Big REIT Opportunities in the Housing Market Recovery

If you listen to most pundits, you would think housing is on its way back.

But I don't listen to people. I do my own research and make up my mind.

And what I've found is that this housing rally is a double-edged sword. But if you're smart you take advantage of its potential while eliminating much of its real risks.

The one edge: A more active market is undoubtedly good for the economy, since it leaves less money trapped in houses people no longer want. But rising prices are not good news, as I explain below.

The other: There are still some excellent opportunities in the real estate sector through real estate investment trusts (REITs), but you need to be very selective (also below).

And as usual, it's all about 3 things: location, location, location.

Except this time around, it's not the locations you would think.

A Cautionary Tale

Let me explain by example…

I have just returned from Britain and the trajectory of that economy shows very clearly: High real estate prices are a major competitive disadvantage.

House prices in Britain are much higher than in the United States. The average house price in June 2013, according to Rightmove's house price index, was 253,000 pounds, about $382,000 at today's exchange rates.

That compares with about $266,000 in the U.S., taking a weighted average of new and existing home sales prices. However, you have to add into this calculation the reality that British incomes are only around 80% of U.S. incomes, when converted at market exchange rates (about 75% at purchasing power parity).

So in terms of earning power, U.K. house prices average about 80% higher than U.S. house prices.

That doesn't take into account the fact that British houses are on average substantially smaller than U.S. houses, or the exorbitant additional costs of trying to live in London, Britain's bloated capital, where house prices have been pushed up by the advent of wealthy Russians.

This isn't just bad luck for Brits, it imposes huge additional costs on the economy. When the Bank of England wanted to attract the Canadian Mark Carney as its new Governor, it had to pay him a housing allowance of 250,000 pounds annually, tax-free, on top of his already substantial salary.

The same premium applies in a hidden way at all levels of the income spectrum. Ordinary blue-collar and white-collar workers must be paid extra to cover the cost of their expensive homes, especially in southeast England.

The more mobile of them are tempted by job offers paying similar wages, but in locations where real estate is much cheaper. For example, to duplicate my Poughkeepsie, NY house near my hometown of Cheltenham would run me 4x more – so in practice, if I returned to England I would have to accept a substantial reduction in lifestyle.

And the same is true for office, commercial and industrial space. It was headline news in 1984 when London became more expensive than New York for prime office rents.

Today the differential with New York is almost 2 to 1; according to CB Richard Ellis's latest survey total occupancy costs in London's West End are $222.58 per square foot compared to New York's $120.65.

Of course, a similar or even larger differential for retail space adds substantially to the U.K. cost of living and makes British retailing very inefficient compared to the U.S.

Buying Smart

The same competitive factors apply within the U.S. market.