A common staple of finance websites and literature is a comparison between different investing options. Stocks? Bonds? Real Estate? Where should you put your money?

The answer, of course, will depend on your resources, your risk appetite, and your goals. But for investors who still have a fair amount of runway ahead of them before they hit retirement, most comparisons fail to highlight the true benefits of investing in real estate. 

The bottom line:

Over the long run, the stock market has yielded great returns. From 1987 to the present the S&P 500 has appreciated at an average rate of almost 10% per annum, and the NASDAQ has averaged over 11%. Over the same period the average home price in America has increased at around 5.6 percent. 

This is the comparison upon which many analysts focus. One dollar invested in real estate in 1987 would be worth around $2.84 today. That same dollar would be worth $5.74 or $7.31 were it invested in the S&P 500 or the NASDAQ, respectively. But this is the whole picture

Volatility: Real Estate Bubbles vs. the Stock Market

We’ll get to leverage in a moment – that’s where these conversations inevitably lead. But the first thing to consider is volatility. 

Yeah - we know that stocks yielded an average of 10% to 11% over the past twenty years or so, but how did we get from point A to point B? Investors will remember the period from 1999 to 2002 which were rough years for the sock market. From its peak in August of 2000 to the bottom in September of 2002 the S&P 500 lost over 40 percent of its value. Over roughly the same period the NASDAQ declined by a whopping 75 percent. Eventually the market managed to shake off these doldrums, but this was a tough period for investors. 

Real estate has hit some hard road bumps too. It’s interesting to compare the severity of regional real estate downturns with the stock market collapses listed above. Global Insight periodically releases a study of market valuations in which they list, among other things, a summary of major past price corrections. The most severe being associated with the oil bust in the ’80s; fellow Texans will remember this period.

• Lafayette LA, declined by 35% over 15 quarters
• Odessa TX, declined by 28% over 18 quarters
• Abilene TX, declined by 28% over 11 quarters

All three of these markets were significantly overvalued before they fell. The lesson here being: what goes up must come down, and investors who live in regions characterized by overvalued markets have reason to be concerned. 

If you live in certain parts of Florida, California, and other overheated regions of the country, this means you.   But for the rest of you: note that the three historical cases above are the worst of the worst. There never in recent history has been a major national correction in real estate prices, and most regions have experienced continuous growth in property values for decades. Watch out for regional markets that have been spiked into a speculative frenzy - but overall, volatility in housing prices is low.

It doesn’t make sense to talk about leverage without first talking about volatility. You can use leverage to turbo-charge the returns on about any investment, but high volatility usually makes leverage prohibitively risky. 

Not so with real estate.

Aside from a handful of regional exceptions notwithstanding, real estate prices historically have marched steadily upwards at a steady 5.6 percent per annum. Factoring in leverage this return ratchets up to over 13% per annum; considerably better than stock market returns at lower volatility. 

What is leverage?

Simply put: a dollar invested in stocks buys you one dollar’s worth of stock. But that’s not the way we buy real estate. A typical investor might put $20,000 down to buy a $100,000 home. So instead of getting one dollar’s worth of house for your one dollar investment you’re getting control over five dollars worth of house. 

That’s 5:1 leverage. One buck from you, and four bucks from the bank. 

That $5 invested in the housing market in 1987 would be worth around $14.18 today. Assuming that you hadn’t paid down any of the mortgage your $1 investment would be worth $10.18. Compare that against the $5.74 that your S&P 500 investment would be worth or the $7.31 that your NASDAQ would have netted. 

The upside...

I’ve made some simplifications, but overall they’re conservative ones:

• Dividends and rental cashflow. I left ‘em both out of the analysis. But any property that you’ve had for twenty years will be raking it in cashflow-wise, whereas corporate dividends these days are pretty skinny. Advantage: Real Estate.
• Paying down the mortgage. Back in the late '80s interest rates were hovering around 10% (gasp!). At this rate a standard fixed 30 year mortgage would have paid off around 30% of its principal balance over twenty years. That’s another advantage that I haven’t included in the comparison. Advantage: Real Estate

Timing can be important and in some regions now isn't the best time to be jumping into the market, but over the long term it's hard to argue that real estate doesn't have a place in your portfolio. 

There’s a multi-factorial equation brewing out there that is going to impact real estate investors. 

Concerns about flatting property prices tend to get the most press time, along with the ongoing sub-prime lending soap opera. And we’re all keeping an eye on interest rates and hang on Bernanke’s every word. But in my opinion the real story will be how all these factors impact all those risky loans out there, and this is a die that has yet to be cast. 

First American CoreLogic recently released a study on Mortgage Payment Reset and the potential impact that it will have on our economy. Note that First American CoreLogic is an arm of First American – and many visitors will be familiar with First American Title, one of the nation’s largest Title companies. The point being: just like the National Association of Realtors the title industry has a dog in this fight so be careful about taking all of CoreLogic’s conclusions without a bit of scrutiny. But that said, there’s a lot of good data in this report. 

