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Stock Strategist

Real Estate Slowdown, Subprime Meltdown--Now What?

How to profit from recent troubles in real estate.

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We at Morningstar had long believed that the runup in real estate prices from 2001 to the end of 2005 was unsustainable and had to end at some point. We've also been bearish on property REITs during that time, as most of their returns came from price appreciation--driven by ever-higher estimates of underlying property valuations--rather than dividends and dividend growth. My colleague Craig Woker went as far as comparing the real estate bubble to the dot-com bubble of the late 1990s and 2000. He detected the same emotional approach toward purchasing real estate that people adopted toward purchasing stock in Webvan.com and Pets.com--the "so many people can't be wrong" rationalization. Arguably, buyers were more confident in their real estate purchases because real estate is more tangible, with real intrinsic value.

Signs of Weakness
Since 2005, we've seen several signs of weakness. Growth in real estate prices has slowed significantly, and reported prices have dropped precipitously in a few of the most speculative areas, such as Miami and San Diego. However, we think the decline is far more severe than headline numbers would suggest. Sale prices can be propped up by having a buyer purchase at the list price, while the seller throws in incentives such as free upgrades, parking spots, and help with closing costs, assessments, and even mortgages. A more telling metric is the drop in sales volume and the buildup of inventory. It stands to reason that if sales volume remained at normal levels, price declines would be more severe. But perhaps the canary in the coal mine was the retirement of www.condoflip.com--a Web site catering to speculators who flipped condos sight unseen.

Ganesh Rathnam has a position in the following securities mentioned above: MTG, RDN. Find out about Morningstar’s editorial policies.

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