San Francisco Fed unemployment study

Part 5

Implications of the Fed’s model for REITs and homebuilders

Implications of the Fed’s model for mortgage REITs

Mortgage REITs are driven by interest rates. The unemployment rate and the inflation rate are the two drivers of Fed policy, given their dual mandate to minimize unemployment in the context of price stability. The mortgage REITs like Annaly (NLY), American Capital Agency (AGNC), and MFA Financial (MFA) have been bloodied since spring, when the Fed hinted that the days of quantitative easing are numbered. The Fed advised that it expected the unemployment rate to fall to around 7% by the end of the year and to 6.5% by mid-2014. If those expectations played out as expected, they would begin to reduce asset purchases by late 2013 and fully end the program by mid-2014.

NAHB Housing Market IndexEnlarge Graph

The Fed decided to hold off on changing policy at the September meeting, and the government shutdown pretty much guarantees it won’t do anything at the October FOMC meeting either. You can see from the chart that the mortgage ETF (MORT) has underperformed the S&P 500 and Treasury bond futures since rates started increasing in May. For the REITs, decreases in unemployment mean higher interest rates at the margin. For non-agency REITs, the decrease in unemployment could mean better credit performance, which offsets the interest rate effect.

Implications for homebuilders

Unlike the mortgage REITs, declining unemployment is strictly good news for the builders like Lennar (LEN) and Standard Pacific (SPF). Homebuilding is a highly cyclical business, and the builders have been in a highly defensive posture since 2007. The builders began to experience a recovery as housing bottomed in early 2012. The California market has recovered the quickest, and builders like Standard Pacific and KB Home are seeing big jumps in backlog and orders. You can see the increase in sentiment in the chart above.

However, even with the rebound in the real estate market, we are still seeing historically depressed housing starts. Prior to the housing bust, starts averaged around 1.5 million units per year. They are now averaging around 900 thousand. Given population growth, this is a highly depressed number. As the job market improves, the first-time homebuyer will return to the market, which will drive earnings for builders at the lower price points like PulteGroup (PHM).

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