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Home Prices Are Almost 4% above the Bubble Peak

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Home prices breach peak levels

May’s 5.6% year-over-year gain in home prices has put the FHFA (Federal Housing Finance Agency) House Price Index at about 4% above its April 2007 level. Strangely, the financial press has largely ignored what has happened to this index. The press tends to focus on Case-Shiller, which is still below 2007 levels.

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.

According to most indicators, real estate prices should be flattening because wages haven’t been keeping up. Although home prices have historically correlated tightly with incomes, 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. The median-home-price-to-median-income ratio is 4.4x, which is much higher than its historical range of 3.2x–3.6x. That ratio peaked at 4.9x at the height of the bubble.

Granted, low interest rates are playing a part in making expensive homes more affordable. This will probably unwind as interest rates rise. Notably, borrowers with adjustable-rate mortgages are most at risk.

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Implications for mortgage REITs

Big agency REITs (real estate investment trusts) such as 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 these companies don’t care about real estate prices.

As home prices rise, homeowners who were previously underwater gain the ability to refinance, which 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 be paid off as borrowers are able to refinance. Prepayment burnout is probably already baked into the cake at these interest rate levels. However, investors in Ginnie Mae mortgage-backed securities are at risk of streamlined VA (United States Department of Veterans Affairs) interest rate reduction refinances.

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 in the real estate sector as a whole could look at the iShares Mortgage Real Estate Capped ETF (REM).

Continue to the next and final part of this series for a discussion of home price appreciation and geographical considerations.

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