Snapping Up Second Homes

Demographics and Wall Street's woes make for a superheated market

Want to buy a vacation home? Join the crowd. From Montauk (N.Y.) to Monterey (Calif.), the second-home market is on a tear. "Sales of resort condos and single-family houses around the country have been strong for the past five years, and we see no signs of slowing," says Earl Lee, president of Prudential Real Estate Affiliates in Irvine, Calif. Second homes in the U.S. sold for a record high median price of $162,000 last year, up 27% from 1999, according to the National Association of Realtors.

Low mortgage rates are stoking the boom, but there's more. A dreary stock market is prompting some to snap up second and even third homes to diversify their investments. Demographics is also a factor, with baby boomers hitting middle age, when people traditionally buy a second residence. In addition, a fear of flying is prompting some who used to splurge on overseas vacations to use the dough for a getaway they can reach by car.

Since September 11, the hottest second-home markets are in resort areas that are a tank full of gas from big cities. They include tony environs like the Hamptons on Long Island (N.Y.), as well as lesser-known areas like the Outer Banks of North Carolina, Florida's Gulf Coast, and New Hampshire's White Mountains. Resort-home prices in these areas are up 10% to 40% in the past year, local brokers say. On the Outer Banks barrier islands, prices for beach houses in upscale towns such as Duck have jumped around 25% since last summer, thanks to an influx of buyers from the Washington area. Similarly, Susan Spica, owner of Prudential Lake Ozark Realty in Lake Ozark, Mo., says her company has sold more resort condos in the first five months of this year than in all of 2001, many to professional couples from nearby St. Louis and Kansas City. Meanwhile, Seaside, Fla., on the northwest Gulf Coast, is increasingly popular with families from Alabama, Georgia, and Texas.

Is it too late to find a great deal? Not necessarily. Sure, the market is frothy, but with 77 million baby boomers set to retire in the next three decades, housing in prime spots will only get pricier. And many desirable resort areas have a limited amount of land available for new development, which should keep vacation home prices firm.

A second home may be especially affordable for empty nesters who have built up equity in their primary residence. Realtors in resort areas say many recent buyers are couples who trade down to a smaller dwelling, then use the profit to finance a weekend home where they may eventually retire. That strategy has been popular since 1997, when tax laws changed so that married couples no longer have to pay capital-gains tax on the first $500,000 of profit when selling their primary home.

Don't buy a resort home just because you think today's strong price gains will continue. If interest rates rise later this year, as some economists expect, second-home demand could slow. Also, vacation homes are luxury items that owners dump in severe economic downturns. So pick a place you'll enjoy returning to often. Investment considerations should be secondary.

Before buying, rent a vacation home to get a feel for the community. Find out which type of properties are easiest to rent or resell. On Cape Cod (Mass.), condos aren't as popular as traditional New England clapboard houses. In New Hampshire's White Mountains, Joy Tarbell, a real estate broker in North Conway, recommends prime properties on lakes and golf courses because they are easiest to sell.

In Taos, N.M., adobe-style homes are hot. So when Donnie Michael of Midland, Tex., purchased an adobe-style fixer-upper 18 months ago, he figured he wouldn't lose. Michael--who spends long weekends in Taos with wife Karen and three-year-old son Cade--has spent some $50,000 on renovations. He reckons the house, for which he paid $250,000, is now worth $350,000.

Local realtors can help you estimate maintenance and other costs. Homeowner's insurance rates, for instance, could be stiffer if the property is more than six miles from a firehouse. You might also need to arrange for driveway plowing or to have repairs made when you're not there.

If you need rental income, take a hard look at what you can earn. In many of the hottest markets, rental rate hikes haven't kept pace with home prices. In the Outer Banks, buyers who rented out their homes during the summer used to count on annually grossing an amount equal to 10% of the purchase price, local realtors say. But with rents continuing to rise 3% to 5% annually while home prices have climbed around 25% in the past year, rental income is proportionally less. Also, count on paying 10% to 40% of rental income to a management agent who arranges rentals and maintenance.

Still, renting out a vacation home can be lucrative. Five years ago, Janice and Barry Brodil of Duxbury, Mass., purchased a $58,000, two-bedroom condo in Bartlett, N.H., for family ski weekends. Three years later, they wanted more space, so they bought a three-bedroom condo in Bartlett for $109,000. Instead of selling the smaller unit, they opted to rent it out year-round, earning $13,000 last year after management fees. "It didn't pay to sell," Janice says. Another plus: The two-bedroom condo has doubled in value since they bought it.

Whether you rent or not will determine your mortgage payments. If you plan on keeping your vacation home to yourself, you'll obtain the same rates as you would with a first mortgage, says Keith Gumbinger, a vice-president at HSH Associates, which tracks mortgage rates. If you count on rental income, you may pay up to one percentage point above prevailing rates for primary residences. Second-home buyers with good credit can put a 5% to 10% downpayment on a vacation home, vs. 3% to 5% for a primary residence.

Becoming a landlord will affect your tax bill. You owe no taxes on rental income if you rent for fewer than 15 days a year. If you rent for 15 days or more, however, you must report the income. Although you can deduct rental-related expenses, the Internal Revenue Service rules governing what you can deduct are complex. If you personally use the place for more than 14 days, or 10% of the number of days rented, the IRS considers it a personal residence and you can only deduct a pro-rata share of rental-related expenses based on the number of rented days. If you limit personal use to 14 days, or less than 10% of the days rented, you can deduct more of those expenses.

Buying a second home can be tricky. But if you're smart about it, you'll wind up with a getaway that's also a dream investment.

By Susan Scherreik

Before it's here, it's on the Bloomberg Terminal.