American property has turned the corner - the time to buy is now

It increasingly looks as though the American housing market has hit rock-bottom and is now finding its feet. The most recent numbers from the S&P Case-Shiller index suggest that house prices in nearly every part of the US rose in value between July and August 2012, with an average annual price rise of 2%.

Encouragingly, former basket-case local markets, such as Detroit, Phoenix and Atlanta, showed the strongest growth.

This index may even be underestimating the recovery. The Federal Housing Finance Agency's Home Price Index has risen by 4.9% over the past year. Another survey from CoreLogic puts the increase at 5%. Other key indicators are also flashing green.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

New housing starts grew to an annualised rate of 872,000 in September, the highest in nearly four years, while the number of building permits granted rose to 894,000. Sales of existing houses rose in October, helped in part by growing international interest. Total sales volume to international clients grew to $82.5bn for the year to March 2012, up from $66bn the previous year.

This positive momentum is being powered by incredibly low servicing costs on mortgages, helped along by the US Federal Reserve's aggressive intervention in the market via Operation Twist (designed explicitly to lower mortgage costs).

Mortgage rates are now near their lowest levels since long-term mortgages were first offered in the 1950s. A 30-year fixed mortgage currently costs as little as 3.60% in interest to service each year. This has made houses more affordable and driven a big rise both in mortgage applications and in refinancing to cheaper deals.

America's demographics also support the market. Younger people still find houses relatively expensive, so they've switched en masse to renting. As a result, America's rental market has boomed in recent years, helping to support prices.

Rental vacancies are now at their lowest levels in over a decade, while the homeowner vacancy rate is at its lowest point since March 2006. According to JPMorgan analysts, selected "regions in the US can easily give a rental yield of well above 5%".

It's not all sweetness and light. Even if the housing market has stopped falling, that's a long way from suggesting a boom is just around the corner. Most economists expect a slow, muted recovery, with still-high levels of inventory hanging over any upturn.

Credit remains tight for anyone but prime borrowers, and there's some evidence that some rental markets in large metropolitan areas are overheating, with rents and prices heading for an inevitable fall back in the not too distant future.

House builders have soared

But this hasn't stopped many US-based investors from betting on a big recovery in the housing market. US-based house builders listed on the New York Stock Exchange have been the main beneficiaries. I'm talking about companies such as Pulte Homes, DR Horton, KB Home and Lennar, which are the US equivalents of our own Wimpey and Persimmon.

Among the top tier of these firms, the worst stock is up almost 50% for the year while the best has surged by as much as 160%. This impressive showing is reflected in the exchange-traded funds (ETFs) that track the sector and invest in these firms. The biggest can all be bought via a UK-based stockbroker.

State Street's ETF SPDR Homebuilders (NYSE: XHB) is the cheapest with a total expense ratio (total costs TER) of 0.35%. It's up a cracking 61% this year. The iShares Dow Jones US Home Construction Index Fund (NYSE: ITB) is up a whopping 116% over the year. Its TER is slightly higher at 0.47%. Top holdings include Lennar at 10%, Pulte at 9% and DR Horton at 8%.

I'd be careful about these ETFs. They've already done very well, and many builders are priced for perfection. The average price/earnings ratio of companies in the iShares ETF is 32, and collectively the companies yield just 0.35%.

That said, I think house builders could still go higher if the housing bounce is even stronger than expected. So I'd look at a novel US house builder tracker from PowerShares the Dynamic Building & Construction Portfolio (NYSE: PKB). It has a TER of 0.63%, and is up a relatively sedate 42% on the year.

This index weights its holdings based on "investment merit criteria, including fundamental growth, stock valuation, investment timeliness and risk factors". Looking down its list of holdings, it seems to be more focused on US small caps, and may be better value with its average p/e of 22.

How to play the rental market

There's a more conservative way of playing any possible US housing recovery, especially in the rental markets. This is through a real-estate investment trust (REIT) focused on residential investment.

These operate just like REITs in Britain, in that they have to distribute at least 90% of their income via dividends. British investors do need to be aware, though, that this income focus can open up problems, as you'll still have to pay a 15% withholding tax even if you have an American tax waiver signed with your stockbroker.

