Dwelling on Investments? Try Housing Stocks

American Century Investments V.P. Steve Brown on how investors can gain from investing in real estate.

Real estate as an investment was once left for dead. No longer.

Housing prices have crept steadily upward this year. And the much-watched Standard & Poor's/Case-Shiller home-price index in 20 U.S. cities has logged eight straight months of increases, rising 4.3% in October alone over the same period in 2011.

The engine for the market's improvement is surging demand and low supply. Single-family housing starts in September grew at the fastest rate since summer 2008, feeding supply. Conversely, the amount of vacant housing reached its lowest level in almost 10 years, according to Freddie Mac calculations.

One prime beneficiary: homebuilding stocks. The bellwether S&P Supercomposite Homebuilding Sub index has risen a stunning 73% in the past year as of mid-January versus only 13.9% for the S&P 500 index. But, home improvement stocks and real estate investment trusts, or REITs, which mainly own commercial properties, also have notched healthy gains.

"REITs have stabilized and have gotten more attractive," says Mark Luschini, chief investment strategist at Philadelphia-based Janney Montgomery Scott LLC.

And there's still room for growth, analysts say. According to the International Monetary Fund, housing rebounds typically last seven years after hitting a bottom. "We're still in the early years of a multiyear recovery," Luschini says. "And this rising tide will lift all boats."

Here's how to get the best bang for your buck in housing stocks.

Valuing Builders

Homebuilding stocks are in a boom time, and the easiest way to invest in them is through exchange-traded funds, or ETFs, says Rick Ferri, founder of the Troy, Mich.-based investment adviser Portfolio Solutions LLC. Currently, there are three homebuilder ETFs, which have had 44%-plus returns in the past year as of mid-January, according to ETF Database.

Luschini says ETFs offer instant diversification. But if you prefer owning homebuilding stocks, Luschini recommends diversifying your portfolio with companies catering to specific housing niches. For example, Toll Brothers aims for the high-end housing market, while Lennar Corp. caters to the middle market. Don't bet on just one part of the housing market.

"You're not talking about homebuilders with pristine balance sheets," Luschini says. "So you need to do your homework and stay on top of each stock."

Taking a Chance on REITs

REITs, which mostly own commercial properties such as shopping malls or office buildings, haven't performed as well as homebuilding stocks. The MSCI US REIT Index has posted compounded annual returns of 19.5% per share in the past year as of mid-January. However, REITS should be part of any long-term asset-allocation strategy, says Ferri, who recommends an allotment of 10% of your portfolio to REITs or to housing stocks.

"REITs will beat inflation, and they also have high cash flows because they don't have to pay federal taxes," he says.

So REIT dividends are typically very handsome. In November, the average REIT yielded 4.3% per share, and many REITs have been increasing their dividends this year, according to the REIT Monitor. Yield refers to the dividend divided by the share price.

Also, REITs have been rebounding since March 2009, says Frank Haggerty, a portfolio manager at Chicago-based Duff & Phelps Investment Management Co. They've chalked up almost four years of positive returns in an upcycle that usually lasts seven years, he says. "So we're only halfway through recovery."

"Supply-and-demand ratios are very favorable in commercial property," he says. This means that REITs could generate double-digit returns for the next three to five years.

Look at ETFs and mutual funds that own equity REITs because they invest directly in real estate, Haggerty says. Avoid investments that hold mortgage REITs, since they invest in property mortgages and are mainly a hedge against rising interest rates.

If you do invest in individual REITs, buy several so that you can diversify across property types and geographies because some REIT sectors are stronger than others, Haggerty says.

For example, lodging and self-storage REITs have had a nice recovery, but shopping centers are only now bouncing back, Haggerty says. "The plus is that REITs let you avoid the headaches of owning property."

For defensive investors whose aim is minimizing the risk of losing principal and who are considering housing stocks, Haggerty recommends investing in health care REITs. They yielded dividends of 5.2% of the share price in November. They also have longer lease durations on their properties, he says.

In addition, several single-family housing REITs are coming on the market this year. Their objective will be to ride out the hot home-rental market.

"Keep an eye on them," Ferri says.

Taking Stock of Home Improvement

When people buy homes, they also buy home siding and other materials. Home-improvement spending picks up along with homebuilding growth, Luschini says. So, you might want to own shares in the two major companies in this niche of housing stocks -- Home Depot and Lowe's, he says.

Also, Peter Wahlstrom, a senior analyst at Morningstar Equity Research, says both companies offer dividends, currently yielding 1.8% of the share price, and each company is buying back stock.

"Last year, profits began picking up," Wahlstrom says. However, these stocks already have had good runs. "Three to four years of recovery are already baked into stock prices." His advice is to wait for a pullback before buying either stock.