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Home Prices Hit New Records: What Does This Mean for REITs?

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Home prices broach peak levels

The recent 5.5% year-over-year gain for home prices has put the FHFA (Federal Housing Finance Agency) House Price Index about 3% past its April 2007 levels. Strangely, the financial press largely ignored this event. While most indexes show the housing market bottoming out around February 2012, the FHFA House Price Index shows it bottoming out around May 2011. Distressed sales may have dominated at the end of 2011, pushing the other indexes lower.

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According to most indicators, real estate prices should be flattening because wages haven’t been keeping up. Although home prices have correlated tightly with incomes historically, that relationship became unmoored with the Fed’s extraordinary easing, which started in the late 1990s. While incomes aren’t rising, scarcity is pushing up prices.

For most families, homes comprise the lion’s share of their net worth. While most middle-class families would like a raise, 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

Big agency REITs American Capital Agency (AGNC), Annaly Capital Management (NLY), and MFA Financial (MFA) invest in mortgage-backed securities that the government guarantees. But that doesn’t mean that 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 mortgage-backed securities that have high coupons and low prepayment rates. As home prices appreciate, these loans will pay off as borrowers are able to refinance.

If you’re interested in making directional bets on interest rates, you could 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 impacts investors.

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