Time to Invest in Real Estate Again; Here's How

by: Jeffrey Dow Jones

A lot has changed in the last two months.

The latest economic data has taken a turn for the slower. The market reacted negatively and analysts are revising down their forecasts for the second half of the year. We wrote about these things two months ago, everything from a drop in the stock market to a sharp correction in commodity prices. For rational-minded individuals, this market action and negative data shouldn't come as a huge surprise.

But buried in all of that negative is a bit of sneaky-good news that not enough people are paying attention to -- especially not the emotionally-driven investors that make up much of the mainstream. It looks like residential investment will probably make a positive contribution to GDP this year, for the first time since 2005. I know that's probably not enough to get you to indulge in a glass of your favorite adult beverage and boogie down in the streets, but it's a sign that the freefall is over. That's good, right? Stabilization is what we want, isn't it?

Real estate has been one of the biggest drags on the economy in the last few years. It's such an integral part of the U.S. economy, and I'm sure you'll agree that it's difficult to see any kind of self-sustaining recovery in which real estate does not play a part. This is a middle-class industry and many other middle-class industries depend on it, everything from your local electrician to retailers like Home Depot (NYSE:HD) and Lowe's (NYSE:LOW).

Unemployment in the construction industry is nearly double the national rate. And this year, for the first time since 2005, growth in residential construction employment will probably be positive.

This industry is clearly stabilizing, and I know that's not the most popular perspective right now. But the numbers are telling an interesting story.

Here's the latest data from the Census Bureau:

As crazy as it seems, at some point this country is going to have to start building houses again. It will be forced to for demographic reasons. This was the crux of Bill Ackman's argument a while back. The U.S. will add 3-3.5 million new people to its population every year for the rest of each of our lifetimes. Where are they going to live? This will require resources and labor. It will create jobs and strengthen the economy. Never underestimate the power of good demographics.

Anyway, the point with this latest data is that the internals of the housing industry are stabilizing. It’s not growing gangbusters, but it’s finding support. This is after five years of epic deterioration. Simply eliminating this drag is one of the best bits of legitimately good economic news I’ve seen.

Barring economic disaster, it’s reasonable to think that sometime by 2013 or so this industry could be growing back in line with its historical trend. The time to prepare for that is now, not once the recovery is fully and obviously under way.

But real estate sucks!

Look, I understand. You hate real estate. Your neighbor hates real estate. All of your buddies down at the club hate real estate and you're afraid they're going to laugh at you if you tell them you're going to start investing in this space again. I totally understand. But if you want to make money in this sector you have to chin up and ignore what everybody else thinks. You have to assess the situation rationally.

It requires understanding of several factors.

The first is price. Prices in real estate are still falling. One of our predictions for 2011 was that real estate would double dip and make a new low. That's happening right now. But I think that this is the dip in which price finds something of a longer-term bottom. Most likely, it’ll be a nominal bottom, and real, inflation-adjusted prices may struggle for a while after that. But I think this is the phase where prices finally go splat.

So if you're buying a house in a declining market you have to be really, really careful about the price you pay. You’ve got to have a nose for value. You have to understand your local market and know which properties represent good value. I cannot emphasize this point enough. This is the "capital preservation" portion of this portfolio's management. Depending on whose forecast you listen to, there could be another 10-15% of downside from here. But that's nationwide and doesn't apply to the foreclosure across the street. That one may not get substantially cheaper in the next year.

Affordability is at record highs

For some context, let's look at housing affordability. It's at or near record highs on virtually any metric you choose to use. You can go to the crazy-biased NAR and check out their Housing Affordability Index.

Not bad, huh? It's the NAR, so you have to be careful of the extent to which you rely on the details.

Zillow, who I'd argue has a better data set, better quantitative metrics, and less inherent bias, just published a similar study.

Click to enlarge

Personally, I like to relate prices to incomes. I like it because Americans are hard-wired to buy the biggest, nicest house they can afford, so relating income to price tells you how normal the market is. With the exception of the bubble years, the relationship tracks as you'd expect it would.

That ratio hasn’t been this favorable since the 1970s. If you're a cash buyer and not dependent on a mortgage, that's an important chart for you.

You can also just look at measures of raw price and compare them with some sort of historical trendline. For this I used a line based on real wealth expansion, which is almost identical to the little bit of extra that houses appreciate at beyond the inflation rate. But feel free to use any other sort of trendline for this, even a normal regression.

If you want to get a slightly different perspective that also incorporates the super-low interest rate environment, then look at the inflation-adjusted median mortgage payment. There was a big spike in the late 1970′s when the 30year mortgage rate was a 15%, so who knows how helpful the details of this chart truly are. But still, the general point is that it hasn’t been this cheap to finance a house in a long while.

