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by Steven Peletz

We’re all seasoned real-estate investors, right? So, we all know how to value our buildings and make good decisions about our investments. Well, maybe—or maybe not.

We certainly know that we have been rewarded richly for investing in apartments in San Francisco over the last 10 to 20 years or more. We all know that San Francisco comprises a finite land mass. We are bounded by water on three sides, and they aren’t making any more land. And yes, rents are going up again!

But, wait a minute. Does all that good news mean we should hold on to our San Francisco properties forever? In order to make smart investment decisions, we must consider something few real-estate professionals talk about: “opportunity cost.” The concept of opportunity cost reflects the notion that we need to consider where else we might be able to invest the equity we have built up in our real-estate holdings, and how the returns in those alternative investments might stack up relative to the returns we obtain from our San Francisco apartment buildings.

There are a few good reasons to consider where else we might be investing our equity. By looking at other investments, we may well find ways to maximize our returns, hedge against or minimize risk, and minimize management costs and headaches. Alternatively, we may simply find out that we are indeed happy with our existing portfolios and comfortable with our existing level of risk, while validating our present courses of action (or inaction).

Opportunity Cost
A simple way to apply the notion of opportunity cost would entail asking yourself, “What could I be getting if I invested my present equity elsewhere?” More formally, Webster’s Dictionary defines opportunity cost as “the cost of an alternative that must be forgone in order to pursue a certain action.” Put another way, it is the benefits you could have received by taking an alternative action.

Another definition is “the difference in return between a chosen investment and one that is necessarily passed up.” Say you invest in a stock and it returns a paltry 2% over the year. By placing your money in the stock, you gave up the opportunity of another investment—say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4%.

Many real-estate investors analyze their holdings based upon the cost at which they purchased a building. They look at the cash flow today compared to the amount of cash they invested years ago to get a “cash-on-cash” return. In most cases, if you have purchased your property at least 7 to 10 years ago, you are probably receiving very handsome returns on your original investment. We all might congratulate ourselves based upon these calculations.

See Table 1 for summary information on a typical San Francisco building purchased in a working class neighborhood with some upside in rents in 1997. With some turnover in the ensuing 10 years, the building performs as noted in Table 1. To summarize that picture, if you invested in a small apartment building with $100,000 in gross rents back in 1997 at a price of $1.2 million, while it was just breaking even back then, with some turnover you would now be seeing roughly $68,163 per year of cash flow on your original cash down payment of $300,000. In a quick and dirty calculation, that is a nearly 23% return on your original cash investment. Not bad!

Your property value will have grown to $3,150,000 and your equity would have grown from $300,000 in 1997 to $2,169,000 (net of sales transaction costs) in light of today’s market values. Your equity would now be seven times what it was 10 years earlier.

But what, if anything, do these wonderful recent experiences tell us about the next 10 to 20 years? Is it a given that the next decade or two will provide these same kinds of returns as in the past 10 years? Do the extraordinary returns of the last 10 to 20 years (coming out of the local real-estate recession of 1989 to 1995) mean we should simply hang on to our existing buildings? The future may look very similar to the most recent 10 years—or it may not.

To make good decisions, one must at least hazard a guess on what returns will be for various investment alternatives. True, this is a hazardous venture, fraught with uncertainty, but to make wise choices, we really must take a stab at it.

Forward-Looking Analysis
When considering the opportunity cost, the evaluation is far different than the historical cost analysis. Opportunity-cost analysis starts with the market value today and evaluates what you can do with the equity you can capture today, not what your original investment was 10 years ago. In other words, the analysis looks at your present and future circumstances, not past circumstances. The return will look quite different from this perspective, and your decisions about trading, holding or cashing out may be quite different using this methodology.

Your decision will depend on whether you expect that your existing property or some other set of investments will provide higher returns in the future. The analysis compares the projected returns on your existing property against those on the alternative investments (after taking into account transaction costs and taxes). These alternative investments could be different types of real estate in different locations, or they could be stocks and bonds, or even artwork for that matter.

 So let’s consider the merits of conducting a 1031 tax-deferred exchange into a NNN deal in another state, or cashing out and investing in a diversified portfolio of stocks and bonds.

Alternative 1: The 1031 Exchange
Table 3 shows the cash flow one can receive by trading into a NNN deal where you can also diversify your assets (against a local financial glitch or a local natural disaster). In this scenario, one can nearly double the cash flow of $68,163 in Table 2 to the $134,840 projected for the NNN deal summarized in Table 3. Cash flow is nearly doubled due to the higher cap rates possible in NNN deals in other parts of the country.

In an existing NNN deal, one can obtain a 6% or 6.5% capitalization rate on properties in other states, while a San Francisco apartment building can now fetch a whopping sales price reflecting at most a 4% capitalization rate (or return). True, one gives up much of the appreciation in a NNN deal; but for investors who are approaching retirement, the nearly 100% increase in the cash flow today may more than compensate for much of the appreciation given up over the next 20 years. Furthermore, when the lease options run out in 10, 20 or 30 years, the appreciated value of the property may then be reset to future market (appreciated) rates.

