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House Prices Eclipse Their Bubble Peak of April 2007

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Home prices approach peak levels

The recent 5.9% year-over-year gain for house prices has put the FHFA[1. Federal Housing Finance Agency] House Price Index about 1% past its April 2007 levels. Strangely, the financial press ignored it. While most indexes show the housing market bottoming out around February 2012, the FHFA House Price Index shows it bottoming out around May 2011. Perhaps distressed sales dominated at the end of 2011, pushing the other indexes lower. As you can see from the chart below, prices are nearly back to their prior peak.

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Real estate prices are beginning to flatten because wages haven’t kept up with real estate prices since the downturn. Historically, real estate prices and incomes have correlated pretty closely. After the real estate market had bottomed out, professional investor demand pushed up prices, but wages didn’t move. This made further home price appreciation difficult.

On the other hand, low inventory continues to provide pricing support. The latest data from the National Association of Realtors pegs existing home inventory at 3.9 months, or well below what would be considered a normal inventory of around 6.5 months or so. Take that 3.9-month supply number with a grain of salt, however, as regulatory issues added a lot of noise around that number.

For most families, homes comprise the lion’s share of net worth. While most middle-class families would like a raise as well, home price appreciation is the next best thing. Many homeowners are finding that they can now do a cash-out refinance on their homes and use the cash to pay off higher-interest-rate credit card debt. This lowers monthly payments and gives the homeowner more disposable income to fund consumption.

Implications for mortgage REITs

The big agency REITs like American Capital Agency (AGNC), Annaly Capital (NLY), and MFA Financial (MFA) invest in MBS (mortgage-backed securities) that the government guarantees. But that doesn’t mean these companies don’t care about real estate prices.

As home prices rise, homeowners who were previously underwater gain the ability to refinance. This increases prepayment speeds. Since they’re underwater, many homeowners hold 2006-vintage and 2007-vintage MBS that have high coupons and low prepayment rates. As home prices appreciate, these loans will pay off.

If you’re interested in making directional bets on interest rates, you can consider the iShares 20+ Year Treasury Bond ETF (TLT). Investors interested in trading the real estate sector as a whole could look at the iShares Mortgage Real Estate Capped ETF (REM).

In the next part of this series, we’ll look at how home price appreciation varies by state, and how this affects investors.

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