The Fed's Unintentional Superheating Of U.S. Real Estate

by: Zoomie Brokers

In chemistry, superheating is the phenomenon in which a liquid is heated to a temperature higher than its boiling point, without boiling. This phenomenon will occur when the additional force of surface tension is applied under the right conditions. Similarly, many U.S. real estate markets are being superheated by the additional force of the Federal Reserve. Note, in sticking with the chemistry analogy of superheating, there are no visible bubbles, but it creates a potentially explosive situation if the tension is breached through sufficient heating.

Whether you are a supporter of Bernanke's Fed policies or not, most would agree that the multiple rounds of quantitative easing, the double shot of operation twist, and the ongoing monetization of mortgage backed debt has assisted U.S. real estate in its recovery. When viewed nationally, housing definitely appears to be in recovery, but few would characterize the national market as booming and most would likely argue that the housing market would run out of steam without the Fed's accommodative policies in place. Combine that notion with recent reports reflecting a softening economy and the Fed's accommodating policies toward U.S. housing appears to be a lock for the next 6-12 months, at least. This should continue the momentum for real estate and investors could capitalize simply by betting on the sector (NYSEARCA:IYR), homebuilders (NYSEARCA:XHB), or home improvement stocks Home Depot (NYSE:HD) or Lowe's (NYSE:LOW).

This is where the superheating comes in - there are many markets across the country that have shown very strong housing recoveries. Markets such as San Francisco, Phoenix, Los Angeles, San Diego, South Florida, Denver, and Las Vegas, among others (Best Places to Invest in U.S. Real Estate), have seen strong appreciation and demand for housing. A tight supply of homes for sale has even kick started significant new construction in many of these markets. So while the Fed attempts to keep the national housing market on track with accommodating monetary policy, they are unintentionally superheating numerous strong and healthy metro housing markets. Investments targeted to these markets may include specific homebuilders such as KB Homes (NYSE:KBH), Taylor Morrison (NYSE:TMHC) and Lennar (NYSE:LEN) or companies heavily invested in these regions such as Silver Bay (NYSE:SBY) or Blackstone (NYSE:BX).

While prices have increased at a swift pace in these high performing markets, much of the activity has been driven by investors making sensible investments rather than everyone and their brother speculating on the ever-appreciating real estate concept of the last bubble. As interest rates are currently nearing all-time lows (again), this allows investors, private equity, and REITs to continue to acquire real estate at higher prices while receiving a comparable internal rate of return (IRR). With ample IRRs of 20% or more on real estate investments in many of these markets, one would expect continued strong demand until interest rates, prices or a combination of both rise sufficiently to reduce anticipated investment IRRs below investors' appetites or below other investment alternatives. This should continue to drive up real estate prices over the short term.

Whether the Fed can keep these markets from boiling will be interesting to see, but if they continue targeting their monetary policy for the "national" housing market, it's more than likely that additional demand from first time home buyers, boomerang buyers, etc will eventually create bubbles in the stronger metro housing markets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.