Here’s something that jumped out at me. In 2006 lenders issued $200 billion in ARMs w/ their first reset in 2006. Of that $200 billion worth of quick reset mortgages the vast majority was at super-low teaser rates of less than 2%. Seemed like a good idea at the time: rising prices and brisk home sales made the risks easier to stomach.  Now that market has cooled those 2006 resets are causing problems for many buyers who were overstretched in the first place, and that’s what’s triggering the current wave of foreclosures. 

But, there’s more to come. Most of the ARMS originated in 2006 w/ 2008 resets ranged from 6% to 9% initial rates. Sub-prime territory. And these folks, based on CoreLogic’s assumptions, will be facing increases of from 30% to 50%. The second half of this story is that 23.9% of ARMs originated in 2006 have negative equity, versus only 10.3% of fixed rate loans taken in the same period. 

So not only were ARMS used by the most vulnerable buyers, they were also more than twice as likely to be used for properties in which the owners had no equity. The punchline: during the run-up ARMS were used as an instrument to buy homes that people couldn’t really afford. 

The New York Times ran an interesting article today advising those homeowners who are about to get into trouble to negotiate with their lenders. Many owners don’t realize what we do as real estate investors: the bank doesn’t want your house. Foreclosure is a disaster for the homeowner, but it’s no picnic for the bank. Expect troubled owners to take a page out of the short-seller’s playbook.

Figures released last week indicated a contraction both in housing starts (lowest level since 1997) and in median sales prices.  Median prices fell in 73 metro areas in the final three months of 2006.  These results on the back of one of the strongest housing booms in U.S. history.  The sober view is that concern is not unwarranted.

Glance at today’s USA Today, however, and you’ll get the idea that everything is rosy; unless you dig into the article you might come to the conclusion that some positive numbers have been release.  The main headline on the front page of the Money section (three of our columns - use your imagination if you're looking at the online version): Realtors expect home price recovery.  The first quote is from David Lereah expressing optimism that a “discernable improvement in both sales and prices” is already upon us. 

Real estate professionals will know who David Lereah is, but some investors might not.  Lereah is the Chief Economist for the National Association of Realtors®.  The NAR is the industry group charged with keeping the real estate market moving, keeping prices on the rise – and most importantly ensuring that sales volume stays high, which means more commissions flow into Realtors® pockets. 

A statement from Lereah isn’t "news", it’s a sales pitch.  Lereah is just doing his job – trying to convince homebuyers (and investors) that everything is rosy.  The problem is that consumers will read an article like this one – prominently published by a high volume national news source like USA today, and mistakenly conclude that it’s news. 

So what does it mean to me?  Two things to consider as an investor.

• Consider the source.  It’s fine that the National Association of Realtors® has a voice in the press, but don’t give their forecasts and vies the same weight that you’d give to an impartial market expert.  The NAR has a point of view that they’re trying to sell. 

• Look at the underlying numbers.  Even a bad article like this can yield some information.  National median sales price for an existing single family home is down 2.7% nationwide from the same period last year – so instead of trending upwards with inflation (the natural path) the market has entered into a quantifiable correction.  Ask yourself “is this enough.”  What’s your view on your own area. 

• Be skeptical about some “information” you get from the popular press.  I note that on the same page of the USA Today they have a color photograph of the new Ford Edge HySeries prototype SUV, a fuel-cell plug-in hybrid that the paper refers to as “pollution free”.  This is simply wrong.  A car that you plug into your wall to recharge runs on electricity, and the vast majority of electricity in the United States is produced by power plants that burn hydrocarbons – primarily coal and natural gas.  Electricity isn’t free, and it can’t be produced unless you burn something, which creates pollution.  Fuel cells run off of hydrogen, which in itself is clean, but is produced as a by-product of natural gas – again, a hydrocarbon. All cars pollute – it just makes us feel a bit greener if the pollution is coming from the smokestacks of a remote power plant or hydrogen facility instead of the tailpipe of the car we’re driving.  A tangent from the topic of real estate?  Perhaps – but for me it’s a clear example of the fact that the press will simplify issues until they’re simply wrong – and that’s dangerous for an investor.  

Glance over at Wall Street and you’ll find some troubling indications on the health of some of the lenders.  We know that foreclosures are on the rise and that there are looming concerns about interest rates, but seems that the analysts are taking notice. 

New Century Financial Corp (NEW) took a big hit late last week on the back of news of  an unexpected fourth quarter loss .

New Century Financial focuses on sub-prime lending, the market that is taking a disproportionate share of the blow being dealt to financial institutions by rising default levels.  Sub-prime lenders get a lot of scrutiny from watchdog groups and consumer advocacy organizations - and rightly so; this is a market that is prone to abuse.  But inarguably sub-prime lenders provide a service to the real estate community by offering options to potential homeowners who otherwise would be unable to purchase a home.  Look for liquidity to be negatively impacted as these companies get clobbered – which will impact homeowners as they try to refinance adjustable rate mortgages that they entered into back in rosier days. 

