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Case-Shiller home price index rockets in May, driven by the red-hot West

Brent Nyitray, Sr Real Estate Analyst

Real estate and mortgage professionals watch the Case-Shiller index closely

The Case-Shiller index is the most widely quoted index of real estate values. Real estate values are big drivers of consumer confidence and spending, and they therefore have an enormous effect on the economy. The phenomenon of “underwater” homeowners—those who owe more than their mortgage is worth—has been a major drag on economic growth. Underwater homeowners are reluctant to spend, and they can’t relocate to where the jobs are. So real estate and mortgage professionals watch the real estate indices closely.Real estate prices are also a big driver of credit availability in the economy. Mortgages and loans secured by real estate are major risk areas for banks. When real estate prices start falling, banks become conservative and hold reserves for losses. Conversely, increasing real estate prices make the collateral worth more than the loan, which encourages banks to lend more.

It’s becoming more certain that home prices bottomed around this time last year

(Read more: Mortgage REITs get crushed as rates increase)

May’s gain was slightly less than April’s gain. The index increased 2.4% month-over-month and over 12.2% year-over-year. This was the largest gain in the index’s history. Prices have risen the most in areas that were hit the hardest—places like Phoenix and Detroit, as well as some of the hot markets in California, especially San Francisco. However, prices haven’t shown as much growth in states where a judge must approve foreclosures. The judicial states are primarily in the Northeast, most notably New York and New Jersey.

The theme of the real estate market for the past year has been tight inventory. Professional investors (hedge funds and private equity firms) have raised capital to purchase and rent out single-family homes. This trend has been driven by auctions from the Federal Government, primarily the FDIC (Federal Deposit Insurance Corporation) and FHA (Federal Housing Administration). These entities have been auctioning off billions of dollars worth of real estate and have required investors to hold them for three years. This requirement has taken supply off the market (or at least the perception of supply), which has helped the real estate market find some support. These professional investors are competing for properties with first-time homebuyers, which is making the starter home a scarce commodity.

(Read more: Radar Logic futures curve predicts flat real estate prices until September 2014)

Implications for mortgage REITs

Real estate prices are big drivers of non-agency REITs, such as CYS Investments (CYS), Newcastle (NCT), PennyMac (PMT), Redwood Trust (RWT), and Walter Investment Management (WAC). When prices rise, delinquencies drop, which is important because non-agency REITs face credit risk. Even for agency REITs, which invest in government mortgages, rising real estate prices can drive prepayments, which negatively affects their returns. Rising real estate prices also help reduce stress on the financial system, which makes securitization easier and lowers the cost of borrowing. Finally, those REITs with large legacy portfolios of securities from the bubble years are able to stop taking mark-to-market write-downs and may revalue their securities upwards. Since REITs must pay out most of their earnings as dividends, higher earnings means higher cash flows to the investor.

(Read more: What to watch for in real estate next week)

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