Housing Has Hit Bottom, But Investing in Real Estate Has Not

We have hit the bottom in the US housing market. There are plenty of signs of stabilization in the residential real estate market after the horrible three year downturn. In July existing home sales were up 7.2% from the June level Abdo Romeo (the most since August 2007 and well ahead of expectations). July home sales were up 5% from a year ago, the first year/year increase since November 2005. Housing prices have recently moved up for the first time since July 2006 according to the Case-Shiller home price index. The housing affordability index has improved to the highest level in nearly 40 years thanks to lower home prices and low mortgage rates (5.3% 30-year fixed). The average home is now about one-third cheaper than it was at the peak three years ago. For the first time since 2004 sales of existing homes have risen for four straight months.

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Most of the rebound in sales has been at the low end of the market. Is now is good time to buy that cabin or that second home in Florida/Arizona/Las Vegas? I don’t expect a significant rebound in housing prices over the next few years. Housing was extremely inflated in a credit fueled bubble which has now burst. Housing prices have just now gotten back to their long-term trend which is roughly in line with inflation (3%+ per year). We are not going back to the home prices of three years ago for a long time.

Is residential real estate a good investment?

Between 1975 and 2007 residential real estate has appreciated just 1.8% ahead of inflation according to Harvard’s Joint Center for Housing Studies. By comparison, stocks have historically returned about 7% over inflation. People should think of the homes they own as consumption and a place to live, not as a likely great investment. The days of levering up and buying as much and as many homes as you can are over. Don’t underestimate the costs of owning residential real estate (such as a second home). Property taxes alone can often be 1%-1.5% of the value of your property. If you add insurance, maintenance, utilities, lawn care, repairs and other costs the total can add up to 2.5%+ of the value of your property per year. If your property is appreciating at the long-term average of 3%+ per year, your costs of ownership are eating up most of that gain. As the huge wave of baby boomers age over the next 10 years they will be selling large 4-bedroom homes in the suburbs and buying smaller homes/condo’s in the cities, in the country, and in the south. That’s bad for large suburban home prices. People used to think real estate prices only went up.

Negatives that will keep a lid on home prices for some time:

The unemployment rate is still very high at 9.4%. We are heading into the seasonally slow fall/winter time of year for home sales. The $8,000 temporary refundable tax credit for first time home buyers has been helping home sales recently but it expires November 30, 2009. Interest rates are likely to increase as the economy recovers, hurting affordability. The Fed has been pumping billions into the market to keep interest rates low. That won’t last forever. A new wave of foreclosures may be coming in the prime mortgage market and as many variable rate mortgages with low teaser rates reset later this year and next year. In the second quarter of 2009 one in 8 households with mortgages was either in foreclosure or late on their payments. Household debt remains at very high levels, and this will take years to correct. The banks are much more careful about lending to home buyers and about appraisals. Down payment requirements are up and income verification is actually required now (no more liar loans). That will not change anytime soon.

Residential real estate as an income-producing investment opportunity?

My prior comments about housing as an investment relate to homes you own for your own use. Income producing property can be a very different story if you buy right and can manage the properties efficiently. Real estate investors typically evaluate properties on an unlevered cash-on-cash return basis. That means comparing the dollars you invest in the property to the cashflow you get in the first year after all expenses. I know real estate investors who are buying foreclosure properties right now in the Twin Cities who are getting 15%-20%+ cash on cash returns (without any leverage) buying homes and renting them out. With these kind of returns you don’t need to “hope” for significant home price appreciation to get a very good return. If you are going to “invest” in real estate, do it with income producing properties. Income producing real estate investments are great diversifiers for your portfolio and provide an excellent hedge against future inflation. Most investors use income producing commercial real estate (rather than residential) in their portfolios. Publicly traded real estate investment trust (REIT) funds are good vehicles to get low-cost, liquid, diversified exposure to commercial real estate. If you can find income producing real estate properties with cash-on-cash returns significantly above other investments (such as bonds or REIT funds at 5% yields) then you may have a good investment.

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