So what does it mean to me?  Well a lot of real estate investors have jumped into risk/complicated loans during the easy-money days, with they expectation that they would either a) sell the property or b) refinance in the future.  Well refinancing will get harder if the current trend continues; they very companies that started the trends in sub-prime lending and exotic mortgages are on the brink of leading the market towards tightening lending standards.  Take a look at your situation and decide whether or not you need to take action. 

See also:

• Option ARMs in the news
• Mortgage choices for investors

Today economy.com and cnnfn.com released the most recent data on housing prices, compiled for November of 2006 - it's clear that the slide in values is starting to accelerate.  The chart below shows the one month change in housing prices - for the first time we're seeing negative bars almost across the board. 

Surprises...
Most of these results were as predicted.  Overheated markets like San Diego, San Francisco and Phoenix are starting to backpedal - but there are a couple of things that caught me by surprise.

• Dallas:  Should be a safe haven at these levels, undervalued by more than 20% according to the recent Global Insight study - yet it gives up ground, falling by half a percent in November. 
• Miami:  Continues to tear it up.  Overvalued by more than 60%, Miami is up almost 8% year-on-year and continues to rise, going up half a percent in November. 
• Boston:  Surprises as the biggest loser, down almost 2% in November. 

Investors...Expect a wild ride in coming months, and note that contrarian speculators with nerve can make profitable trades in markets like Miami as owners with jittery nerves hit the exits.  But note that I said "speculators", not "investors" - personally I'm still a fan of undervalued markets where your investing dollars land properties that yield positive cashflow.

I wrote a few days ago about the phantom bounce that some housing statistics may be implying.  The New York Times has followed up with an additional piece on the evolving condominium market, which might flag some opportunities for real estate investors.  

The condominium market is more vulnerable to large fluctuations in price because they disproportionately attract speculative investors, as opposed to single family homes.  Residential homebuyers tend to be less fickle – a property which is purchased as a home as opposed to an investment is less likely to be whipsawed by the market.  

That’s starting to show in some major metropolitan markets where condos used to be selling like hotcakes, but are now slowing down.  Buyers in some cases are forced to sell at a loss – or to rent them out at a rate that turns them into negative cashflow investments.  

This, undoubtedly, will turn out to be a blip in some areas, not a long term trend.  Nervy, contrarian investors can find bargains by jumping onboard when everyone else is headed to the lifeboats – and this current wave of woes was prompted by investors who did exactly the opposite: they broke ground when the market was white hot and development costs were through the roof.  

Check out these stats on the WashingtonDC area.  

Note:  the downturn at the tail end of the "condos sold" graph is in reality likely to be even more severe than the chart indicates, given that cancellations are probably not accounted for. 

Shoot me a note and let me know how your metro area is faring.   

...but some are starting to cool. 

This month Global Insight and the National City Corporation teamed up to publish a survey of regional housing market valuations.  Of the 317 metro areas evaluated:

• 219 (69%) showed a slowdown in appreciation over the past year
• (21%) showed outright declines in property values
• 79 (40%) qualified as extremely overvalued. 

See the full study here.

The most overvalued metro areas were clustered on the west and east coasts with California and Florida dominating the top twenty.  Naples FL had the highest overvaluation at 101.5%, followed by Bend OR at 89.3% and Salinas CA at 79.4%.

At the other end of the spectrum, seven of the ten most undervalued markets were in Texas.  College Station, home of the Texas A&M Aggies, was the most undervalued at -22.3%, followed by Dallas TX at -21.2%, Fort Worth TX at -19.3% and Houston TX at -17.3%.

Source:Global Insight/National City Housing Valuation Analysis

The paper also lists the major regional price corrections of recent years.  Texas also features heavily in this list; back in the mid 80’s the oil industry fueled a glut of investing that resulted in a speculative bubble which spectacularly popped when the oil market crashed.  Houston declined by 21% over 12 quarters.  Odessa, another oil hub, declined by 28% over 14 quarters. 

The current market condition in cities like Houston and Fort Worth has created an environment in which it is comparatively easy to find investment properties that generate positive cashflow at relatively low risk.  The ratio of rents to property values is high, and although there is always market risk the probability of an absolute decline in mean values from this level is relatively low. 

Investors in overvalued markets however should be wary.  Price dips might look like buying opportunities, but at these levels getting into the market feels more like speculation than investing. 

David Lereah, the chief economist for the National Association of Realtors, gave a view of the future of the housing market this week during  a meeting of agents in Saratoga Springs.  In Lereah’s estimation the decline that started in the third quarter of 2005 was a needed cooling off period, but would be short lived. Interestingly, he stated that a rebound would occur in the next three to six months in most regions, but prefaced this prediction on the condition that the Federal Reserve shows restraint in raising interest rates. 

Lereah’s most quotable statement was in reference to the median price for a single family house in San Francisco: $740,000:  “Who can afford that?”

Read the full article here

Note that prices vary widely by region.  As a sample, according to NAR figures Houston averages $152k, Orange County $726k, Boston $421k, Chicago $278k, and Springfield $112k.