Avoid Bubble Trouble in the Real Estate Market

Whether you're fretting over it, considering speculating on it, or berating yourself for missing the boat, real estate is on everyone's mind these days.

Even if you don't live in one of the housing markets that Federal Reserve chief Alan Greenspan characterizes as "frothy," you've no doubt observed some pretty impressive appreciation in residential real estate prices in your own locale.

The fact that housing prices soared during and after the recent bear market for stocks cemented the view that real estate is a can't-miss investment to which the normal guidelines don't apply. But as any survivor of the dot-com bust can attest, the phrase "It's different this time," is one of the most dangerous in any investor's lexicon. True, real estate will never be worthless (unlike, say, Pets.com), and stagnation is probably a more realistic scenario for real estate prices than is an all-out bust. (I don't know about you, but I don't plan to sell my house and move to an apartment, even if real estate prices could be getting overheated in my area.) However, there have been times when home prices fell sharply. In the early 1990s, for example, many homeowners in Southern California and New England saw their home prices fall below the amount they still owed the bank on their mortgages. Thus, it pays to avoid getting caught up in this or any other mania and to think rationally about how real estate fits within the context of your portfolio.

Here are some factors to bear in mind as you contemplate the current environment for real estate.

Resist the Urge to Speculate
Okay, so maybe you're not gobbling up seven or eight homes at a time and financing them with risky interest-only loans. But that doesn't mean you're not speculating. If you're considering stretching your budget (and short shrifting other investments) to finance a larger home than you need or to pay for home improvements above and beyond what's standard in your neighborhood, you, too, are speculating. You're assuming that home-price appreciation will justify any and every home-related expenditure.

But that may not be a safe bet to make. Yes, residential real estate prices have outpaced major stock-market indexes over the past five years, and real estate has also proved its mettle as a diversifier for a stock- and bond-focused portfolio. Over the long run, however, housing prices have been every bit as cyclical as stock prices (click here for a nifty table depicting long-term appreciation and depreciation trends in some of the major U.S. housing markets) and have logged gains about 1 percentage point above inflation. Thus, it makes sense to hold real estate as part of--but not in place of--a well-diversified portfolio.

Get a Grip
"Real estate in (name your well-located hometown) will always go up," I hear my neighbors say.

Well, maybe it will. But many real estate market participants are assuming that real estate must be a good investment because you're likely to get someone to pay more for a piece of property tomorrow or next year than you paid for it today.

But that mindset--often called the "greater fool theory"--can be a dangerous thing, because it assumes that there's an infinite supply of buyers willing to step up and buy at any price. It also ignores the fact that real estate is like any other asset in that you can estimate its intrinsic value and from there decide how much you're willing to pay.

If you're considering making a real estate investment, you owe it to yourself to make a rational assessment of whether that property is over- or undervalued. For help, check out my colleague Craig Woker's excellent article from a few weeks ago.

Check Your Other Real Estate Exposure
Homes aren't the only type of real estate that has been soaring over the past several years--commercial real estate prices have also escalated, translating into higher prices for real estate securities such as REITs. Thus, it's a good time to check what real estate securities your funds own and consider reducing that weighting back as part of a regular rebalancing plan. (When you rebalance, you strip money away from the asset classes that have done well over the past year or so and put the money to work in those areas that haven't fared as well.) Remember: You don't have to own a dedicated real estate fund to have real estate securities in your portfolio; small- and mid-cap value offerings also frequently hold REITs.

Also be on the lookout for any homebuilding stocks in your portfolio, which will tend to rise and fall with the strength of the housing market. Such stocks have been superstar performers over the past several years but could be vulnerable to a downturn in the housing market or even rising interest rates.

Be Judicious About Taking on Debt
Much of the talk about a possible bubble in the housing market has centered around interest-only loans, which have enabled some real estate buyers to take on more debt than they might otherwise be able to afford. Such loans carry significant risks, however. For one thing, these loans usually carry adjustable interest rates, which would jack up the borrower's payments if rates were to rise. In addition, once the "interest-only" period is over, buyers who can't afford the principal payments could be forced to sell their properties at a loss. Thus, you're really doubling your bet that interest rates will stay low enough to prop up the housing market and that your income will grow to the point where you can afford your mortgage.

Even if you're not speculating with exotic mortgages, it's still a good time to be judicious about taking on any mortgage-related debt. Soaring home prices mean that even those who have lived in their homes for a short period of time have built up a healthy amount of equity that banks are all too willing to let you tap into. Do so with care, however. Yes, home-equity loans and lines of credit can be a decent way to finance necessary purchases or to make improvements that put your home in line with others in your neighborhood, as the interest from these loans is tax-deductible. But real estate prices have already enjoyed a big runup, meaning that appreciation in your home's value won't always offset your borrowing costs. Meanwhile, many market watchers argue that investors will be lucky to see single-digit stock- and bond-market returns in the coming decade. Against such a backdrop, it's tough to call any debt "good debt."