Inspired by it all, we’re going to take a look at a star performer of the first decade of the 21st century: real estate. Of course, it’s a fallen star now.

But it occurred to us that, fallen star or not, the purchase of real estate — specifically a house — has been, is now, and will be, the biggest single financial decision we make in our lives. Besides, even with real estate in the dumps, you’ve still got to live somewhere. Home sales may be weak, mortgage delinquencies and foreclosures may be on the rise, but the fact remains houses are being bought and sold in spite of it all.

The thing is buying and selling in a beaten down market like this can wind up being a bit daunting. On the one hand, you think it’s a good time to find a bargain. On the other, how can you be sure you’re not overspending? A house that looks like a bargain today may still lose value in the next few years.

But if you’re looking at buying or selling a house right now, or think you might want to, not to worry. When we’re done today you’ll know:

• The #1 Problem With Buying Real Estate Today
• When Owning a Home Is Your Best Bet — and When It’s Not
• The Right Way To Decide Whether to Buy or Rent
• How to Know When a House Is Priced Right
• The Simplest Way to Calculate the Affordability of a Home
• When We’ll Know We’ve Hit the Bottom of the Housing Market

We hope this letter helps you to see real estate and the decision to buy or rent a home in the right light — or at least in a way that’s more suited to today’s market.

Sure enough, ever since the 1950’s that’s pretty much what real estate did. Of course, there were some hiccups along the way. The worst of these was a short period in the late ‘80’s/early ‘90’s (depending on where you lived). In metro areas like Boston, houses took a pretty good hit for a couple of years. But then they started back up again.

But now, after 50 years of virtually uninterrupted profits, we’re in the 4th year of losses. Real estate’s down over 30% in many parts of the country. It’s the first and worst national real estate fall since the Great Depression. And that one lasted from the early 1930’s until the early 1950’s. That’s right. It took about 20 years for real estate to come back to where it was in the early 1930’s.

So now we’re all a little out of shape, kind of like athletes who used steroids in the past, but now have to get back to just working their tails off to get in shape. What came easy then isn’t so easy anymore. You can’t just close your eyes, buy and hope the price will go up year after year anymore.

We’re not saying today’s real estate crash will be like the Depression. But we don’t want to be placing big bets that things will go back to what they were like for the last 50 years — at least not right now.

So it’s time to roll up our sleeves and get to work. We’ve got to start looking more closely and carefully before we buy. But before we even decide to buy at all, we suggest you take a deep breath and first consider whether owning a home is for you.

Who came up with that idea anyway? Somewhere during those 50 years of real estate going up, we guess it just seemed obvious — until 2006. That’s when real estate started heading down. Before that, it seemed pretty obvious: If real estate always — ALWAYS — goes up, naturally it must be your best “investment.”

Now, the fact is for many Americans, owning a home may have been the best use of their money. Notice we said “best use of their money” rather than “best investment.” Owning a home isn’t an investment and never was. A home is where you live. That’s it.

There’s a difference between using your money wisely andinvesting wisely. For example, you can use your money wisely when you carefully shop for a car and buy just what you need at a good price. But a car isn’t an investment.

Investing wisely pretty much comes down to starting with a clear objective, managing your risks and knowing when to sell.

What about a home? It’s certainly not like a car, or much of the “stuff” we purchase. A car, for example, loses money the minute you buy it. A home, on the other hand, doesn’t usually lose value the moment you buy (unless you bought let’s say in 2005). On the other hand, it’s not strictly an investment — where you establish a clear objective, manage the risk and set a price target to know when to sell.

Then again, it can increase in value — or at least hold its value vs. other items. The fact is a home — even if it’s not strictly an investment — can play an important role in your life, should you decide to buy. So even if it’s not strictly an investment, you might prudently use your money wisely and buy a place to live, rather than rent.

But first do yourself a favor. Think about how you really want to live. A home takes a lot of work. Even if you have others do the work, it still takes time and effort to coordinate all that — never mind the expense.

On the other hand, if, for example, you have kids and really think they’re better off in a home rather than an apartment, you’ve got to weigh that as part of your decision.

Or maybe you just like the idea of having a garden to putter around in.

Whether you own a home, or instead rent, the decision-making process should pretty much start with what sort of person you are and how you live your life. That’s it. Forget all the numbers crunching about owning vs. renting for now. The reasons vary from person to person. Just make sure you think about what you want and what you’re getting yourself into.

Start with this simple observation: most people buy more home than they really need. On the other hand, they probably would not rent more apartment than they need. How do you compare the cost of one vs. the other?

Next, consider the real costs of owning a home. They don’t start and finish with the monthly mortgage payment. What about maintenance and home improvements? These can add up — sometimes to a whole lot of money. When real estate went up all the time, people didn’t think much about this. But now that it’s been going down…

Then there’s the #1 mistake people make when they calculate the cost of owning a home. They forget all about the lost opportunity cost of owning a home. That’s the money you could have made over time by investing your down payment, (plus those maintenance and home improvement costs, in addition to other unanticipated costs) in something else instead of putting it into the house,.

These calculations can vary from situation to situation, but we’ve got a number we think is pretty safe to use. In the end, the real cost of owning a home comes to about 10% of the purchase price — per year.

So if you buy a house for $400,000, it’s going to “cost you” $40,000 a year in the long run. I know it seems like a lot, but when you count the cost of a mortgage and that opportunity cost we mentioned above, you’ll find it’s pretty accurate. It’s a lot more than most home owners think they’re spending. (And it also doesn’t factor in that concept that people tend to rent less space than they buy.)

So if the way you really want to live is worth 10% a year of the purchase price of the home, go ahead and buy.

