How to Profit in Today's Real Estate Market

Gloom and Doom

Everyone has heard that the real estate bubble has burst, interest rates are not conducive to homebuying, it's a buyers market, new home construction is plummeting, houses are sitting unsold for longer periods of time, etc. Stocks of most builders are well off their highs. Some say we have not yet seen the bottom in this market.

All this is enough to attract those with a contrarian bent. If you are looking to buy when the news is bad, could this be a good time to jump in?

It all depends on how you approach the real estate market. What we have seen in the real estate market is the demise of easy money and, with it, the demise of the McMansion. There is still significant activity in more modest homebuilding as well as in urban apartments, offices and condominiums. The companies that are diversified or derive significant revenue from these still active areas are prepared to rebound or, indeed, already have. Those companies that are still addicted to the wide margins available on luxury housing will see their stocks underperform. To use an old adage: "It has now become a market of stocks." Even Toll Bros, known for their suburban McMansions, is shifting resources into building urban apartments now. (For a couple of pro and con opinions, see this article on CNNMoney.com describing the recent trend of movement out of the suburbs and back into the city and, on the other side of the argument regarding the growth potential of apartments and condominiums, see this article at TheStreet.com)

Speaking of contrary opinions, if you look at sentiment indicators based on option put/call ratios, you will see that the outlook for the housing industry is very pessimistic. To the contrarian, the deeper the pessimism, the greater the potential for a rally. (See Shaeffer's Research web site for more background on put/call ratios and market sentiment).

Are prices too high?

During the housing bubble, especially in frothy areas like California, Phoenix, Las Vegas, etc., prices reached the point where many home buyers could not afford to buy. Now, as demand has softened, prices are falling back. As a result, we are seeing some first-time home buyers return to the market. This in turn will help other segments of the market as current homeowners will have an opportunity to move up. There is no stampede of first-timers as of yet but at least the trend is starting to turn up.

Are interest rates really killing the real estate market?

Look at the 10-year note (chart). Even as the Fed has raised rates and is now in a holding pattern, we have seen the yield on the 10-year stabilize and actually fall back to levels we have not seen since the latter part of the housing boom. With mortgage rates typically tied to the 10-year note, this is good news for credit worthy buyers. This is echoed in a recent WSJ article that puts the blame for the downturn on unsustainably high demand, not high rates. Indeed, lower rates have been a factor in a recent rebound in mortgage applications.

What about buyers who are not so credit worthy?

Ah, the Fed has done this group of consumers no favors. All the various exotic (and risky) loan products that peg payments to interest rates are starting to cause increases in defaults. The companies that are serving the sub-prime market are the companies to stay away from. Once again, it's a market of stocks so choose carefully.

Which investments to consider?

Here are a few I believe are worth investigating:

1. Tarragon Corp. (TARR) - I have highlighted this one as my Pick o' the Month for December for all the reasons listed above as well as a TradeRadar buy signal. This stock has not yet rebounded as vigorously as some of the larger players in the industry so we are just now coming off a bottom. This will help reduce downside risk. They are also more diversified than many of the single-family home builders as they have a significant revenue stream from building and managing urban properties.
2. REITs are not home builders; they typically invest in commercial property, a segment that is not doing badly. There are a number of ETFs available that allow you to play the real estate market without having to sift through dozens of REITs looking for a reasonable investment candidate. A good investment in this area is the iShares Dow Jones U.S. Real Estate Index Fund (IYR). It has had a good run over the last few years (it is now richly priced with a yield of only 3.1%) and seems to be taking a little breather since mid-November. Nevertheless, the overall trend is still clearly up with just a modest pullback during the middle of the year. More ETFs to consider are the streetTRACKS Wilshire REIT (RWR) and the iShares Cohen & Steers Realty Majors (ICF). Their charts are nearly identical to that of IYR. Speaking of charts, all these ETFs are significantly above their 200-day moving averages and are just about at the point where they usually begin to weaken. That dip would provide a good buying opportunity.

Which ones to avoid?

The usual suspects in residential construction I would avoid for now. These include Toll Bros, Pulte Homes, KB Homes, DR Horton, Hovnanian, etc. Some of these stocks have bounced back more than I think is warranted. This increases the risk of buying them today. Most of them focus on the higher end of the home market and that, I believe, is where the risk lies. Most of these guys are also taking big write-downs on land and projects that are not going to generate returns sufficient to cover fixed costs.

For an overview of the biggest names in the residential construction industry, see the Industry Center page at Yahoo! Finance.

Conclusion

If you feel that some portion of your portfolio should be dedicated to real estate, there is some good news. This may not be the most lucrative part of the market at this (post-bubble) time but there is still profit to be made if you are careful where you put your money. Avoid high-end residential home builders and sub-prime lenders. Buy the ETFs mentioned above when their prices come down. Focus on companies with significant operations in urban construction and management of condos and apartments. This approach is not for short-term traders but should provide reasonable safety and growth in one segment of a diversified portfolio.