While the economy is showing signs of gradual improvement, precarious as they may be, the housing market continues to suffer. Nationwide home prices have cratered from their peak, a fifth of homeowners are underwater on their mortgages, and banks are picking up the pace of foreclosures.
Disheartening as these facts are, there is a bright side to the housing market -- and in it, a remarkable opportunity for astute investors.
The sea change in housing
Since their peak in April 2006, home prices for the nation as a whole have fallen nearly 35%. More than $7 trillion in home equity -- that's more than half of the total home equity that existed during the 2006 peak -- has been wiped out. This scale of home price declines hasn't been seen since the Great Depression.
According to Yale economist Robert Shiller, one of the foremost authorities on the housing market, the American dream of homeownership is going through a sea change that could last "for many years." In recent years, a combination of falling home prices, rising foreclosures, and tight mortgage credit has led to a fundamental change in the way Americans view housing. The resultant shift has been from homeownership to renting.
A homeownership dream deferred
The booming demand for rental housing is leading to what a Morgan Stanley housing market report calls the new "Rentership Society." With the homeownership rate currently at a 15-year low of 65.4%, down considerably from its 2004 peak of 69.2%, more and more Americans are turning to rental housing for their shelter needs.
According to PIMCO's mortgage bond head, Scott Simon, 6 million financially distressed Americans will lose their homes in the next five years, resulting in 4 million new rental households. He added that the homeownership rate would fall below 64% by 2015 and continue to fall for the rest of the decade.
What should investors make of these changes?
Shiller, in a recent interview at Fool HQ, discussed the collective trap Americans fell into during the housing boom of the 2000s -- that housing was a great investment because home prices would continue to rise. This illusion of housing as a great investment is now being rightly challenged.
But given current affordability, rising rents, and pent-up demographic demand, I think housing is still a great investment -- you just have to look at it differently. Allow me to make a comparison with stocks.
During the 2000s boom, investors looked at a house as a growth stock, hoping to profit by selling it later at a considerably higher price than we paid for it. Now we might better look at a house as a dividend-paying stock, one that generates a steady stream of rental income. I think it's that simple. While it may be awhile till we see another housing boom, a growing population and an expanding economy will doubtless produce a surge of renters.
Rental housing: a supply and demand picture
The primary driver of housing demand is household formations. With a growing population and rising jobs and incomes, more households tend to form. While the number of households formed over recent years has failed to keep pace with population growth, recent data suggest a more positive trend. According to the latest Census Bureau report, there were 1 million more households in the first quarter of this year as compared to a year earlier.
But these newly formed households, particularly those with residents under 30 years of age, face an uncertain economic outlook and are therefore postponing homeownership in favor of renting. Some are even moving back in with their parents. As the economic recovery picks up, many of these young households should become renters. Meanwhile, financially distressed households, those facing short sales or foreclosures, will also drive additional demand to the rental market.
Add to these factors the unavailability of mortgage credit for a wide swath of prospective homebuyers, and you have a tidal wave of demand for rental housing. The lax lending standards that prevailed in the three or four years before 2006 have reversed drastically. Today, mortgage underwriting standards are comparatively much tighter and down payment requirements have also increased considerably.
On the supply side, new construction has been at a virtual standstill until very recently. As a result, apartment vacancy rates are at an 11-year low of 4.9% and average rents nationwide have risen 4% in the past year. While construction has seen a slight uptick in the past six months, demand for rental housing still far outpaces supply. In the most recent National Multi Housing Council quarterly survey, the apartment market is the tightest it's been in the past six months.
The combination of these factors convincingly points to a long-term trend toward rentership. And with record-low interest rates and housing affordability at an all-time high, now may be the best time in decades to invest in a buy-to-rent property.
Alternative ways to play housing
If you're uncertain about becoming a landlord but still want to benefit from rising rental demand, residential real estate investment trusts may be just what you're looking for. Many of the big-name REITs own large concentrations of urban apartment buildings and are benefiting from high rents and record-low vacancy rates. Boosting their appeal even more is the fact that REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends.
Going forward, Post Properties (NYS: PPS) , Camden Property Trust (NYS: CPT) , Essex Property Trust (NYS: ESS) , and AvalonBay Communities (NYS: AVB) look well-poised to capitalize on the sea change in housing. These stocks aren't exactly cheap right now because of high expectations for earnings growth, but they could be worth keeping an eye on.
If you're eager to add more steady income to your portfolio, but want to avoid the cyclical nature of housing, we've found an even safer strategy for you. Don't miss the opportunity to discover nine rock-solid dividend stocks in our free special report.
At the time this article was published Fool contributor Arjun Sreekumar does not own shares of any of the companies listed above. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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