For Real Estate Investors, Time to Scout New Locations

Housing’s recovery may not equal rising REITs.

Beware of animals in your home or garage.

Beware of animals in your home or garage.

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With the real estate recovery finally looking real, some investors are jumping into red-hot real estate investment trusts (REITs) to get more property into their portfolios. But there may be better places to locate if housing continues on its present path to recovery after five miserable years.

Optimism grew last week as U.S. home prices rose a fourth month in a row and sales volume increased, both gaining about 10 percent compared to a year earlier. Perhaps more important, the number of foreclosure-forced sales is down by more than 20 percent from last July.

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How to make money on real estate? Real estate is all about location, they say. But buyers know price is also a factor, and REITs have risen so much the past few years that bargain hunters might want to find another way to get more out of the rebound.

"The stocks of home builders are the purest play if you want to participate in the recovery of the housing market," says Sorin Roibu, global security analyst who covers the housing sector at Turner Investments.

REITs have been a top-performing asset group over the past three years, turning in the best performance of any fund group, with a 33 percent average annual gain, according to Morningstar data. Few expect them to remain at that lofty peak.

The shares of homebuilders have also been climbing sharply, and some would argue that just like REITs, they have already gotten pricey. As investments, however, they are very different beasts, and will perform differently.

"REITS and homebuilders are at different stages of the recovery cycle," says Roibu. "Homebuilders are at the first stage and REITs are onto the second stage."

The big difference for investors is that REITs are financial instruments set up to generate income, and pay out virtually all of their investment property profit as soon as it's earned. Investors reap the benefit immediately.

With company stock, that same income is theoretically invested in growth prospects, which can ultimately boost the share price and create capital gains. Investors are forever buying into the future earnings stream of equities, and waiting for an eventual payoff or dividend growth.

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That could be relatively soon for homebuilders, says Roibu, because companies have been cutting costs during the downturn and putting their cash to work buying up low-priced building sites in desirable locations.

There is that word again: location. It really does matter, Roibu says. The builders are investing in the sturdiest markets and the ones with the smallest foreclosure rates. "When they recover, the gains will go straight to the bottom line," Roibu says.

To be sure, the shares of homebuilders are not buried in a bargain basement. They began recovering later than REITs, but many have doubled in price from the recession lows.

Among Roibu's favorites, Lennar (ticker: LEN) has climbed from a 52-week low of just over $12 to above $30 now, but it has solid orders to fuel future growth. Toll Brothers (TOL), another pick, has more than doubled, but its target market of higher-end homes makes it attractive. Meritage Homes (MTH) is relatively small, as the ninth-largest builder. The company has targeted eco-friendly homes that are becoming more popular.

If those are not so exciting to bargain hunters, a recent report from Putnam's co-head of U.S. equities, Bob Ewing, said materials companies, which benefit from new housing construction, have been underpriced because of Europe's woes.

Jefferies put out "buy" reports on two of them recently, Texas Industries (TXI) and Vulcan Materials (VMC). Lumber giant Weyerhaeuser (WY) and has risen to the year's highs but has not gained as much as homebuilders. Some analysts have cited Home Depot (HD) and Lowe's (LOW) as well, although both have risen sharply the past year.

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REITs in stage two of cycle. Why did REITs perform so well over the past two years? The trusts invest primarily in commercial properties ranging from movie theaters to office complexes. The biggest category is apartment buildings.