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Must-know: Why home prices are within 6.5% of their bubble highs

Brent Nyitray, CFA, MBA

Must-read insights from the May 2014 FHFA Home Price Index (Part 2 of 3)

(Continued from Part 1)

27 consecutive months of year-over-year gains

The 5.5% year-over-year gain puts the index back at July 2005 levels. The rate of price appreciation appears to be slowing. While most indices showed the housing market bottoming about February of 2012, the FHFA shows the bottom around May of 2011. Perhaps distressed sales dominated at the end of 2011, which pushed the other indices lower. As you can see from the attached chart, prices are within about 6.5% of their prior peak.

The theme of the real estate market for the past year has been tight inventory. This theme was borne out again in the National Association of Realtors “Existing Home Sales Report.” Professional investors (think hedge funds and private equity firms) have raised capital to purchase single-family homes and rent them. Lately, professional investors have reduced their buying. This reduction shows that the easy money has been made in the distressed-to-rental trade.

Implications for mortgage REITs

Real estate prices are big drivers of non-agency REITs, like CYS Investments (CYS), Newcastle (NCT), and Redwood Trust (RWT). Prices are less of an important factor for agency REITs, like Annaly (NLY) and American Capital (AGNC).

In fact, increases in real estate prices can be a positive for non-agency REITs and a negative for agency REITS. When prices rise, delinquencies drop. This trend is important because non-agency REITs face credit risk. But for agency REITs, which invest in government mortgages, rising real estate prices can drive prepayments. This negatively affects their returns.

Rising real estate prices also help reduce stress on the financial system. This makes securitization easier and lowers the cost of borrowing. Finally, 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 mean higher cash flows to investors.

Continue to Part 3

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