For investors, "home" is no longer a four-letter word.
The real-estate sector, for the first time in years, is serving as a beacon of relative strength in an otherwise weak economy. Standard & Poor's on Tuesday reported that home prices in its S&P/Case-Shiller 20-city index rose 0.9% in May from the prior month, after adjusting for seasonal trends, and have risen 2.6% since bottoming in January.
Some of the world's smartest investors, including Warren Buffett, are taking notice, placing big bets on a continued recovery in the housing market. Other kinds of real-estate investments -- including real-estate investment trusts that own shopping malls, apartment buildings and hospitals -- also have been among the best performers this year.
For ordinary investors, the rebound serves as an opportunity to rethink how much of their portfolio should be in real-estate investments -- and to participate in the rebirth of a sector they once left for dead.
"After the recent returns we've seen, people are naturally asking 'Have I already missed it or is there further upside to come?' From our perspective, yes, there's further upside," says Frank Haggerty, a portfolio manager at money manager Duff & Phelps Investment Management who comanages a $1.3 billion mutual fund that invests in commercial-real-estate companies.
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To be sure, some promising signals during the recession turned out to be false alarms. In mid-2009, the 20-city S&P/Case-Shiller Home Price Index began a yearlong rise, only to fall again. Yale professor Robert Shiller, who called both the early 2000s stock-market crash and the recent real-estate bust, says he isn't certain prices have bottomed.
But even if the absolute nadir hasn't been reached, most economists say the odds are good that real estate will be stronger over the next few years than it has been in the past few.
Meantime, experts say that because commercial real estate is such a big part of the economy, it should make up about 15% or more of the stock portion of an investment portfolio. Yet these days, commercial real estate comprises only about 3% of funds that track the broad stock market -- meaning investors who follow the major indexes are drastically underexposed.
With that in mind, here is how to play the real estate turnaround smartly in three main ways -- investing in home builders, buying real-estate investment trusts and buying and managing individual properties.
Picking the Best Builders
At least some of the real-estate recovery already has been priced into the market, experts say. The iShares Dow Jones U.S. Home Construction (ITB: 16.96, 0.16, 0.95%) exchange-traded fund has returned 35% this year including dividends, according to investment-research firm Morningstar, trouncing the S&P 500's jump by 25 percentage points.
But even with the increase, housing stocks are still 66% below their May 2006 level, when the housing crisis was just getting started.
There is reason to believe some home builders have more room to run, says Mark Luschini, chief investment strategist at Janney Montgomery Scott. While valuations might look rich at first glance, the numbers are skewed, he says. Investors commonly value home builders by looking at the ratio of their share prices to their book value, a measure known as the price/book multiple. But those ratios look artificially high because builders' land and other assets are just starting to reflect the recovery, he says.
The ratio "is distorted," he says. "Even without making heroic assumptions on new-home sales, there's room for home builders to go up."
Another reason to be bullish: On average, after home prices reach their trough, upturns last seven years, according to a study by the International Monetary Fund of 55 housing rebounds world-wide since the 1970s. So, if a bottom has in fact been reached, home construction companies could be in for another 6 years of increasing sales.
The easiest way to make a broad bet on home builders is through an ETF, such as SPDR S&P Homebuilders (XHB: 22.16, 0.17, 0.77%) or iShares Dow Jones US Home Construction (ITB: 16.96, 0.16, 0.95%) . Given the market's run-up, however, it might be smarter to stick with specific home-related stocks that have the most room for growth, says Bob Wetenhall, a senior analyst at RBC Capital Markets.
KB Homes (KBH: 10.10, 0.32, 3.27%), for example, has shown improving new-home orders that set it above other home builders, Mr. Wetenhall says. What's more, after accounting for tax benefits that it accrued during the housing downturn, the company's price/book ratio is 1, about 30% below that of other home builders, he says.
Lennar (LEN: 30.51, 0.14, 0.46%), which has a price/book ratio of 1.5 after adjusting for tax benefits, looks expensive next to its peers. But since it gets revenues not only from single-family homes but also multifamily housing and other kinds of real estate, it will be buttressed, Mr. Wetenhall says.
Rethinking REITs
Although single-family housing made the headlines during the real-estate boom, the performance of real-estate investment trusts -- which mostly manage portfolios of commercial properties such as office parks, malls and apartment buildings -- was also spectacular.
The National Association of Real Estate Investment Trusts index of publicly traded REITs nearly tripled between January 2003 and the index's peak in January 2007, including dividends -- making large-company stocks' total return of 62% look paltry by comparison.
Then equity REITs, which primarily own real estate rather than mortgages, were crushed during the downturn, losing more than two-thirds of their value from their 2007 high. But equity REITs have risen 15% this year and now are about even with their peak, after dividends.
Many financial advisers argue that since REITs already make up about 3% of funds that track total stock-market indexes, they don't deserve a separate allocation in a portfolio. Others say REITs should get up to 20% of the overall pie because of their low correlations with other asset classes and high dividend yields.
