NEW YORK (TheStreet) -- The stock market is high. Bond yields are low. You own a home and have plenty of savings. So where should you invest any extra money?
Consider what the smart money -- private-equity funds -- has been investing in, quite successfully, over the past several years: distressed real estate. The funds have spent tens of billions of dollars buying foreclosed homes and turning them into rentals.
They also have entered the business of providing landlord loans of $500,000 to $50 million at above-market mortgage interest rates to mom-and-pop investors who want to join the Monopoly game. Three large private-equity firms alone -- Blackstone Group (BX) - Get Report, Cerberus Capital and Colony Capital -- have lent $1.5 billion.
Such is the ebullience in the residential real-estate market these days. Across most of the nation, property prices are on an upward trajectory that should last through the next stock-market correction and even through much of the long-forecasted increase in bond and mortgage rates.
From an asset-allocation standpoint, buying properties to rent looks like a smart move. As both a self-directed investor and as someone who runs a mortgage bank, I believe property prices are more stable than equities are.
Banks still are seeking to sell almost 600,000 houses they have taken over from homeowners who defaulted. But the number of homes in default nationally, in May, was 1.3%, the lowest since December 2007, according to CoreLogic, an analytics provider. Some 14.6 million single homes in the U.S. are owned by individual investors and small investment funds own that 10 homes or fewer.
Those who own a home already know how well real estate has been performing. Many home owners also might be wondering how they can leverage their so far-successful bet on a home in an era of low interest rates, when paying off or down a mortgage with extra cash may not make the most financial sense.
For those home owners, rental properties, small multiplex apartments, vacation homes, second homes or even adding a small property on the lot of their primary residence may all sound intriguing.
Of course, taking cash out of a primary residence and buying another property is risky. Only those who are well capitalized and can handle the unexpected, such as the steep decline in prices that occurred during the great recession, should finance any investment in this manner. Diversifying geographically, if possible, is helpful, too.
Soaring property values also may have some investors investigating commercial properties, raw land and investments in private mortgage funds. These can't be financed with residential mortgages, however.
So, with those caveats in mind, here are some thoughts on five kinds of real-estate investments for risk-tolerant home owners.
Residential mortgages can be used to buy single-family homes and condominiums for rental properties. You'll need a minimum down payment of 20% to avoid private mortgage insurance, just as with a primary residence. Because lenders consider renters to be a slightly greater risk, your interest rate will be higher by perhaps a fraction of a percent. Insuring a rental property is more expensive, too, but usually only by a few hundred dollars a year.
Growing families, in particular, might find it advantageous to buy a second home and rent out the old home. I did that a few years ago; at one point I owned nine homes. It's still quite doable.
The short-term goal of any investment property is positive cash flow. To wit, the monthly costs of the home rented out should be lower on balance than the rent collected. And over time, the asset, as a whole, should appreciate, thanks to the land, even if depreciation is taken on the structure at tax time. Remember, too, the purchase of the property is leveraged. That is to say, if the buyer put 20% down, or $40,000, on a $200,000 house, an appreciation of 1%, or $2,000, is a 5% gain of the down payment.
Long term, think of the process as having a tenant pay off the mortgage, and, afterward, the continuing rent payments are a guaranteed income stream. Capital-gains taxes will apply when the property is sold -- and without the $500,000 exemption on the sale of a primary residence receives.
But tax deductions also can be taken annually on the mortgage interest, insurance and other expenses. Make sure, though, a lease exists to prove to the bank and the Internal Revenue Service that this home is a rental property, unless you would qualify for two primary residence mortgages.
Two- to Four-Unit Buildings
Purchasing a two to four unit apartment building with a residential mortgage is cheaper than with a commercial loan. Often buyers also make one of the units their home. The interest rate always depends on the buyer's credit history, debt-to-income ratio and the down payment. The rate, however, will be only slightly higher, perhaps five-eighths of a percent, above a comparable owner-occupied home mortgage. The interest rate and fees are lower, though, than on a commercial mortgage, too.
Down payments are generally 25%, but exceptions exist, such as the Federal Housing Administration's 3% down mortgages for residences of up to four units. In fact, as long as you can prove you are upgrading in space, and your family has grown, you can get multiple FHA loans with only 3% down.
Add Rental Space to Your Home
Here's a twist on the current interest in rentals: With rents growing faster than the cost of buying a home, some homeowners are borrowing on their home's equity (via a cash-out refinance, home-equity loan or home-equity line of credit) and using the money to add rental space to their homes. I've seen clients build basement mother-in-law apartments or construct small freestanding rental cottages behind their homes. The added income can help pay the mortgage or put extra money in your pocket, as long as zoning permits it.
The relatively cheaper cost of buying versus renting also inspires some of my clients to, rather than endure a super-long commute, purchase second homes in cities where they work rather than renting there.
Mortgage rates on second homes are similar to a primary residence with down payments as small as 5%. But there are caveats when it comes to financing: Your second home must be at least 50 miles from your primary residence, and you must be prepared to prove that this is neither a second home nor a rental.
The hot housing market also has sparked a boom in vacation home purchases among affluent owners, particularly baby boomers who are aiming to retire to pleasant surroundings. Mortgage requirements, fees and rates are identical to those for second homes with one exception: lenders need your vacation home to be not only 50 miles distant from home but also in a vacation community, such as a beach town or a mountain resort town.
The bottom line, though, on vacation homes, as seductive as they are, is that they are expensive to maintain and generally aren't practical for middle-class buyers.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stock mentioned.