Real Estate Will Be Bad Business For Awhile

by: Todd Chalem

Fortunately for me I haven't had positions in REITs and home builders. Moreover, I almost certainly won't be in any when the inevitable recovery happens. Since I already have an extraordinarily concentrated real estate investment (my house) I choose not to have more exposure. This isn't to gloat, as I've had plenty of pain from small value plays in capital goods, commercial and municipal construction and trucking.

There's another reason I intend not to invest in real estate. I try to invest in good businesses with cheap stocks (or at least cheap relative to prospects) and as expectations change, the stock follows the business. Not always, but usually. What's more since I don't have any clients to please I can deviate from this approach now and again as I see fit. Thanks to Vestopia, readers can decide for themselves if I'm a genius, a moron or somewhere in between.

And I think real estate is going to be a bad business for at least as long as it was a great business.

Undoubtedly there will be exceptions. Even at random there have to be some stocks so ravaged that the mere whiff of good news will send them into orbit. But I can say from personal experience that when industries go from good to great to dreadful they don't bounce back quickly.

In fairness, industry dynamics in my former business (options market making) bear little resemblance to real estate. It's much smaller and much less fragmented than real estate. There were and are far fewer niches, orders of magnitude less institutional capital, and virtually no politicians, government institutions, reporters or commentators with even a passing interest in the business. Moreover, real estate touches nearly everyone (you have to live somewhere, after all). If all the world's options traders simultaneously died from food poisoning, pretty much only their families and employers would notice.

All that said, the business was a good one through most of the 90s and then for three years ending in early 2001 it was a remarkable business. Bid/ask spreads were very wide, volatility was high and trading volume exploded. Then the Fed cut rates surprisingly in January, 2001 and volatility went into a death spiral, only to revive in fits and starts until this past August. For much of that time, independent traders like me were being pushed aside as a handful of institutions (with better cost structures, technology, analytics and capital bases) expanded their footprints in the business.

So what does this have to do with investing in real estate stocks? Take a look at this graph from Robert Shiller, of Irrational Exuberance fame. Housing was a stagnant market from 1890 until almost 2000, though if you bought a house any time after WWII, you almost certainly made money. Then values went stratospheric after 2000.

Even when the market stabilizes (and who knows when that will be) it just can't resume its post 2000 trajectory any time soon. The forces that pushed real estate so high won't come back right away. Lenders will be more cautious. The Federal government (which has been on an affordable housing kick for almost 20 years and bears huge responsibility for this calamity) I guarantee will more tightly regulate both borrowers and lenders so that "this never happens again" (a phrase politicians use to look earnest). Am I predicting 20 years in the desert for real estate? No, but this is not a one or two year cycle.

Again, there will be pockets of real estate that will be great. Vulture investors will probably make a killing. Great stock pickers will undoubtedly find the next rocket just before it goes airborne. But if your expectation is that you can jump in and catch a killer industry that's temporarily on pause, guess again.