The right answer is in between.
In the last decade, REITs increasingly have moved in lock-step with the broader stock market, according to a Morningstar analysis, meaning their low-correlation benefits are nearly gone.
And since the 1970s, REITs' dividends have also grown more slowly than inflation, knocking down that benefit, says money manager William Bernstein, author of "The Investor's Manifesto."
But investors should put a hefty chunk of their portfolio in REITs, says Rick Ferri, founder of investment adviser Portfolio Solutions.
The reason? Most commercial real estate isn't publicly traded, so broad stock-market funds grossly understate the sector's importance to the economy, Mr. Ferri says. To make up the difference, investors should invest an extra 10% of their stock allocation in equity REITs -- -which would turn a hypothetical 60/40 portfolio into one with 54% in a total stock-market fund, 6% in a REIT index fund, and 40% in a total bond-market fund, Mr. Ferri says.
Warning: Don't confuse equity REITs with mortgage REITs, which use short-term debt to buy long-term mortgage-backed securities and are more of a bet on interest-rate and credit-quality trends than real-estate performance, says Mr. Bernstein.
The easiest way to capture equity REIT exposure is with a low-cost index fund, like the Vanguard REIT (VNQ: 65.75, -0.52, -0.78%) ETF, which has an expense ratio of 0.10%, dividend yield of 3.3%, and has returned about 17% this year, including dividends.
Finding bargains among specific REITs might be more difficult, given the recent rally. Experts suggest starting with valuation.
Rather than use a price/earnings ratio to value real-estate investment trusts, many REIT investors calculate a price/funds-from-operations ratio, which excludes depreciation and amortization -- both hefty expenses for heavy property owners.
Based on that measure, the valuations of REITs in some sectors already are approaching their 2007 heights. REITs that own industrial properties, for example, had a forward P/FFO multiple of about 15.4, according to Nareit, the same level as in January 2007. And REITs that own regional malls have a P/FFO of 15.4, above 2007's 13.7.
On the plus side, apartment REITs' multiple of 17.2 is still well below the 19.6 level seen in 2007.
REITs that will benefit most from an economic turnaround will be those with shorter lease terms that can quickly raise rents, says Mr. Haggerty of Duff & Phelps, making those that own hotels, apartments and storage units the strongest players. High-quality mall properties also will fare better in a slowly expanding economy, he says.
For example, as of the end of May, Mr. Haggerty's fund had positions in self-storage REIT Extra Space Storage (EXR: 32.99, -0.15, -0.45%) and apartment REIT Essex Property Trust (ESS: 150.86, -2.64, -1.72%) . The fund also had holdings in mall owner Simon Property Group (SPG: 158.53, -0.86, -0.54%) and regional-mall REIT Taubman Centers (TCO: 78.33, -0.60, -0.76%) .
Being a Landlord
Although home builders and REITs have risen in anticipation of the real estate turnaround, the prices of single-family homes have barely begun to increase.
To value single-family homes, some investors divide average home prices, as measured by an index such as that run by S&P/Case-Shiller, by "owners' equivalent rent," which is calculated by the Bureau of Labor Statistics.
By that measure, home valuations are almost as low as they were in the first quarter of 1998, well before the most recent real-estate run-up began.
That has caught the attention of many investors, including Mr. Buffett, who in February said he would buy "a couple hundred thousand" homes if it were practical.
Instead, Mr. Buffett has said he plans to bid on the loan portfolio of failed mortgage lender Residential Capital and also has profited from gains at some of Berkshire Hathaway (BRKB: 84.73, 0.06, 0.07%)'s home-related subsidiaries, including paint maker Benjamin Moore and modular-home builder Clayton Homes.
Smaller investors could benefit from the trend as well, experts say, by directly buying properties.
Of course, renting out homes and apartments can be tricky. Investment property owners have to deal with problems ranging from prolonged vacancies to deadbeat tenants. They also might underestimate maintenance and insurance expenses and overestimate rents.
Cash buyers often are favored by sellers and might even command a better price. But banks are willing to lend for investment properties as long as the investor can make at least a 30% down payment on the home, says Bankrate.com senior financial analyst Greg McBride.
For investors who aren't keen on dealing with such obstacles but want exposure to single-family housing, an alternative is coming.
In May, private-equity firm Kohlberg Kravis Roberts (KKR: 14.00, -0.03, -0.21%) and home builder Beazer Homes (BZH: 2.68, 0.13, 5.10%) announced plans to soon go public with a REIT that will own and rent single-family homes. Other private-equity firms have announced similar intentions.
"There's great opportunity in actually buying residential homes directly for investors who have the capital," Mr. Luschini says. "Prices are clearly turning the corner, and housing affordability is the highest in a generation."
Taken from: http://www.smartmoney.com/invest/strategies/how-to-invest-in-a-realestate-rebound-1344285855698/
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