An adventurous play on the US housing recovery

America's housing market is going from strength to strength. So how can you profit? John Stepek picks a high-risk play for adventurous investors.


The US housing recovery seems to be going from strength to strength.

House prices across the country are now up by more than 10% on the year, according to the most recent S&P/Case Shiller Home Price index. Even the bubble-era practice of flipping' buying a house, doing it up, then selling for a quick profit is making a comeback, according to the FT.

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But there's a dark cloud on the horizon. While buyers are still sending house prices higher, stocks of housing-related companies have taken a hit in the past month or so. Some of the housebuilders are off by around 20% from their 2013 highs.

What's driving this pullback? And are investors right to be concerned, or is this a buying opportunity?

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The US housing market hits a pothole

We've been keen on the idea of investing in the US housing marketfor quite a while now. And it's certainly been one of the brightest areas in the US economy.

However, the shine is starting to come off a little. For example, sales of existing homes dipped a little in June falling by 1.2% on May according to the National Association of Realtors. Meanwhile, the number of unsold houses rose by 1.9%.

Now, this isn't an especially big deal on its own. After all, it's just one piece of data. However, if sales are heading for a slide, there's a fairly clear reason for it. The cost of borrowing for US homebuyers has shot up over the last six weeks or so.

Fear that the Fed will stop printing as much money each monthsent the average 30-year mortgage rate up from 3.68% to as high as above 4.5% at one point. It doesn't sound like much, but it's the highest rates have been in two years.

For anyone slightly baffled by this, it's worth understanding that the US mortgage market is not like the British one. To cut a long story short, British mortgage rates are quite short term. Ten years would be a very long time to fix your mortgage in Britain. Most home loans are taken out for shorter periods than that, and often rates are tied to the Bank of England interest rate.

In the US on the other hand, 30-year home loans with fixed interest payments are normal. So the important rate is not the Fed's funding rate (the equivalent of the Bank of England rate). It's the rate for much longer-term borrowing.

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This structural difference in the home loan market was the main reason why the US had a massive house-price crash and we in the UK didn't see as much damage. When the Bank of England cut interest rates hard, mortgage rates came down rapidly as a result.

In the US, it was much harder for the Fed to bring down home loan costs rapidly. It wasn't until the money-printing began in earnest that rates really came down.

The US housing market won't collapse again yet

In any case, the point is that the cost of borrowing for homeowners is rising in the US. Meanwhile, the cost of houses is rising too. So houses are no longer as affordable as they were.

So how much impact is this going to have on the market?

Well, mortgage rates may take a while to rise further. Ben Bernanke was clearly unnerved by the market reaction to his vague suggestion in May that money-printing might not be a permanent fixture in the US. As a result, he has back-pedalled sharply on the idea of ditching the money-printing. He's not going to be happy if bond rates continue to rise much further.

And affordability is still high. Steve Sjuggerud, writing in the Daily Wealth newsletter, notes that "housing affordability is still well above its long-term average."

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On top of that, consumer sentiment still seems to be on the side of US property. If people start to feel that they have to snap up a property before rates go any higher, then it's distinctly possible that there will be further gains for US property prices.

Meanwhile, some housebuilders are apparently slowing down the pace of sales growth in favour of boosting prices, reports the FT, particularly in areas where land and skilled workers are in short supply. Higher sales prices mean higher profit margins, which means higher earnings.

Year-on-year, the average selling price rose 16% in the first quarter, notes the FT. "Existing inventories are so low that buyers have no choice but to pay up," Drew Reading of Bloomberg Industries tells the paper.

In short, it sounds as though there may be life in the US housing market yet. Trouble is, it all seems to be priced in. Housebuilders have rebounded in many cases from the recent panic over interest rates, and few look like compelling value here.

A high-risk sector for adventurous investors

However, there is one interesting area that those with an appetite for risk might want to take a look at: mortgage real estate investment trusts (Reits). Mortgage Reits use cheap short-term debt to buy mortgage-backed securities paying out higher rates.

They profit from the gap between the two. And because they are Reits, they have to pay out 90% of this profit in dividends. So their yields are often in double-digit territory.

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They've done very well in recent years. The Fed has kept short-term interest rates down, and has also bought mortgage-backed securities, pushing their prices higher.

However, the recent jump in interest rates on mortgages has been bad for the price of mortgage-backed securities (as yields rise, prices fall). That in turn has been bad for these mortgage Reits. That's because, as Jordan Wathen of the US Motley Fool website notes, they use a lot of borrowed money to buy these securities. When the price falls, that hits their balance sheets hard.

But as long as the companies can weather this, in the longer run, this might be a good time to buy. The Fed has promised to keep short-term interest rates low for as long as possible. If the gap between short-term interest rates (the price the Reit borrows at) and longer-term mortgage rates (the yield it gets from its investments) grows, then it should have a better opportunity to profit.

These are complicated investments, so you should investigate them yourself to be sure you have a good idea of the risks involved. But if you're interested, one of the biggest is Annaly Capital Management (NYSE: NLY), which currently yields around 13%.

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