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Why do increasing home prices matter to REITs and homebuilders?

Part 3
Why do increasing home prices matter to REITs and homebuilders? (Part 3 of 4)

Why do mortgage REITs like Annaly care about real estate prices?

Negative equity has been a cancer on the U.S. economic recovery

The most obvious issue with negative equity has been the collapse of consumer spending. Since 70% of the economy is consumption, this matters a lot. Unfortunately, during the housing boom, many people used their houses as ATMs, taking out home equity loans and using them to fund lifestyles they couldn’t really afford. This had the same effect that leverage does on an investment: it magnifies the pain on the downside. As you can see from the chart below, the increase in home prices has made a real dent in the number of homes with negative equity.

Negative EquityEnlarge Graph

Second, negative equity has made labor immobile, which has meant that some parts of the country (think shale country) are facing labor shortages, while there are pockets of the country (think the Midwest) where there are huge labor surpluses. This lack of mobility has depressed the labor force participation rate, which is a huge net economic drag. To put the decline of the labor force participation rate into perspective, roughly half the gains that were attributable to women entering the labor force starting in the mid-’60s have been given back.

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), don’t bear credit risk, they’re affected by rising home prices, as they increase prepayment speeds.

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