Reassessing Real Estate Risk

While a collapse is highly unlikely, now is a great time to re-evaluate exposure to housing.
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In the late 1990s, everyone wanted to be a daytrader. Today, everyone wants to be a landlord.

And why not? With interest rates at all-time lows, seemingly just about anyone can get an affordable mortgage, buy an apartment building, collect some rent and/or sell the building for a profit.

Clearly, real estate is

en vogue

. And with the availability of new products, like interest-only mortgages, many people are able to stretch into properties they could otherwise never afford. So folks who know nothing about managing properties are investing tons of money in the sector in hopes of riding the wave and flipping the buildings before the roofs start leaking.

That is, until the interest rate on that adjustable-rate or interest-only loan goes through the roof and you can't find a buyer for that building. That would be reminiscent of those pesky margin calls from five years ago, and the accompanying pain felt by holders of myriad "can't miss" tech stocks.

Indeed, if you've got multiple properties under management, own real estate investment trusts and/or homebuilding stocks, you might be overexposed to the sector. In turn, you may be exposed to some serious interest rate risk, especially if you also factor in your fixed-income holdings and other rate-sensitive stocks.

The good news is, things could hardly be better for real estate and related investments. New-home sales hit record levels in April and existing-homes sales were stronger than expected; mortgage rates have fallen again, along with 10-year Treasury yields (which move in opposition to price, meaning your bond holdings are up, too); homebuilding stocks remain ascendant (the Philadelphia Homebuilding Index is up over 20% year to date) and even financial stocks have been perking up lately.

But if things could hardly get better, they quite conceivably could worsen. Recent weakness in furniture stocks such as

Ethan Allen

(ETH) - Get Report

and mortgage lenders such as

Doral Financial

(DRL)

may be temporary blips or they may be a harbinger of a rough patch in the sector.

Although a near-term collapse in real estate is highly unlikely, now is a great time for individuals to re-evaluate their holdings and exposure to the sector. Better to do it when everything's turning up roses vs. waiting until the market cools, or worse.

So How Much is Too Much?

Real estate has always been and will continue to be a very sound investment. But like anything else, just make sure you allocate the real estate portion of your portfolio properly, more especially because the

Federal Reserve

seems intent on tightening further and the threat of an economic slowdown is ever pending.

"It's reasonable to assume that going forward, real estate will do reasonably well but don't expect

gains of the last three years to continue forever," says Rande Spiegelman, vice president of financial planning at the Schwab Center for Investment Research.

Because real estate is generally less correlated to stocks and bonds, it's a great way to hedge your portfolio. But the sector does tend to err on the riskier side, so your risk tolerance will dictate how much you own.

To start, the home you live in should not be viewed as part of your real estate investment portfolio, says Spiegelman. Your equity in the home should be included in your personal net worth, but the home should be separate from your investments.

If you have a very aggressive portfolio, Herb Daroff, a C.F.P. and J.D. at Baystate Financial Services in Boston, suggests exposure of anywhere from 10% to 20% to real estate, whereas a very conservative portfolio should probably stay clear of it all. A good middle-of-the-road growth and income portfolio could probably hold around 5% to 7% in real estate.

Whether it's two-family homes or real estate funds, there are ways for investors to get practical exposure.

If you do go the two-family route, be sure you can change a light bulb. If you need to hire someone every time something goes wrong with one of your properties, your profits will dwindle quickly. And you'll need to make sure you invest in different geographic areas as well. So if the economy in the Northeast tanks, your properties in the Northwest will cover your losses.

Then be careful with your leveraging. "You might balk at the idea of buying stocks on margin but won't think bad about 100% financing on a rental condo," says Spiegelman. So make sure you're not in over your head.

"Remember, you're underwater from day one by virtue of the real estatebroker's commission if you have to sell the place tomorrow," Spiegelman says. So be sure you can carry the property in good times and bad.

If you're not a handyman and have no interest in getting dirty, consider relying on the pros and get your sector exposure through real estate funds or REITs. A REIT is a corporation or trust that uses the pooled capital of many investors to purchase and manage properties. In addition, REITs trade just like stocks and pay dividends.

REITs have had a great run recently. The asset class has returned 18.47% annually over the past five years, making it the best-performing category at Morningstar. (Click

here for more on REITs.)

Notably,

Merrill Lynch

recently lowered its rating on six REITs, citing valuation issues. The downgrade came as the Morgan Stanley REIT Index, which tracks 121 real estate stocks, hit an all-time high this week. This is how research is

supposed

to work -- downgrades at or near peaks vs. after big declines.

The advantage of going the REIT or fund route is that you can rely on managers who know the sector well. Presumably, they will know when to switch from residential to commercial properties and know which areas of the country are up-and-coming. Even better, you don't have to play landlord and pretend you know how to fix a hot-water heater.

So check out REITs like

Vornado Realty Trust

(VNO) - Get Report

and

Kilroy Realty

(KRC) - Get Report

. And in thefund world, research some good funds like the

(IARAX) - Get Report

AIM Real Estate fund, the

(CGMRX) - Get Report

CGM Realtyfund and the

(FRESX) - Get Report

Fidelity Real Estate Investment fund.

Let's face it. People are always going to need places to live and shop. So whether you invest in a strip mall or a real estate fund, odds are good your investment will serve you well. But like any other sector, you need to prepare yourself for ebbs and flows.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

click here

to send her an email.