What Now for Real Estate?

To be fair, the foundation was already set. After the technology bubble popped in 2000, investors grew wary of the stock market and started considering real estate as an alternative investment. Then after 9/11, equities became even more volatile. The Federal Reserve aggressively dropped interest rates to historic lows. Lenders loosened lending guidelines. And folks were fearful of travel and stayed home to nest instead.

Indeed, nervous Americans took their travel budgets and money earmarked for the stock market and shifted it into either the purchase of larger homes or renovations, says Celia Chen, director of housing economics for Moody's Economy.com. As a result, real residential investment (both renovations and home purchases) increased as much as 40% over the past five years surpassing levels seen during the last real estate boom of the late 1980s, according to the Economic Policy Institute, a Washington, D.C.-based nonprofit think tank. Those who rode the real estate market were well rewarded. Home prices jumped 47% over the past five years while the S&P 500 increased nearly 19%.

But just as the memories from Sept. 11 are beginning to fade, so is the strength of the real estate boom. The National Association of Realtors reports that in July existing home sales decreased 11% compared with the prior year and existing home prices increased less than 1% during the same time frame. And anyone who isn't well diversified is likely to get hurt.

"Many of the drivers that had supported the housing market during the last five years have retreated," says Chen. "Now we are in the midst of a downturn and will be seeing more softening for at least the next year."

As real estate softens, financial planners like Stewart Welch of Birmingham, Ala., are reminding their clients that over time the stock market is a better investment than real estate. Over the past 30 years, the S&P 500 posted an annual return of 12% compared with just 6% for real estate, according to Schwab & Co. So if all your excess cash is going to real estate, now is the time to reallocate those funds back into equities and start following a more traditional retirement savings plan, says Welch. (For more on retirement, click here.)

Here's what you can do to reposition your portfolio and protect your nest egg:

Assess Your Portfolio
Not sure if you're too heavily invested in real estate? Use this as a guideline. Saving for that first down payment is notoriously difficult. So it's understandable that for most first-time home buyers a house will make up a large percent of one's total net worth. But as folks age and grow closer to retirement, they should have liquid assets that generate enough income so they don't need to downsize into a smaller condo to fund their golden years, says Patricia Powell, a certified financial planner based in Martinsville, N.J.

At 45, a portfolio can be more balanced. At this stage folks are in good shape if half of their total net worth is the value of their home and the other half consists of stocks and bonds, Powell says. And someone in his early to mid-30s can get away with 75% of his net worth locked up in real estate.

Time to Refinance
Here's another post-Sept.11 real estate pitfall worth correcting. As home prices skyrocketed over the past years, lenders came up with more inventive ways for buyers to purchase properties. Enter the risky adjustable-rate and interest-only mortgages.

While these mortgages, which often require no down payment, sounded brilliant while interest rates were hovering at historic lows and home prices were rising at an unprecedented rate, they could now be the very thing that threatens to sink a family's finances, warns Peter Bonnikson, a senior vice president at online lender E-Loan. Here's why: Adjustable-rate mortgages are based on highly volatile short-term interest rates, such as the LIBOR rate, which now sits at 5.4%. Only one year ago, the LIBOR rate was 4%. (Lenders generally set their rates by adding two percentage points to the LIBOR rate.)

What does this mean for homeowners? Those low monthly payments are about to get much steeper. If one year ago a family took out a $400,000 adjustable-rate mortgage with an interest rate of 6.0%, they will have to pay $400 more this year when the loan resets to 7.5%.

The solution? Now's an excellent time to lock in a 30-year fixed-rate mortgage. This more traditional loan is pegged to the 10-year bond and is still considered a relative bargain weighing in at just 6.5%, according to HSH Associates Financial Publishers. If, however, you can't afford the payment on this mortgage, then you are living beyond your means and had better remedy the situation. Better to sell now while prices are high enough to guarantee that you won't owe more on your mortgage than the home will sell for.

Learning from the Tech Bubble
Finally, consider yourself warned. Recall the most important lesson investors learned back in 2000: All cycles come to an end. So it's time for all those novice speculators to reconsider investment properties in places like Miami and Southern California. Those who hang on trying to squeeze every last bit of profit out of the real estate market may get burned just like all those stock market investors did back when the technology bubble burst.