The residential US REIT market is huge. The funds in the sector are built around two main operating specialisms. They own either multifamily residences' (flats to you and I), or lower-cost manufactured housing, which can include trailer parks.

On average, these residential REITs trade at a discount of about 2.6% to their book value and yield about 3% a year. Share prices have risen by between 10% and 35% in the last year, but all the big companies have a strong pipeline of new developments. Business is booming for these conservatively managed outfits.

MH Properties is focused on the north-east of America and Sun Properties operates nationwide. These two dominate the manufactured housing segment, boast higher dividend yields (above 5%) than average, and are focused on families who earn less than the average income and so appreciate housing that can be as much as 40% cheaper than traditional builds.

In the multifamily' segment, the dominant players are Equity Residential (NYSE: EQR), headed by famous American entrepreneur Sam Zell, and AvalonBay Communities (NYSE: AVB). It may also be worth looking into smaller, self-administered outfits (this means the REIT is internally managed for investors), such as Apartment Investment and Management Company (NYSE: AIV) and UDR (NYSE: UDR), which is a fast-growing player.

Buy mortgages for high yields

Adventurous investors looking for a chunky yield might be tempted by a more racy alternative: funds that invest in residential mortgages. These mortgage REITs traditionally pay out huge yields, powered by massive leverage on their balance sheets gearing of six to eight times is not uncommon.

The biggest player is American Capital Agency Corporation (NYSE: AGNC). Its margins are pretty typical the spread between the funding cost it has to pay (at 1.08% per year) and its asset yield' (what it gets back from clients) is just 1.65%. But its shares yield over 14%, through all that leverage.

The risks inherent in this model are obvious (leverage is a nasty thing in a downturn), yet it's also true that this can be a very profitable sector when markets are buoyant.

What would I invest in?

If I had to make a big, bold bet, I'd say that we're only just at the beginning of a multi-year recovery story in the American housing market, with at least another two to four years of upswing ahead. I've run through my favourite picks in the sector in the box below.

My favourite picks in the American housing sector

First I'd look at a specialised REIT called RAIT Financial (NYSE: RAS). This is a much-diversified player. RAIT invests in residential properties and commercial real estate. It also manages properties for clients, while its core focus is real-estate lending. It's yielding close to 7% and trades at well below book value.

I'd also consider dipping my toe cautiously into mortgage REITs and their income flow, although I'd keep a beady eye on the threat of any future interest-rate increases (which would be bad news for firms carrying all that leverage).

Luckily there are US equivalents to our investment trusts, and some of these funds have a focus on income from the mortgage REIT sector.

The BlackRock Income Trust (NYSE: BKT) is overwhelmingly invested in residential mortgages, yields 6% and trades at a discount to book value of 10%. Rival firm Nuveen has not one but two closed end funds: the Nuveen Mortgage Opportunity Term Fund (NYSE: JLS) and the Nuveen Mortgage Opportunity Term Fund 2 (NYSE: JMT), which each pay out over 10% a year, and invest in commercial property mortgages too.

But perhaps the least expensive and lowest-risk way of buying into any American housing recovery is not to buy a fund but wait for it a bank! Roger Altman, a former Treasury official and founder of investment giant Evercore Partners, reckons a US housing recovery could boost the American economy by 1%-2%, although analysts at JPMorgan put this much lower, at 0.5%.

Whatever the exact boost, a housing recovery is good news for the economy, which in turn is likely to be good for outfits such as Wells Fargo (NYSE: WFC), the largest residential home mortgage originator in the US (it wrote a third of all new mortgages in America in the first half of 2012).

It might also be worth taking a closer look at those smaller regional banks that are dominated by their mortgage book. One example is Regions Financials Bank (NYSE: RF), based in the south. This bank boasts a booming mortgage book and even pays a dividend (remember them, British bank shareholders?).

And if the banks don't benefit I have one last idea: Home Depot (NYSE: HD), America's foremost DIY specialist. The company has seen sales pick up steadily in the last year, yields 1.8%, and trades at 1.3 times revenue and 22 times profits.