Why slowing home price growth since the summer affects some REITs

The CoreLogic index of real estate prices increased 12.5% year-over-year in October

The CoreLogic index is a widely followed index of real estate values. Unlike the other major indices, like Case-Shiller or Radar Logic, CoreLogic separates distressed sales from non-distressed sales. Non-distressed sales more indicate the core market in general. Note that CoreLogic recently bought the Case-Shiller indices, so we’ll see if it changes its methodology.

CoreLogic Home Price Index 1 yearEnlarge Graph

The CoreLogic Home Price Index

Real estate values are big drivers of consumer confidence and spending, so they have an enormous effect on the economy. The phenomenon of “underwater” homeowners, or those who owe more than their mortgage is worth, has been a major drag on economic growth. Underwater homeowners are reluctant to spend and can’t relocate to where jobs are. 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 are falling, banks become conservative and reserve funds for losses. Conversely, increasing real estate prices make the collateral worth more than the loan, which encourages them to lend more.

Month-over-month growth is decelerating, but still positive

The 12.5% year-over-year gain resembles the gains we saw during the bubble years. On a month-over-month basis, the increase was only 0.2%—much lower than the numbers we saw over the summer. Both distressed sales and non-distressed sales rose by similar amounts. The consensus is growing that prices bottomed in February of last year. The rebound has been strongest in the western states—primarily California, Nevada, and Arizona. That said, of the 100 distinct markets that CoreLogic measures, 99 showed year-over-year gains. Only New Mexico reported a drop.

The theme of the real estate market for the past year has been tight inventory. Professional investors (think hedge funds and private equity firms) have raised capital to purchase single-family homes and rent them. This has been driven by auctions from the federal government, primarily the FDIC and FHA. These entities have been auctioning off billions of dollars worth of real estate and required investors to hold them for a period of three years. This 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.

Implications for mortgage REITs

Real estate prices are big drivers of non-agency REITs, such as Two Harbors (TWO), PennyMac (PMT), or Redwood Trust (RWT). When prices are rising, delinquencies drop, which helps servicers and those who invest in non-agency (non government-guaranteed) mortgage-backed securities. It also helps 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. While agency REITs, like Annaly (NLY) or American Capital (AGNC), do not bear credit risk, they’re affected by rising home prices, as they increase prepayment speeds.