Time to Invest in Real-Estate Stocks

By JAMES B. STEWART

It's springtime for real estate.

Last summer I wrote that it was time to buy residential real estate if you were in the market and looking for a bargain. I never expect to call a market bottom, and certainly not for long-cycle assets like houses, but I seem to have come pretty close. The latest S&P/Case-Shiller survey results, released last week, suggest housing prices bottomed out around April 2009, when its 20-city composite index was down 32.6% from its peak reached in June/July 2006. Since then it has gained 3% through January 2010, with some markets much stronger, especially San Francisco and Minneapolis. (Charlotte, N.C., Las Vegas, Seattle and Tampa, Fla., continued to hit new lows, but at a much slower rate of decline.)

Now it may be commercial real estate's turn. Reis Inc., a commercial-real-estate research firm, reported last week that average rents in the office sector dropped just 0.8% in the first quarter of 2010 compared to the last quarter of 2009. Rents were stable or rose in 23 of the 79 markets Reis tracks. This may not be a bottom, but it's a considerable improvement from just three months ago, when rents in 70 of the markets fell. Given the reporting lag, the bottom may well have already been reached.

If so, this moment has important implications for investors, the banking and real estate sectors, and the economy as a whole. Last year I warned that commercial real estate was a "dark cloud" hanging over the banking industry, echoing comments that were coming from the Federal Reserve. Like many aspects of the financial crisis, the clouds seem to be dissipating.

That's not all that surprising, given the recent positive economic news. Unemployment seems to be stabilizing and even improving, and workers need office space. Consumers have been spending, returning to malls in droves. Rock-bottom interest rates have allowed strapped developers and real estate owners to refinance on favorable terms. There's no doubt that many grossly overpaid at the height of the boom, and there have been some highly-publicized defaults, like Tishman Speyer Properties' decision to walk away from the Peter Cooper Village and Stuyvesant Town apartment complexes in Manhattan. But despite big write-downs, most commercial real estate borrowers have had the cash flow to keep loan payments current or refinance to buy more time.

It's true that many commercial real estate assets have already rallied strongly since bottoming in March of last year. Vanguard REIT Index Fund is trading above $51, a high for the year, and double what it was at its low for the year, to cite just one widely held example. Those who were willing to embrace considerable risk when the economy seemed to be collapsing have been amply rewarded, as they should be. Now that those risks have subsided, so have the potential returns. But I still believe long-term investors will be rewarded. The Vanguard ETF generates a 3.8% dividend yield.

It's rarely practical for individuals to invest directly in commercial real estate, but there are plenty of other ways to gain exposure thanks to mutual funds, exchange traded funds, REITs and even individual stocks that are liquid and offer diversification. It's probably never been easier to participate in the real estate sector. I suggest a mix: an exchange traded fund, a managed mutual fund, one or more REITs, and possibly some stocks of banks with significant commercial real estate exposure.

There are a multitude of ETFs and mutual funds. Among publicly traded REITs, some of the biggest, best known, and most highly regarded are Simon Property Group, Vornado Realty Trust, and Boston Properties. Among bank stocks, the biggest banks, like J.P. Morgan Chase and Bank of America, have substantial commercial real estate loans, but they amount to a relatively low percentage of their total. At the other extreme are Western Alliance Bancorp and Zions Bancorp, which, as of September, had some of the highest exposure to commercial real estate in some of the most troubled markets in the country.

These two remain high-risk propositions in my view, and I don't own them. Western Alliance has doubled from its lows, but is down by a third from the $9 it hit last May. Zions has nearly quadrupled from its low of last March, but at $24, is still far from the $88 it hit in 2007. Neither is for the faint of heart, but both may offer higher potential returns. Many regional banks occupy a middle ground between the big money-center banks and the high exposure of these two.

Whatever mix you deem prudent, I believe it's time to reevaluate your exposure to the real-estate sector. In my view, real estate belongs in every diversified investment portfolio. It's not highly correlated to equities or fixed income, and it offers income opportunities as well as a potential hedge against inflation. I've been keeping some cash on hand designated for real estate, and I've concluded it's time to put some of it to work.

—James B. Stewart, a columnist for SmartMoney magazine and SmartMoney.com, writes weekly about his personal investing strategy. Unlike Dow Jones reporters, he may have positions in the stocks he writes about. For his past columns, see: www.smartmoney.com/commonsense.

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