S&P Case-Shiller index and its effect on mortgage REITs

The Standard and Poor’s/Case-Shiller index of real estate prices increased 7.3% year-over-year in January, hinting that the real estate market bottomed around this time last year.

The Case-Shiller index

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, 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 cannot relocate to where the 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 hold reserves for losses. Conversely, increasing real estate prices makes the collateral worth more than the loan, which encourages them to lend more.

Predictions of future growth

The real estate market is seasonal, spring and summer tend to be the months when most transactions take place and pricing is the strongest. Winter is a seasonally weaker period. In the chart above, you can see the seasonal dips in real estate prices for the past four years. This year, prices have not exhibited much of a seasonal dip due to tight inventory. This bodes well for this year’s summer selling season.

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 single family homes. In some of the hardest hit areas, prices are rebounding the strongest – the Phoenix metropolitan statistical area (MSA) is up 23% over the past year due to demand for rental properties.

Implications for mortgage REITs

Real estate prices are big drivers of REIT (such as MORT, RWT or PMT) performance. When prices are rising, delinquencies drop, which helps the 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.