Alternative 2: A Portfolio of Stocks and Bonds
The expected value of a stock and bond portfolio that averaged 10% over 20 years (despite paying the capital gains tax in a real-estate sale in the year 2007) is reflected in Table 4. At the end of 20 years, the value of the diversified portfolio is projected at approximately $11,145,000. By contrast, the value of the apartment building along with the value of the cash flows reinvested at 5% per annum would grow to roughly $11,188,000.

These numbers would be accurate if expected returns in real estate were essentially limited to 5%, while stocks and bonds delivered 10% over the time horizon of the investment (say, a 20-year period). This scenario would be plausible in an environment when stock and bond returns match historic long-term returns and in which real estate is overvalued (with subnormal returns projected in the near term).

While the expected value of the apartment building and its cash flow is marginally higher than the stock and bond portfolio under this set of assumptions, the slightly higher returns for the apartment building come with added long-term management responsibilities and added risk. It is wise to consider the cumulative risks of further rent control and property rights restrictions, earthquake risks, economic risks for the local economy and more.

Another way of looking at this analysis is that if you believe that real estate is unusually highly valued right now (in terms of rents and cash flow, not absolute dollars), then it may pay off to cash out and either increase expected returns or minimize risk and management burdens. It also means that if you can give up some risk and management headaches and are almost as well off, it may be wise to give up a bit of return.

In the event that the mortgage crisis broadens, the job market in the Bay Area turns downward as it did after the tech wreck, or another major earthquake occurs, diversifying at least some portion of your net worth out of San Francisco will likely dramatically improve the actual returns obtained in the 5- to 10-year horizon.

Tax Avoidance Versus Income Optimization
While it is true that no one wants to pay capital gains, there are scenarios in which we may do better by biting the bullet and cashing out. This would be true in the scenario in which real-estate returns going forward were lower than returns in a balanced portfolio of stocks and bonds. Such a scenario could be present in an environment where real-estate values were unsustainably high relative to rents (and/or in which cash flows or capitalization rates, calculated on today’s equity, were unsustainably low).

I would argue that both of these conditions exist in San Francisco today, as buyers are paying as much as 20 times rents, and therefore can do no better than a 3.5% return on the asset. In this environment, even with really strong rental appreciation, market values may not appreciate nearly as dramatically as they have over the past 10 years, as capitalization rates may reasonably be expected to return to something higher than the cost of capital—to 6.5% or 7% for example.

Generally speaking, we should try not to obsess over paying taxes (and the pain we feel in paying capital gains taxes). Instead we should focus on the action that provides the highest return net of taxes.

Furthermore, we cannot replicate the leverage we obtained 10 years ago since prices are far higher today relative to income. With today’s high valuations, we can only borrow 40% to 50% of the property value, not 75% as in past years when prices were far cheaper relative to income. Without that leverage, returns will not be nearly what they were in the past.

Another symptom of today’s very high valuations has to do with cap rates. If you buy (or own) an asset with a 3%-4% cap rate, and borrow at 6.5%, you are losing money on the borrowed money, not making a spread as in past years. Any small amount of debt will eat up an oversized slice of your cash flow. Thus, there are numerous conditions that make today’s environment very different than the conditions that existed 10 to 20 years ago, when prices were cheap and upside was potentially huge. Given today’s prices, potential upside appears far more limited, and a flat or down market appears far more possible.

Value of the Analysis
Whether you believe that the future will be similar to the recent past or not, you owe it to yourself to think about your financial and lifestyle goals over the next 10 to 20 years. Doing some analysis periodically will help you evaluate and manage risk, optimize your risk-adjusted return, and develop a financial future and lifestyle that is tailored to your needs.

So take some time, sharpen your pencil and grab a cup of coffee or tea. Start the process and make sure that you are on a solid path as you approach the next 10 to 20 years.

I strongly recommend that you work to:

1. Calculate the value and return on your investments; 2. Calculate your returns on the existing equity (not the historical cash investment); 3. Evaluate your objectives for risk, return, management intensity and lifestyle; 4. Consider at least a couple of other investment options; 5. Project expected returns on the various investment alternatives; 6. Weigh return, risk and management intensity on each alternative; 7. Consider which set of investments best fits your personal needs; and 8. Align your investments with the objectives you selected.

At the end of the analysis, you may choose to hold on to your existing holdings, double down (buy additional buildings in San Francisco), trade into other real-estate holdings in other classes or locations, or cash out.

In any event, the process should be informative. It will force you to evaluate risks and returns, and will inspire you to evaluate your own goals thoughtfully. The process may also lead to higher cash flows with less risk and fewer management headaches, which we all deserve.

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The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Steven Peletz is the Managing Principal at Peletz & Company Real Estate (www.peletzco.com). He advises clients in making investment decisions and helps them analyze their investment alternatives. If you have questions or feedback, Peletz can be reached at steve@peletzco.com or 415-772-7777.Copyright © 2007 by SF Apartment Magazine. All rights reserved.