran into the 1982 recession, and ended up buying back the land from his limited partners, giving them a modest profit.

Since then Latham, who is a general partner in his deals, has been more successful. He estimates that his recent partnerships returned 15% to 40% over their lifespans of one to two years. Latham has just finished a 130,000- square-foot shopping center in Roseville. He is building another south of Sacramento and is laying plans for a third. The Sacramento center will cost about $13.5 million. Investors put up $400,000, and Latham borrowed the remainder from local banks. FINDING A good local partnership requires legwork. You can probably get leads from bankers, accountants, or financial planners, but you must personally check the credentials of the general partner. Read the offering circular and see how much he has at stake in the project, look at other property he has developed, and talk to former investors and to bankers who have worked with him. You want to be sure that he has the financial strength to help bail out his partners if the project goes bad, as Latham had to in the early 1980s. Then ask about the fees you'll be paying. Latham charges investors a one-time fee of 2.5% of the total project costs for development -- definitely less than the fees some public limited partnerships charge. Says Latham: ''The projects to worry about are those where the developer is not putting money in and is taking out large fees up front. They have a tendency to go bad.'' Investing in development projects is no place for a real estate tyro. Start by buying your own home. Then you might graduate to pass-through certificates or shares in a REIT. Suppress the urge to take a flier until you have become knowledgeable about real estate investing. Even then, most investors find armchair participation as owners of real estate securities sufficiently diverting to allow them to forgo the time-consuming process of managing property directly.