Seven Harsh Truths
About Real Estate

It'll end in tears.

When I was growing up, that was one of my mother's favorite battle cries, as she stormed into the room to break up yet another fight between my brothers and me. Recently, that phrase popped into my mind again -- as I was thinking about today's overheated housing market.

We have entered the silly part of the real-estate cycle, where folks are saying things and doing things that are utterly ridiculous. Don't want your housing foray to end in tears? My advice: Never forget these seven harsh truths.

Even in today's booming real-estate market, making big money isn't guaranteed. Sure, we have all heard about the hefty gains in places like California, Rhode Island and Washington, D.C., where home prices have more than doubled over the past five years, according to home-finance corporation Freddie Mac.

But not every market is like these three. Indeed, homeowners in Alabama, Iowa, Indiana, Mississippi, North Carolina, Nebraska, Ohio, Tennessee and Utah have eked out cumulative gains of less than 25% over the past five years.

When the current real-estate frenzy dies, the downturn probably won't look like the 2000-2002 stock-market rout, with its terrifying plunge in share prices. Instead, the housing market will likely see moderate price declines accompanied by a sharp slowdown in sales, as homeowners balk at selling their properties for less than what they deem fair.

To get a sense of how much prices might drop, check out the early 1990s performance of two of today's hotter markets, Boston and Los Angeles. According to Freddie Mac, prices in the greater Boston area sank 10% during the 30 months through mid-1992, while Los Angeles was hit with a grueling six-year 21% decline.

Homeowners often quip that the bank owns most of their house. This, of course, is nonsense. The bank has merely lent these folks money. Whether their property is 60%, 80% or even 95% mortgaged, they are still the owner and thus benefit from every $1 of price appreciation and suffer every $1 of loss.

Usually, that's reason to cheer. Suppose you buy a $300,000 house, putting down $60,000 and borrowing the other $240,000. If your home's value climbs 20% to $360,000, your home equity would double, from $60,000 to $120,000.

This leverage, however, can also work against you. Let's say you bought that $300,000 house in Los Angeles in the early 1990s, just before prices dropped 21%. Suddenly, your house is worth just $237,000 -- and your down payment has been wiped out.

What if you need to sell? With any luck, you will have whittled down a decent chunk of your loan balance with your regular monthly mortgage payments. Still, once you figure in the brokerage commission you will pay to sell, there is a chance you could leave the closing empty-handed.

Because it costs so much to sell real estate and because the combination of leverage and a home-price decline can be so devastating, you shouldn't purchase a house unless you plan to stay put for at least five years and even longer if you are buying in one of this year's frothier markets.

Yet, today, stories abound of people buying properties with a view to unloading them in a matter of months. What can I say? A few years from now, we will look back and marvel at such foolishness.

Unlike today's housing "day traders," most successful long-term real-estate investors don't buy properties solely for price appreciation.

Instead, these investors are focused on the rental income they can collect and how that rent compares with each property's monthly mortgage payment, property taxes and other costs.

There's a lesson here for home buyers. The biggest reason to purchase a house is so you can, in effect, rent it to yourself. Indeed, the value of this "imputed rent" will likely be far greater than any gain you score from price appreciation.

The bottom line: When you buy a house, focus on finding a place that you will enjoy living in and where you can envisage staying put for a good long time -- and view any price appreciation as a bonus.

Many homeowners think that remodeling the kitchen, adding a deck or replacing the roof somehow constitutes an investment. It just isn't so. In 2004, Remodeling magazine analyzed 18 home-improvement projects. In all 18 cases, the magazine found that homeowners were unlikely to recoup the full cost when they went to sell.

In other words, if you fix up your home and sell it a year later, you might recover 80 or 90 cents out of every $1 spent. And the longer you wait to sell, the less you will get back, because your home improvements will look increasingly shabby.

That doesn't mean you shouldn't fix up your home, especially if you will get a lot of pleasure from the resulting improvements. But think of these improvements as spending, not investing.

These days, I hear stories about folks borrowing against their homes to take vacations and buy new cars.

Their justification: Whatever they borrow is less than their home's price appreciation, so they are still ahead of the game.

Eventually, however, all this mortgage debt will have to be repaid. But when? In many cases, homeowners plan to trade down when they reach retirement and use the proceeds to pay off their loan balance.

This plan may work. But keep in mind that trading down can involve unpleasant choices. To get your mortgage paid off while buying a comparable home, you may have to move to another state.

Alternatively, you could opt to purchase a smaller place in the same part of the country. Problem is, you will probably be inclined to buy in a better neighborhood or get a home with a better view. "I've had people downsize in size," says Charles Farrell, a financial consultant in Medina, Ohio. "But they don't downsize in price. The price is pretty comparable."

Email your comments to rjeditor@dowjones.com.