The bottom line is that prices are low, rates are low, and affordability is high relative to historical norms. This is the data talking, not the angry guy down the cul-de-sac who has two HELOCs and is upside-down on his house. That guy is Emotional Real Estate Guy, and you have to be careful with those guys. He got burned and he has reason to be upset.

It is his views that are driving sentiment right now. As far as I can tell, the key argument against real estate is that it will keep going down in price and never stop. Falling prices are a legitimate concern, so make sure you protect yourself and don't just buy a house willy nilly. Be patient with the market and aggressive with your bidding to secure something below market value.

Investing in real estate isn't like investing in stocks

The second crucial factor to understand is that making money in real estate is not about buying a home and holding it while the price goes up. Over the long-term, housing prices basically appreciate at the inflation rate plus a little bit which accounts for real wealth accumulation. It's not enough to get excited about if you're a buy-and-hold.

Real estate does not work like the stock market. It doesn’t naturally grow at GDP + Dividends. If you want GDP + Dividends, you can just buy the SPDRs (NYSEARCA:SPY) or Diamonds (NYSEARCA:DIA), or a bellweather like Johnson & Johnson (NYSE:JNJ), Exxon (NYSE:XOM), or Intel (NASDAQ:INTC). I like all those companies too and think they'll pair nicely with a long-term real estate portfolio.

In real estate, you have to make your own GDP + Dividends.

You have to work the property to make it pay. That means leasing it out. Check out this article from Fortune Magazine to see how people are doing that. Or read this one from the Wall Street Journal. It's a historic opportunity for people with this skill set.

The rental environment is starting to improve. And why shouldn't it? Lending standards are way tighter now, nobody has the 20% they need to put down on a property, and everyone is still smarting from all this negative equity. It's supply and demand, and the supply of renters is going up.

The 9.4% rental vacancy rate from Q4 last year was the lowest since 2003. Back in the 80s and 90s the rental vacancy rate was down around 7%. Provided the wheels don't completely fall off the U.S. economy, it's reasonable to assume that the rental market could get even stronger in the years to come as it moves towards a more normal equilibrium.

On top of that, rental yields (rental income divided by purchase price) are higher than they've been in a long, long time. Speaking anecdotally, gross yields in my city are between 7% and 10%. That's not too shabby. It might be higher in your neighborhood.

What about REITs?

If you don't want to deal with all that headache of owning rental properties but agree that the math of the real estate market is getting better, you can check out some Real Estate Investment Trusts or REIT funds. They even come in ETFs now!

The iShares NARET Residential Index Fund (NYSEARCA:REZ) gets the highest rating from Morningstar but it doesn't have the biggest market cap. It's had a pretty exciting run from the lows of 2009.

The Vanguard REIT ETF (NYSEARCA:VNQ) is much larger. It yields about 2.75% and has been recovering steadily since the bottom. The iShares Dow Jones Real Estate Index Fund (NYSEARCA:IYR) is very similar.

A lot of these ETFs and mutual funds hold the same companies in their portfolio. These are names like Simon Property Group (NYSE:SPG), Vornado (NYSE:VNO), Equity Residential (NYSE:EQR), and Boston Properties (NYSE:BXP). If you're comfortable with single stock analysis, feel free to look at those as well.

An eye on the future

If you're a short-term investor, none of this applies to you. You should get back to day-trading Apple (NASDAQ:AAPL) and LinkedIn (NYSE:LNKD). I wrote about another short-term strategy here at SeekingAlpha. Real estate investing is a long-term thing. Banish all those memories of flipping homes in six months during the boom days. That's not what true real estate investors do.

In a psychological sense, we’re all still lost in the black abyss. Hatred for real estate has only intensified this year. Posts like this from Calculated Risk are what I’m talking about. Even David Leonhardt, one of the high priests of popular economics, is feeling the hate. This doesn’t mean that we’re at the bottom yet, but it does mean we are getting close. It’s normal for people to be deathly afraid of markets that are bottoming. Do a Google search for “recency bias” if you want to understand the science as to why.

Maybe your property goes down in value. Maybe it doesn't. Maybe in ten years it's worth the same, which is probably about as sensible and realistic a guess as you can come up with right now. That's fine, you'll still have that yield and the cash flow, and in ten years the property will have almost paid for itself.

If you have the ability to work a property and make it generate cash flow and you’re smart about the price you can pay, I think there’s a lot of money to be made. Not all of the gains will come right away, but if you start getting busy, there’s a good chance a portfolio of solid rental properties could be a very valuable asset a few years down the road.

It’s gotta be better than a bag of 10-year Treasuries yielding 3% or a stock market with a low yield and expensive multiple, right?

Disclosure: I am long XOM.

Additional disclosure: For additional disclosure, reference TheDraconian.com/legalnotice. None of this should be construed as investment advice.