Real Estate Is This Decade's Plastics

 | Jul 31, 2012 | 2:30 PM EDT
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I have been spending some time this week reviewing community bank stocks and comparing the recent earnings reports to the condition as of the last call report filed with the FDIC. Credit conditions seem to be slowly improving and real estate collateral values are still a concern for most bankers.

Most community banks are still seeing declines in property values. The pace has slowed down tremendously from 2008-10 levels but a real bottom is still not in place. That applied to both residential and commercial real estate values in much of the country. So far, this seems to be the case almost everywhere outside New York and Washington, D.C.

I came away with another conclusion as well. Real estate of just about every stripe that is not between the rivers or inside the beltway is cheap. Incredibly cheap. Looking at properties outside the zone of the giant real estate investment trusts (REITs) that don't seem to care what they pay for properties, real estate is starting to make a tremendous amount of sense. I realize I am not the only one who sees this, as several hedge funds have said they will be moving into residential properties because their managers believe unleveraged returns are in the mid-teens and higher. Donald Trump was just on CNBC this morning advising investors to go buy a house from a bank.

With all the attention and talk, it is highly doubtful that this is the bottom for real estate prices. Prices may well go lower before going higher. In fact, this morning's Case-Schiller showed month-over-month improvement, as one would expect for summer, but the year-over-year decline in prices continued. Commercial real estate is performing pretty much the same -- with the exception of trophy downtown properties in major markets.

It is also highly unlikely that the predictions of 10% and 20% leaps in the housing market will come to pass. That type of price action would cause the pool of buyers to dry up very quickly. Long-term trendline growth for housing prices is roughly 2% to 3%. I expect that once it does bottom, it will hover along trendline growth until the next bubble in 10 or 15 years. The strong cash flows you can earn off rental properties right now along with the leverage obtained could lead to very pleasant returns of for long term investors.

Even those of us with no interest in being landlords can participate through the stock markets. Patient investors can participate in downtown office markets buy owning REITs such as Commonwealth (CWH) or Parkway Properties (PKY). Those who believe that the economy will eventually recover and consumer spending will improve can own retail REITs such as Kite Realty (KRG) and Cedar Realty (CDR) at discounts from the value of the underlying assets. Northstar Realty (NRF) gives investors a chance to participate in owning, financing and managing commercial real estate property and debt portfolios. Ashford Hospitality (AHT) and Chatham Lodging (CLDT) can put you into the hotel business at a discount to the property value. Of course, the community banks that hold property as collateral can also allow you to participate in the upside of real estate in the U.S.

Real estate probably has not put in a dead bottom. Fellow Real Money contributor Roger Arnold has given us fair warning of the looming shadow inventory problem. However, I think we are close enough to seeing a final bottoming process that the sector can begin to offer attractive returns for long term investors. It may be a bumpy process but the property markets offer great potential for large returns.

In the 1960s, the word was plastics. Today, I think the word is probably real estate. I would be buying those REITs that trade below tangible book value and are reasonably financed, especially during Mr. Market's depressed phases. If I were a few years younger, I would be rushing to start an investment property brokerage and property management firm. If the world does not end, real estate will firm, improve and eventually boom again.

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