How to Play the Real-Estate Market

REAL ESTATE TOPICS

Housing Has Seen a Remarkable Recovery, but its Foundations Look a Little Wobbly

By GREGORY ZUCKERMAN

Is it too late to catch the real-estate rebound?

Just a few years after suffering its worst downturn since the Great Depression, housing has seen a remarkable recovery. Skimpy interest rates, pent-up demand and lower prices have sparked gains of about 20% in the median price of new and existing homes over the past two years.

The Dow Jones U.S. Select REIT Index—which covers a number of investment vehicles—has climbed about 150% since the beginning of 2009, roughly matching the Standard & Poor's 500, including dividends.

But the market's foundation is starting to wobble. In June, home prices fell 0.2% compared with May's levels, according to the seasonally adjusted S&P/Case-Shiller Home Price Index tracking the 20 largest cities. It marked the second consecutive monthly decline. The dip the month before marked the first time in about three years that prices fell on a monthly basis.

JOURNAL REPORT

• 
  

True, prices for June rose 8.1% compared with last year, and data tracking the sentiment of home builders has improved. But every city in the U.S. has seen home prices rise at a slower annual rate lately. Mortgage applications to buy a home recently fell to their lowest levels since February, refinance applications were the weakest since 2008, and housing starts dropped in August.

"The pace of slowing…has been somewhat more abrupt than we had expected entering the year," says Michael Gapen, a senior economist at Barclays, who says there's "downside risk" to his bank's expectation that home prices will rise as much as 8% this year.

                       BECOME A CALIFORNIA REAL ESTATE AGENT. CLICK LINK BELOW...
                                     HTTP://WWW.REALESTATELICENSE-CA.COM

What's going on? In part, the soaring prices of the past couple years have started scaring off first-time buyers. Those higher prices have also encouraged homeowners to put homes up for sale, adding new inventory. Meanwhile, investors, who played a key role in stabilizing the market by buying bargain properties, have become more cautious.

The slowdown is good news for home buyers, of course. And recent weakness in real-estate investments, including home builders, has created opportunities for bargain hunters, some analysts say. But if the Federal Reserve begins raising interest rates next year, as expected, the cost of financing will increase—making things tougher for buyers and investors alike.

Below is a look at the new real-estate game and the best ways to play it.

REITS: Beware Rising Rates

One of the attractions of REITs is that they pay at least 90% of taxable income to shareholders as dividends, about 4% on average lately. But analysts say many real-estate investment trusts are trading at expensive levels. And rising rates could undercut REITs by making their dividends look less compelling compared with bonds.

Expensive valuations don't mean avoiding REITs, analysts say—just shifting to larger, high-quality REITs with lower borrowing, such as Sam Zell's Equity Residential and AvalonBay Communities Inc., each of which pays dividends of more than 3%. Because of their size and balance sheets, these are seen as safer bets if rates rise.

Specific types of REITs could also be particularly hard hit by rising rates, such as those focused on health care. These facilities generally have long-term leases, making rent increases harder. A better option amid rate concerns: REITs such as Extra Space Storage Inc.,Camden Property Trust and Hersha Hospitality Trust. These companies, which own apartments, self-storage facilities and lodging, likely will do better in a rising-rate environment because they can boost rents more quickly than REITs focused on other sectors, argues Matthew Werner, a portfolio manager at Chilton Capital Management LLC. 

If rate increases come slowly, most REITs should do fine, some argue. "REITs have demonstrated that they have performed well in environments when the Fed has gradually raised interest rates," says Kevin Mahn, chief investment officer at Hennion & Walsh Asset Management. For instance, he says, in 2004-2006, when the Fed raised rates 17 times, U.S. publicly traded REITs scored annual returns of nearly 28%, including dividends, and the overall real-estate market boomed.

A more diversified way to wager on REITs is with exchange-traded funds such as SPDR Dow Jones REIT ETFand iShares U.S. Real Estate ETF. ETFs are low cost and allow investors to buy and sell throughout the day, but their diversification means an investor is unlikely to outperform the overall industry.

For those more comfortable with risk, Adam Patti, chief executive officer of IndexIQ, recommends small-cap REITs. He notes that "smaller players are often attractive takeover targets."

But investors should be careful about REITs that don't trade on an exchange. These can have higher dividends than publicly traded REITs but can be hard to sell during downturns and have performances and values that can be difficult to understand, analysts warn.

DIRECT INVESTING: More Stability, Less Liquidity

Steven Karsh, principal, director at Innovest Portfolio Solutions, a Denver-based advisory firm, offers a caveat about REITs: They rise and fall with the overall market. For better diversification, he recommends direct investing in commercial and residential properties.

"REITs have a higher correlation to equities, and currently are overvalued relative to their net asset value," he says, but "within direct real estate, depending where on the risk spectrum you look, values range from undervalued to slightly overvalued. Direct real estate is illiquid, but its performance is steadier."

If inflation picks up, he adds, real estate should do well, because rents rise with inflation.

Another way to invest directly is by buying into a limited-partnership fund, a private vehicle that buys stakes in properties. The partners can avoid some headaches that come with direct investing, such as paying for the upkeep of properties; the limited-partnership structure also gives protection from certain liabilities. But these funds typically are for large investors and come with big minimum investments.

Now is also a good time to buy a home, many analysts argue. The slowing growth in prices makes homes more affordable, even as rental costs inflate for single-family homes and multifamily apartments. Meanwhile, interest rates remain slim. The average rate for conforming 30-year fixed-rate mortgages recently was 4.19%, close to the lowest levels of the year, says HSH.com, which collects mortgage data. Keith Gumbinger, vice president of HSH.com, says, "Price gains have cooled in many areas, and mortgage rates are lower than they were expected to be this year. The combination is a favorable one, and if it holds, it should provide a solid foundation for home sales this fall."

HOUSING STOCKS: Hunting for Bargains

Almost every kind of company in the housing business boomed in the years leading up to the real-estate crisis—and almost every one cratered after home prices began to fall in 2007. Lately, more investors have concluded that the future for home builders is gloomy. Their view: Americans are more comfortable renting and will keep having trouble getting credit to buy a home. "First-time potential buyers are choosing to rent instead of buy," says Peter Boockvar, chief market analyst at Lindsey Group.

As a result, it's been a tough period for many housing-related stocks. The S&P Composite 1500 Homebuilding Index, which tracks the 11 largest companies in the sector, dropped about 2.94% this year, through Sept. 18, while the S&P 500 rose 8.82%. But some stock watchers say the sector is due to rebound. Ivy Zelman, founder of Zelman Associates, says the current gloom is overstated and housing prices will continue to slowly appreciate. "People still believe in the American dream," says Ms. Zelman, who was early in predicting the housing downturn and anticipated the rebound. "The housing market is lukewarm and will get warmer."

Shares of Ryland Group, down about 12% in the past year, look attractive, some analysts say. The home builder has a solid balance sheet and builds homes nationally at various prices, making it safer than some rivals. Lennar Corp. is seen as another relatively safe and attractive builder. Home-building shares are volatile, though, so investors should consider an ETF, such as SPDR S&P Homebuilders ETF, which provides diversification. Home-furnishing companies are another way to play a slowly growing market. Some hedge funds recently added shares of floor-covering giant Mohawk Industries, up 5% in the past year.

Mr. Zuckerman is a special writ