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Outlook '08: Real Estate Offers Bargains And Damaged Goods

By Shelly K. Schwartz, |Special to CNBC.com
Wednesday, 12 Dec 2007 | 11:39 AM ET

Betting on real estate these days is not for the faint of heart.

Between the housing correction, economic uncertainty, the credit crisis and predicted softening in the commercial property markets, determining where to invest for future returns requires an extra dose of due diligence and, let's face it, good old-fashioned courage.

"Uncertainty and challenges characterize 2008, with greater downside risk than [the commercial] real estate markets have faced in close to two decades," writes the Urban Land Institute , or ULI, in its "Emerging Trends in Real Estate 2008" report. "Fear has slapped a necessary sense of reality back into investors, maybe not a moment too soon."

Indeed, speculators, blamed for driving up prices during the boom, have largely fled the market, leaving behind their more cautious counterparts -- seasoned investors -- who better understand the market's ebb and flow.

Those reading the real estate tea leaves, in fact, say investors who are still in the game stand to profit in the year ahead from opportunities created by the downturn.

"Despite its disruptive effects, the volatility in the markets has created buying opportunities, specifically in sectors that are no longer priced for perfection yet continue to have a favorable outlook," notes CBRE's Torto Wheaton Research, a division of CB Richard Ellis Group, in its report titled "Expectations & Market Realities in Real Estate: 2008."

Rental Market

The multifamily market, for one, which consists of apartment buildings and condominiums, is likely to benefit from demographic trends and the prevailing wait-and-see attitude among homebuyers.

Stephen Blank, senior fellow for finance for ULI, notes that the oldest of the echo Baby Boomer generation (children of the Bay Boom group) are just now entering their college years, producing a bumper crop of potential renters in the decade to come.

The growing immigrant population, he notes, is also feeding demand for rental housing, along with Baby Boomers themselves who are looking to downsize during retirement.

"The demographics right now favor multifamily housing investments," says Blank.

Investors should focus on cities with large immigrant inflows and high housing costs - where the average cost of homeownership exceeds the cost of renting, says ULI.

According to the National Association of Realtors, vacancy rates for the apartment rental market are projected to average 5.9 percent in the fourth quarter of 2007 and decline to 5.6 percent by the end of 2008.

Average rent, meanwhile, is expected to rise 2.9 percent for all of 2007 and 3.8 percent in 2008.

Foreclosures

The foreclosure market, of course, is also ripe for the picking, as cash-strapped homeowners struggle to keep up with the higher monthly payments on their adjustment rate mortgages.

According to RealtyTrac.com, an online foreclosure marketplace, the number of foreclosure filings - default notices, auction notices and bank repossessions - were up 94 percent in October over year-ago levels, reaching a total of 224,451 nationwide.

"From a homebuyer's perspective, we have an interesting situation right now with lower house values, mortgage rates that seem to be dropping and a growing inventory of homes (both distressed and otherwise) to choose from," says Sharga. "If you're an investor sitting on cash and you have a long-term time horizon, so you're not looking to immediately resell, it's a very good market and it will probably get better at least through the first half of 2008."

Investors in the foreclosure market today should plan to purchase property selling for at least a 30 percent discount, says Sharga. Those in cities where prices are still falling, however, should exercise caution.

"You might find that that 30 percent discount really amounts to 15 percent when all is said and done," he said, if the resale value of the property continues to drop.

REITs

Those looking for smaller scale investments and added diversification might also consider Real Estate Investment Trusts, or REITs -- companies that own and usually operate residential and commercial real estate businesses, such as apartments, shopping centers, offices and hotels.

The National Association of Real Estate Investment Trusts, or NAREIT, reports the FTSE NAREIT All REIT Index, comprised of all publicly traded US REITs, is down 11.47 percent year-to-date through Dec. 6, 2007. By comparison, the Nasdaq Composite is up 12.16 percent so far this year, the Dow Jones Industrial Average is up 9.28 percent and the Standard & Poor's 500index of large cap stocks is up 8.18 percent.

Over the last 10 years, the All REIT index has produced a compound annual rate of 10.34 percent. The S&P 500 is up 6.16 percent during that period, while the DJIA is up 5.5 percent.

With REITs suffering what he considers a temporary downturn, Philip Martin, managing director of real estate equities for New York-based Cantor Fitzgerald, says such REIT stocks represent a good value for investors in 2008.

"Generally speaking, commercial real estate fundamentals are in good shape with supply and demand in a healthy balance and that should allow for reasonably good rent growth and occupancy gains," he says.

In today's market, Martin says he favors REITs and REIT sectors with stable and predictable cash flow through any economic and real estate cycles. Healthcare REITs, including AlexandriaReal Estate Equities , Health Care REIT and Nationwide Health Properties top his list.

REITS focused on shopping centers that serve everyday consumer needs, such as Kite Realty Group Trust andFederal Realty Investment Trust , are among his top picks, along with Realty Income Corp., which owns real estate leased to retail service tenants.

On the retail REIT front, Chicago-based fund tracker Morningstar also likes CBL & Associates Properties, Cedar Shopping Centers and Vornado Realty Trust .

Homebuilders

Bargain hunting investors would also be wise to explore high-quality homebuilder stocks that have suffered serious blows in 2007, says Morningstar Associate Director Eric Landry.

"Some of these stocks have been beaten down like crazy," says Landry. Many of these stocks are down 60 percent to 80 percent on the year.

"But if you're going to buy homebuilders, the most important criteria is to make sure they're going to be around in the years ahead given today's very difficult market."

For investment guidance, Morningstar recently separated the nation's largest homebuilders into three distinct categories or "buckets."

Those that are "highly unlikely to go bankrupt" in include NVR, M.D.C. Holdings , KB Home, Toll Brothers and The Ryland Group.

A second bucket of builders, those "unlikely to go bankrupt," includes Lennar, Pulte Homes, D.R. Horton, Centex , Meritage HomesandM/I Homes.

And, finally, those for which future viability is less certain, according to Morningstar, include WCI Communities, Standard Pacific andHovnanian Enterprises.

"Risk averse investors should be concentrating on those top buckets since they have very little land," says Landry, noting he thinks M.D.C. and KB Home are particularly undervalued. "When there's blood in the streets, as there will be in the coming year, these guys will be able to move in and purchase land at very low prices. They're extremely cheap right now."

As the residential and commercial property markets retrench, investors must be willing to sift through the rubble, buy and hold for the long-term and wait patiently for the next recovery.

"Investors are going to have to be patient," says Landry. With large inventories yet to be absorbed in both the housing and commercial real estate markets, "there's still a lot of heavy lifting ahead."

(Editor’s note: Blank, Landry and Martin do not own any of the stocks they discuss in this story.)

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