Betting on a Bounce: How to Play Housing

It’s been over a year since the housing sector imploded. Yet, it's still at the epicenter of the current economic crisis. Many market watchers are pinning any chance of a broad recovery on housing pulling one off first, so the data emerging out of the sector is closely watched. Indeed, while most investors have steered clear of the industry, other opportunistic ones are reading into the numbers and predicting housing will make a remarkable rebound over the next few years. They are even betting billions of dollars by investing in housing-related mutual funds, exchange-traded funds and individual stocks. The big question: If they are right should you jump in, too?

The problem with answering that is the data are sometimes contradictory. In fact, these days it seems to always be contradictory. Over the last month, investors have poured over numbers on pending home sales, building permits, regional trouble spots, home builder earnings, mortgage rates and foreclosures. For every piece of news that seems to point to a bottom occurring there is another that shows there's still room to fall further. One detail that can’t be denied: Since the 2006 peak of national property values, average home prices are down nearly a third, back to levels last seen in the fourth quarter of 2002.

All that means making a smart investment in the housing sector is a risky prospect. Just like when “no one had a good forecast about when the bubble would burst,” says Jim Diffley, managing director at the consulting firm IHS Global Insight, “there's a challenge to betting that prices have bottomed or are about to bottom and will come up.”

For investors trying to figure out what to do amidst the crisis the most important thing to remember is that national numbers encompass thousands of smaller stories. There are parts of the country hurting more than others — the ailing Southeast vs. the somewhat stable New England area — and parts of the housing market have succumbed more than others — luxury houses vs. starter homes. For example, recently the National Association of Realtors said pending home sales in New England, New York, New Jersey and Pennsylvania were up 36% in April from the previous month’s level. The southern region lost .2% during that same time period. Various other reports say Phoenix, one of the hardest-hit housing markets, has seen the average home price slip 53% from the peak two years ago. Dallas, however, is only down 11%.

“It's something of a cliché, but all real estate markets are local,” says Jack McCabe, an independent housing analyst and president of McCabe Research & Consulting in Deerfield Beach, Fla., a state with the third-highest rate of foreclosures nationwide. "Every market started this boom and bust cycle at different times." Adds Dave McCarthy, chief executive of Integrated Asset Services, a Denver-based company that runs a proprietary housing index on 360 counties: In some local markets “we're starting to see some leveling off. It's at least looking less volatile than the last couple of months.”

A savvy stock picker could read into those statements and think home builders with exposure to certain areas may have seen the worst of times while others could be in store for worse. That’s a pretty big jump to make, though, says McCabe. He thinks it's early, risky and maybe even foolish to buy home-builder stocks like Toll Brothers (TOL), D.R. Horton (DHI) or Pulte (PHM) just because they appear cheap. “I don't see it,” he says. “You've got escalating foreclosures, escalating unemployment and excess inventory – that should give you an idea of the health of these markets. Home builders just can't compete with existing units on the market.”

Instead of trying to predict which individual home builder will recover first, a less-risky option may be to buy an exchange-traded fund that owns a basket of housing-related stocks. SPDR S&P Homebuilders (XHB) is an ETF that counts Home Depot (HD), Lowe's (LOW), Bed Bath & Beyond (BBBY), Sherwin Williams (SHW) and D.R. Horton among its top holdings. The iShares Dow Jones U.S. Home Construction fund (ITB) tracks an index that includes Toll Brothers, KB Home (KBH) and Meritage Home (MTH). Both are widely traded and cheap. But they can also swing wildly on a daily basis, especially when data are released. (Fidelity offers a mutual fund, Select Construction & Housing (FSHOX), that owns many of the same companies.)

Not every investment has to hinge on a rosy recovery for housing. For investors who can stomach a little more risk, McCabe suggests a bet on more bad news, this time in commercial real estate. General Growth Properties, the second-largest U.S. mall owner, went bankrupt in April, because it couldn't refinance its debts, despite having almost $30 billion in assets. “I'd probably short some of the retail and office public companies,” he says, because many of them are facing large balloon payments or refinancings that will be far more costly than the cheap credit terms they got five years ago.

Real estate investment trusts like Simon Property Group (SPG), Federal Realty Trust (FRT) or Vornado Realty Trust (VNO) have all seen strong rebounds from March, but the combined dropoff in consumer spending and the looming commercial mortgage crunch could bode poorly. “I see that as the next shoe to drop,” McCabe says. “We have over $900 billion in loans on commercial projects that have balloon payments and need new financing, and I don't see the money being there.”

Another atypical option: Buy distressed properties. IAS, which specializes in default valuations, says 42% of the property sales it tracked in April were bought by investors. However, these weren’t big bulk buys of unsold condos in battered markets like Las Vegas, Southern California, or Florida, where vulture investors have been preying. "It's all onesies-twosies," says McCarthy. “Savvy local investors are starting to get back into the market.”

The idea of making tantalizing returns on a well-timed housing play is an intriguing prospect. But most investors should remember this: The average S&P 500 index fund owns many of the same companies in the offerings listed above, so if they rally your plain-vanilla fund will, too.