Interest rates are rising, and years of double-digit price increases have left big portions of the real estate market extremely expensive. But not everything has gotten out of reach. If you stick to properties that are less vulnerable to rising interest rates, and are willing to consider some out-of-fashion cul-de-sacs of the real estate market, you can still find deals that pay an attractive income and have the potential for capital gains.
To make money in real estate in 2006, focus on the sectors that will reap immediate benefits from a strong economy -- and be extremely choosy. Real estate investment trusts (REITs) that own hotels or apartments might be good choices because they can raise their rents relatively quickly in a strong economy -- as opposed to, say, office building owners, whose tenants are protected by long leases. REITs that benefit from global trade could do well in 2006, as could REITs concentrated in Texas, which has largely missed out on the real estate gold rush.
The first rule for 2006: Don't equate real estate with your own home sweet home. For many people in recent years, "investing in real estate" has meant renovating their houses, trading up to a bigger house, or buying a vacation home (or two). The spending seemed to pay off as prices went up and up. But that was an artifact of a bull market that seems to be pretty much over. In 2006, it will become clear that from a strictly financial viewpoint, investments in the places you live can be a waste of money. The $50,000 you spend on a fancy new kitchen could upgrade your lifestyle, but it may add little value to your home if potential buyers don't like your taste. Ditto for the lovely beachfront cottage you hanker for if it's in a market that's about to fall.
If your priority is investment returns rather than luxurious living, save up the money you would have spent on your own home and put the cash into something less glamorous but more profitable. For example, rental properties in blue-collar neighborhoods of cities in the heartland that have been relatively unaffected by the housing sector's gold fever. As a landlord, you have the opportunity to upgrade the property to increase its income-generating potential. That's something you can't do when you buy shares of stock.
The ideal buy is a dog of a property on an otherwise good street. Says Erin Beitelschees, marketing manager of Recasa, a Columbus (Ohio) lender that specializes in rehabs: "The saying goes: 'If it smells, it smells like money."'
You have to look harder to find value among REITs -- corporations that own properties or mortgages and are required by law to pay out nearly all of their income in dividends. According to an October study by Standard & Poor's, REITs have outperformed ordinary stocks over the past three, five, seven, and 10 years. But their shares are trading at anywhere from 13 to 18 times next year's funds from operations -- a measure that's roughly equivalent to pretax earnings in non-real estate companies. Multiples are 30% or 40% above historical averages. "REITs have been very richly priced," says Anthony B. Sanders, a finance professor at Ohio State University's Fisher College of Business and the former head of asset-backed and mortgage-backed securities research at Deutsche Bank in New York. Sanders says some REIT executives have told him privately that they're buying expensive properties just to please Wall Street by showing continued asset growth.
So where is there still value? Some apartment REITs stand to do well because higher mortgage rates could force some would-be house buyers to keep renting, says Stephen C. Swett, chief REIT analyst for Wachovia Securities. Also, he says, apartment leases typically run only a year, so landlords can raise the rents quickly to capitalize on strong job and income growth. Swett sees value in Colonial Properties Trust, which operates in the Sunbelt, and United Dominion Realty Trust, whose stock has trailed its peers.
Some hotel REITs should do well, too. Hotels, of course, have the shortest leases of all -- often just one night -- making their revenue the most sensitive to economic strength. Lately they have been raking in the cash. In New York's Times Square area, luxury hotel chains' average revenue per available room hit $360 in October, up 44% in the past three years, according to Smith Travel Research Inc. of Hendersonville, Tenn. Says Swett's colleague Jeffrey J. Donnelly: "It becomes a name-your-rate business." Some analysts like Strategic Hotel Capital. Hurricane Katrina damaged its Hyatt Regency in New Orleans, which the mayor used as his bunker during the storm, but things are going full blast at its other luxury properties, from the Fairmont in Chicago to Miami's InterContinental.
Stay away from most REITs that own office buildings. They behave like bonds because their tenants have long leases with fixed rentals -- meaning that the value of their buildings tends to fall when interest rates rise. And steer clear of the sectors that have been driven by speculation, such as condos in Las Vegas, Miami, Phoenix, and many parts of California.
Consumer spending may grow more slowly in 2006 than in 2005, but that's no reason to reject retail REITs outright. Retail spending has grown so briskly that tenants of malls and shopping centers who signed their leases years ago have been getting a huge bargain. With the leases coming up for renewal, owners should be able to raise rents substantially, says Scott T. Crowe, global head of real estate research at UBS. He likes Simon Property Group, an Indianapolis-based giant that operates malls and premium outlets, as well as Kimco Realty, which operates neighborhood and community shopping centers. Some investors like another shopping center REIT that's also a play on Texas real estate -- Houston-based Weingarten Realty Investors, which has 40% of its rentable space in Texas.
A good way to play real estate in 2006 is to look for the sectors that will ride the big macroeconomic trends. Global trade is likely to keep expanding in 2006. Morgan Stanley analyst Gregory J. Whyte thinks that will lift ProLogis in Aurora, Colo., which has one-third of a billion feet of distribution space built or under construction -- including projects in China.
Another major macro trend is the recovery of the long-suffering Japanese economy. Crowe of UBS thinks that will boost Mitsubishi Estate, a Tokyo developer of office buildings, hotels, and resorts.
Real estate won't be the surefire investment in 2006 that it has been in recent years. But carefully chosen investments still make sense as part of a diversified portfolio.