Here’s what we think is, again, a reasonably simple, but effective way to determine whether you’re overpaying — as so many did in the last few years. Ask yourself: Can I rent this place out and cover my costs?

For this one, you don’t have to cover that 10% overall cost number we discussed above. Here you want to factor in simply annual out-of-pocket costs. Can you buy this place and rent it and not have to come up with a nickel more out of your pocket? That’s it.

Of course, you’ll probably find that even after the decline in real estate prices, it won’t be easy to find a place that meets these criteria. But that just shows you how ridiculously overvalued real estate became in recent years.

Let’s approach it this way. If you sink every nickel into your house and it doesn’t go up much in value, you’ll wind up with a nice house and no money. The financial term for that is “house poor.” We’ve met lots of house poor folks. And these folks were house poor during the heady days of the real estate boom. You don’t want to go there.

To avoid being house poor, do this. First figure on saving some portion of your gross income and invest it in something else besides real estate (you know, diversify your assets and all that good stuff). You should be looking to save at least 10% of your gross income — more if you can swing it. (We’re talking grosshere, not after tax.) At 10%, you have a chance of building some wealth over time if you invest it prudently. (Less than that, you won’t have a chance — a subject for another time.)

Subtract your FICA, Medicare, Federal and State taxes, subtract that 10% of gross income for savings, then subtract your typical monthly expenses: food, telephone, vacations, entertainment…you know the drill. What’s left?

We’ll bet it’s not anything like the numbers we’ve seen suggested in some financial publications. For example, do you wind up with 40% of your after tax income available for your mortgage? We saw someone claim that you could spend 40% of your after-tax income on a house. 40% is too high.

Listen, we’re not taking you through this to discourage you. Then again, it may help you avoid being unrealistic in your assessment of what you can really afford. Not everyone out there whose house is worth less than their mortgage was lying on their loan application or taking on unrealistically priced adjustable-rate mortgages. Some simply used ridiculous assumptions that appeared to make sense back in the day.

As long as you don’t think you can catch the bottom exactly — like some people try to catch stock market bottoms — here’s the best way to deal with this question.

(We’ve talked in the past about ways to identify stock market tops and bottoms (as well as written about this from time to time on our blog.)

First, your best approach is to re-read the previous part of our letter about how to know if a house is selling at a good price.What do you care about the market as a whole if you can get the house you want for a good price? The whole market could be overpriced, but if your house isn’t, you’re looking at a good deal.

Next, consider that when an item goes down hard for a long time (four years and counting for real estate) it takes some effort to first stop the downward trend, and then it takes more effort to start it going back up again.

Right now, we’re still in the first phase — trying to stop the downward trend. There’s still pressure on home prices. Factors include increasing foreclosures – with more anticipated through 2011. Will these put additional pressure on existing home prices? We’ll find out.

Here are some additional considerations.

The downturn occurred after what may have been the greatest national housing bubble in American history. When such a bubble bursts, you have to expect a violent reaction – exactly what we got.

Now, this doesn’t mean that we will for sure experience additional declines in real estate. After four years, and a 36% decline, real estate has certainly taken it on the chin. But the point is that, given the high level to which it was inflated, it would be prudent to withhold judgment about any turnarounds until we have pretty compelling evidence that the downturn has stopped.

The other consideration would be the possibility that real estate prices, once they do stabilize, may just sit around for a while — like they did after the Great Depression.

In addition, you have to consider that real estate prices may go up in some places, and stay flat for a time in others. A simple example: real estate geared towards the rich may turn up while real estate in middle class neighborhoods stays flat. As long as unemployment remains high, that will affect middle class and upper-middle class families more than the rich.

Conclusion: We’re still in a downdraft until proven otherwise. And it’ll take some pretty dramatic numbers over some longer period of time before we can be sure we’re out of the woods. House prices stabilizing? Probably not.

A Few Words about Memorial Day…

A war veteran recently expressed a feeling I’ll never know:

Then again, I pretty much remember them all year round, not just on Memorial Day. There’s this grand war memorial monument in one of our local parks. Every time I pass it — at least a few times every week — I say a quick prayer for them — all of those who died for my freedom and security.

For this Memorial Day, I decided to do a little research and found out there were lots more of them than I had realized.

Just counting the major wars in our country’s history (American Revolution, Civil War, World War I, World War II, Korea, Vietnam) you get over 644,000 who died in combat. Add in all those lumped into the “other” category (soldiers who died from disease, accidents, etc.) and it’s over 1,263,000 men and women. I think there are even some children in those numbers. The term “drummer boy” comes to mind.

Now maybe this isn’t kosher when it comes to Memorial Day, but when I was adding up these numbers and thinking about all those who made the ultimate sacrifice, I noticed that in these same wars, an additional 1,427,166 were wounded. And of those,over 285,000 were wounded after World War II. That means that we’ve probably got over 200,000 veterans of war living in our midst who were wounded in war. And we probably hardly notice them.

Just recently a World War II veteran that I knew died. He had received a bronze star and a purple heart fighting in Europe. All I knew about his experience in the war was that he was Jewish and derived some satisfaction from helping to defeat the Nazis.

I didn’t know he had been wounded until after he died.

What all this boils down to is that I’m grateful for that war memorial in the park. It helps me to remember — and not just on Memorial Day — the incredible sacrifices made in the past, and the sacrifices being made today to keep us free and safe from those who mean us harm. They all deserve a prayer from time to time, don’t you think?

Your looking-forward-to-a-week’s-vacation-in-Maine editor,

P.S. — Now that markets woke up in May and started scaring people again, next month we’ll take a step back and look atexactly how to assess what’s going on now — along withwhat we can expect in the coming months and years.

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com