Numerous recent reports including a couple this week show that the U.S. housing market is still struggling. That has prompted a flurry of media articles about housing ills—including some that have taken a very pessimistic tone about the long-term future of real estate as an investment. For example, an Aug. 22 article in the New York Times carried the headline “Housing fades as a means to build wealth, analysts say.”

Of this week’s reports, perhaps most surprising was an announcement from the Commerce Department that the annualized pace of new home sales in July was the lowest since the government began keeping records in 1963. The seasonally adjusted annualized rate of 276,600 compared to 375,000 new home sales in 2009. More than 600,000 new homes were sold every year between 1983 and 2007.

Sales of existing homes also declined sharply in July. The annualized rate of 3.83 million was the lowest since 1996 and was 25.5% lower than the 2009 pace of 5.14 million. The Tuesday release of the information about existing home sales was enough the send the Dow to below 10,000 during the day’s trading.

What most media reports and analysts fail to consider is that until the 1990s homes were not usually viewed primarily as investments—especially as short-term investments. People purchased homes to live in and the fact that they might appreciate in value along the way was kind of a nice bonus. As home values began to rapidly appreciate in some areas, people began to take advantage of the situation by flipping homes, or by withdrawing the growing equity from those houses to leverage into other investments. This practice was widely encouraged by mortgage lenders.

The situation escalated exponentially after the 2001-2002 market crash. Many ordinary investors who lost money in the stock market transferred their remaining assets into real estate—believing that real estate was a less risky alternative. Of course by now we know that people who thought real estate could only go up were wrong.

Quoting from the New York Times article referenced above:

“Dean Baker, co-director of the Center for Economic and Policy Research, estimates that it will take 20 years to recoup the $6 trillion of housing wealth that has been lost since 2005. After adjusting for inflation, values will never catch up.”

The real tragedy of the real estate collapse is the shock wave that has spread to other areas of the economy. In that regard, the decline in new home sales is particularly troubling. According to the National Association of Home Builders, each new home creates an average of three jobs for a year and generates about $90,000 in taxes. If those estimates are accurate, the decline in new homes is resulting in a loss of nearly one million jobs each year and tens of millions in direct tax revenue. And we are all well aware of the impact on banks and other financial institutions.

In spite of the problems and pessimism, real estate transactions continue, even in some of the hardest hit areas. My daughter and son-in-law recently bought a house in Las Vegas. During their search they made offers on about a dozen properties and most were for more than the asking price. Homes in their price range in the areas they wanted were generally selling for 10% to 15% above the listed price. And most were selling within a few days of being placed on the market.

There are significant differences between real estate and the financial markets. When an investor buys a stock, he pays the same price whether he is in California or Maine. Real estate is a more localized commodity. A 2,000 square foot house valued at $150,000 in Texas might be priced at $75,000 in Michigan or $400,000 in Boston. But like more traditional investments, without being able to predict the future, it is impossible to know whether or not those properties will turn out to be profitable investments when the owners eventually decide to sell.

What is certain is that some people are making money in real estate even in the current market. Others are not so fortunate. And there are still many ways investors can participate in the real estate market without buying and selling real property. As an example, below is a chart of iShares Dow Jones Real Estate ETF (IYR). I’ve included the S&P 500 for comparison.

This fund peaked early in 2007. Its decline began several months earlier than the S&P 500, but they have shown a high level of correlation for the four years covered by this chart. Both posted strong advances in 2009 but IYR has provided a slightly better return so far in 2010. Like most other sectors of the markets, right now real estate carries a high level of risk. For investors looking for a place to live, this could prove to be a great buying opportunity. For investors hoping for positive gains and low risk, real estate is probably not a good short-term option.

F.S.