Why Real Estate Is Dead for Years to Come

“Profit Confidential” Column, by Michael Lombardi, CFP, MBA

Too often lately, I’m hearing from my friends and colleagues, “I think the real estate market has hit bottom…I’m looking for investment properties to buy.” In my humble opinion, those who are looking to buy real estate now, because they believe property prices have hit bottom, are dead wrong.

We are often tempted to buy that house down the street that we can rent out to get some income coming in. Maybe it is that strip plaza with three or four tenants you’ve suddenly found out is for sale. For bigger players, it’s a bet on the bottoming out of the commercial property market (factories) now that the economy is turning around. Or, on the personal side, it could be that condo in Florida or house in the country you’ve always wanted.

Here are two important points about buying investment real estate that we should never forget. And they are also the reasons why I’m against real estate as an investment today.

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Firstly, after a real estate price cycle has bottomed, it takes years for prices to start moving back up. So, if my colleagues are right and the price of real estate is at a bottom for this cycle, historically it could take up to five years after a price bottom for prices to start moving back up due to inventory backlog. As an investor, I always like to buy an investment when it is rising in price. What is the use of holding something for five years with no price increase?

Secondly, and more importantly, what most people forget is that investment real estate trades in relation to interest rates. From the early 1980s until now, interest rates have come down. And during that period, investment real estate has moved up.

We’ve just come off 27 years of declining interest rates. If we know the Federal Funds Rate is at zero to 0.25%, where is the only way interest rates can go in the future? The answer is up. And when interest rates go up, real estate falls in value.

Let’s look at it this way. Ten years ago, investment-grade properties were trading at a cap rate of about 10 (if you bought something for a million dollars, you could have expected a $100,000 a year net return). Since interest rates fell so aggressively the past decade, it got to the point where investors were buying real estate deals at a cap rate of five (if you bought an apartment complex for one million dollars and you would have netted $50,000 a year).

A five-percent return sounds like a deal when T-bills are paying less than one percent. But add in a bad economy and that five-percent return from your real estate investment all of a sudden is returning three percent to four percent because of vacancies. As interest rates rise, and T-bills start going back to the three-percent return level, investors will move out of investment real estate and back into guaranteed returns of government-issued securities.

Throughout history, real estate has traded based on the direction of interest rates. Given the record amount of monetary and fiscal stimulus by the U.S. government this year, given the fact the U.S. dollar could face a crisis, given the fear that inflationary pressures caused by the government’s massive monetary easing are a huge risk, rising interest rates are only a matter of time. And that’s why I believe that investment real estate is dead for years to come.

(On Monday of this week, huge real estate company Capmark Financial, which is owned by GMAC, Kohlberg Kravis and Goldman Sacks, filed for bankruptcy.)

Michael’s Personal Notes:

You have to love consumers. They are always wrong. When the stock market is at a high (October 2007), they are jumping in. When the stock market is at low (March 2009), they are jumping out. When real estate is at a top (2005), they can’t get enough homes to buy.

Yesterday, the U.S. Conference Board’s Consumer Index was released, showing that Americans are more worried about the economy now than they have been in past 30 years. Do you think they are right? Maybe in the long term they are right, but I say they are wrong in the immediate term. The stock market is telling us at least that much.

Where the Market Stands:

Nerve-racking out there, isn’t it? One day the Dow Jones Industrial Average is up, the next it is down. So what is the real direction, up or down? I’m a big believer in the adage, “The trend is your friend.” With the Dow Jones up 12.6% since the beginning of 2009 and up 53% since its multi-year low of March 9, 2009, it is obvious to see that the trend is still up. Sure, when the Dow Jones surpassed the 10,000 level, we had many analysts coming out of the woodworks and suddenly turning bullish. And you know the stock market…it loves to always give us the opposite of what is expected. Technically, the Dow Jones would have to break below 9,500 to call the rally off and we are far from that right now.

What He Said:

“The Dow Jones Industrial Average, the S&P 500 and the other major stock market indices finished yesterday with the best two-day showing since 2002. I’m looking at the market rally of the past two days as a classic stock market bear trap. As the economy gets closer to contraction, 2008 will likely be a most challenging economic year for American.” Michael Lombardi in PROFIT CONFIDENTIAL, November 29, 2007. The Dow Jones Industrial peaked at 14,279 in October 2007. A “sucker’s” rally developed in November 2007, which Michael quickly classified as bear trap for his readers. By mid-November 2008, the Dow Jones Industrial Average was at 8,726.