For the past year, one of the stronger market sectors has been real estate. That might surprise some investors since troubles in the real estate market were directly responsible for much of the world’s current economic turmoil. Over the short term, real estate funds could continue to offer profit opportunities but investors need to use caution because the longer-term outlook for real estate remains murky.

One of the larger banks in our region of the country is Zions Bank. In a recent newsletter for bank customers, there was an article that addressed the question of whether or not this is a good time to invest in real estate.

I’m including some excerpts from that article below. The author is writing about buying and selling actual property and not real estate funds. But if his insights are accurate, the real estate sector will feel the impact over time. Keep in mind that this is a bank that does mortgage loans in an area of the country where the economy has stayed comparatively strong.

“Nationally, real estate prices still have not reached bottom. And when they do hit bottom, they are likely to stay there for quite a while. There is no rush to get into real estate unless you find a house that you want to live in or hold onto for years. This is not the time to make money speculating.

“The problem is that there are too many houses for sale, and this will not change for some time. … The driver of excess supply is foreclosures on existing homes.

“Contrary to what you might expect, these foreclosures are not being driven primarily by unemployment caused by the recession. During the boom, many people bought new houses at inflated prices and took on big mortgages. Now, a lot of borrowers have mortgages that are much larger than the value of their homes.

“About 25 percent of all home loans today fit this category. Expectations are that this percentage will rise to perhaps 45 percent or more by 2011! For the first time in U.S. history, borrowers who are perfectly capable of paying mortgages are abandoning homes and handing in the keys. It is a rational economic decision, but it will keep foreclosures and distressed sales coming for two or three more years. Residential real estate will not fully recover until we are beyond that period.

“The same thing is happening in commercial real estate, where similar price inflation occurred between 2004 and 2007. Many commercial properties, even ones that are fully occupied with paying renters, are worth less than the size of the loans taken out to buy them. The problem with commercial real estate developed later than it did with residential real estate, so we can expect an increasing number of distressed sales of every type of commercial property for the next several years.

“The issue with investing in real estate now is that you might need to hold on to the property for many years before seeing its value return to what it was a couple of years ago. Property seems cheap now because we’re comparing it to the inflated values of 2007. If you had to hold on to it for 10 years waiting for its value to reach 2007 levels, your rate of return would likely be inferior to what you might have realized by investing in a different type of asset.

“If you still want to invest in real estate, wait a couple of years for real bargains.”

If you know people in the banking, mortgage, or real estate industries—or if you follow the financial news media—you are probably aware that banks are currently tight fisted when it comes to lending money for home purchases.  If the general perception among bankers is that the housing market has yet to bottom, being stingy with real estate loans makes sense. If a bank puts up an 85% loan on a home and the value of the home drops an additional 20% then the bank itself is underwater on the loan if the homeowner defaults.

The accompanying chart shows a comparison between iShares Real Estate (IYR) and the S&P 500 Index over the past four years. Notice that IYR peaked in February 2007, a full eight months before the S&P 500 topped out. The ensuing decline in this real estate ETF was also significantly greater than the decline in the S&P 500.

As long as the current market rally continues, real estate is likely to remain among the leading sectors and the technical picture for IYR is currently positive. So over the short term, some profit opportunities might still be available in real estate. But anyone investing in the real estate sector needs to do so with caution and an awareness of the longer-term risk levels.