The Standard and Poor’s/Case-Shiller index of real estate prices increased 9.3% year-over-year in February, 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 banks to lend more.
It is becoming more certain that home prices bottomed around this time last year.
This is the second time since the bust that we have seen year-over-year gains in the real estate indices (January was the first). The consensus is growing that prices bottomed in February of last year. Prices have risen the most in areas that were hit the hardest – places like Phoenix and Detroit, as well as some of the hot markets in California, especially San Francisco. Conversely prices have not shown as much growth in states where the foreclosures must be approved by a judge. The judicial states are primarily in the Northeast, most notably New York and New Jersey.
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 out single family homes. 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 had the effect of taking 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 Annaly (NLY), Newcastle (NCT), PennyMac (PMT), Redwood Trust (RWT), and Walter Investment Management (WAC). When prices are rising, delinquencies drop, which is important because non-agency REITs face credit risk. Even for agency REITs, who invest in government mortgages, rising real estate prices can drive prepayments, which negatively affects their returns. Rising real estate prices 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.