Jeremy Siegel, Ph.D. The Future for Investors

Real estate has been the hottest asset class over the past five years. Some locales have seen prices double in two or three years and news of investors flipping condos reminds me of the frenzied days of Internet IPOs in the late 1990s.

But with the latest rise in mortgage rates there's been an unmistakable shift in sentiment. Recent data from the research firm ISI shows that the dollar value of unsold homes in the U.S. has now surpassed $500 billion, up an unprecedented 33 percent from a year ago.

It seems like everyone wants to sell, which could spell big trouble for the housing market. So now is an especially good time to ask: How does real estate fit into my long-term portfolio?

The Rates That Really Matter

It's no secret that housing prices have soared in recent years. The main reason: The remarkable drop in interest rates.

Particularly important for the housing market is the real rate. This is the interest rate minus the rate of inflation. The real rate is important for the housing market because the two move in opposite directions.

The yield on Treasury Inflation-Protected Securities (TIPS) provides a measure of real rates. It's currently just 2 percent -- about half its 2000 level. This drop in real rates over the past five years means that the after-inflation cost of long-term borrowing has plunged by about 50 percent.

These declining rates can justify big increases in home prices. In fact, the average price of U.S. single-family homes has jumped from $160,000 in 1999 to $265,000 today, a whopping 66 percent increase.

Housing Still Has Sturdy Foundation

Does all this mean that the roof will come crashing down on the housing market?

No!

While many fear rising rates will trigger a disaster for the real estate market, I see a housing market with a firm, concrete foundation. I believe interest rates are near their peak and that any further rise in long-term rates will be modest.

And although historically low interest rates largely explain the jump in housing prices, other favorable developments also played a role. Changes in the tax code in 1998, in a best-case scenario, allow up to $500,000 of capital gains to be exempt from federal tax if realized from owner-occupied homes. This exemption gives real estate a tax advantage over other asset classes. Rising household incomes and a competitive mortgage market have also boosted housing prices.

But this doesn't mean that recent gains will continue apace. In fact, prices very well may fall in markets where price speculation has been the most intense, such as parts of California and the Northeast. Such softening has already occurred in countries where the housing market was particularly strong and the central bank raised rates to prevent overheating.

For example, over the past couple of years the Bank of England has raised short-term rates from 3.5 percent to 4.75 percent, and the Reserve Bank of Australia raised rates to 5.5 percent. Both countries succeeded in cooling down their super-hot housing markets, and prices have leveled off. It's logical to expect the same to happen now that the Fed has raised rates from an extraordinarily low 1 percent in early 2003 to over 4 percent today.

What to Do Now?

Given this, investors may wonder if they should buy rental property. In many cases, the answer is "no." The cost of financing, taxes, and upkeep is often greater than the incoming rent, creating what real estate investors call "negative carrying costs." These costs can only be justified if there is enough appreciation to offset these costs.

And that's a problem.

Historically the majority of real estate's return does not come from capital appreciation, but from "implied rent," which is the amount one would otherwise spend on rent for the same home. This surprises most investors, because capital gains have overwhelmed rental income in the past decade. But investors must realize this was a highly unusual period that will not continue in the future.

The Bottom Line

If you're comfortable in the home you're living in, keep it. And, if you have a second one, keep that too -- as long as you're not holding it solely for future capital gains.

Furthermore, much of the real estate held in real estate investment trusts (REITs) that trade on the major stock exchanges still offer good yields. Their average dividend yields are between 4 percent and 5 percent, a rate that matches or exceeds what you can get on government bonds. So even if REITs don't rise in price, you're getting a decent yield on your money.

However, if you're thinking of downsizing or selling your home, now might be a good time to do so, especially if it will generate tax-free capital gains. And if you're waiting to purchase real estate as an investment, I'd wait a little longer. The increase in the number of units for sale means that a buyer's market is close at hand.