Investors Have to Be Careful With Real Estate

The housing market isn't getting red hot any time soon. So instead of just throwing money at anything related to real estate, investors wanting exposure to the housing sector will need to be careful how they put their cash to work.

The matter stems from a change in attitude from the largest generation of U.S. residents -- those 75 million people born between 1981 and 1997, a.k.a. the millennials, according to the Pew Research Center.

Housing and economic growth were once synonymous. From the end of World War II up until the financial crisis of 2008-09 there wasn't a single recovery that didn't involve housing playing a major role. Then things changed, and how.

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That's why investors need to cast aside any idea of strength in the housing sector being either a consequence of growth or a cause of it. That's all in the past now.

Rental attitude and student debt. In the first place, the millennial generation doesn't seem to want to buy homes in quite the way that previous ones did. "They have a lot of student debt, and they like urban areas where home ownership isn't affordable," says Stuart Hoffman, chief economist at the PNC Financial Services Group.

For instance, $500,000 in in New York City doesn't go very far and would mean a 20 percent down payment of $100,000, plus some very hefty closing costs. When people are burdened with heavy debt from college or graduate school getting that sort of money together can be a challenge.

The other option, apart from living at home, is renting. And perhaps it's that reality that has brought about a change in attitude, one that means renting is now not seen as something to avoid.

A recent report from Deutsche Bank states younger individuals are "meaningfully less likely to own a home than in the past." That actually has a knock-on effect in the home building sector and related businesses. Rentals tend to be smaller and landlords may spend less money on upkeep than owners, Hoffman says.

So if you are constructing single-family homes, or in the business of selling supplies for the upkeep of such structures, then this shift in attitude isn't such great news.

Boomers still drive housing. The change in preference for renting over buying means that it is still the baby boomers who are driving the market for single-family homes. "It's been more the older generations tending to buy housing. Maybe they're are now sliding into to smaller houses," says Brett Ryan, a senior economist at Deutsche Bank in New York.

That group is aging and dying, which isn't good for the longer-term outlook. But there is a more immediate problem. Rising borrowing costs won't help.

"Real estate will likely be impacted should interest rates work their way higher," says Stephen Guilfoyle, chief market economist at Stuart Frankel & Co. in New York.

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The much-anticipated increases in interest rates will make housing less affordable to anyone needing to borrow to make a purchase. The slight bit of good news is that the rate hikes "should be slow," Guilfoyle says.

Overall, the way the housing market worked for the second half of the 20th century is now history.

Growth has moved. There is some good news. While sales of single-family homes aren't red hot, the situation for multifamily apartment blocks is nowhere near so gloomy. In fact, it's quite the opposite.

"Apartment building is now above its previous peak," Ryan says.

Data from the government show housing starts for multifamily structures with five or more units hitting an annual rate of 403,000, and reached a peak of more than 500,000 in June 2015. The peak for apartment building in the previous cycle reached 423,000 in January 2006.

Where to invest? Unless a lot of things change then the growth in market for single-family homes will likely not accelerate anytime soon. So don't bother with the traditional homebuilders such as those held in the SPDR S&P Homebuilders exchange-traded fund (ticker: XHB).

As an alternative, consider this. People still need somewhere to live, and given the demographic shift in preference there will likely be more demand for apartment rentals.

One way to benefit from that would be to look for real estate investment trusts. In addition, to focusing on an area of the economy with the wind at its back, there are also some tax benefits.

As long as the REIT distributes 90 percent of its profits to the shareholders it is not taxed. Instead the shareholders pay tax on the distributions. The structure avoids the normal double taxation that investors in most corporations have to deal with -- the company pays income tax, and then the investor pays tax on the dividends as well.

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A couple of REITs to consider are Equity Residential ( EQR) and Avalon Bay Communities ( AVB). Both REITs yield around 3 percent in dividends based on recent stock prices.

Simon Constable is a columnist and author. In addition to following the financial markets, he likes to watch his cat play with string. You can follow him on Twitter @simonconstable.