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By Thomas H. Kee Jr.

Interest rates and price are inversely related and that means of course that bonds will come under pressure if interest rates rise. Bond prices react immediately to market moves because bonds are a liquid market, that means bond fund investors are already feeling the pain of higher rates today, but higher rates will also apply to the housing market.

The difference is that the housing market is not an efficient market, at least not nearly as efficient as the bond market or the stock market. Housing reacts like a snail sometimes but that does not change the inverse relationship between interest rates and price.

Although individuals may still be clamoring to buy property, institutional investors have already started to back off and some of them are strongly reconsidering their real estate holdings. Just a couple of short years ago, the largest banks and financial institutions in our country were forced to sell massive amounts of real estate (and MBS too), and because of the high risks at the time and the often low quality of many of those assets, they were forced to do this at a fraction of what they were worth.

As a result, hedge funds, which were the buyers of these assets, have massive amounts of real estate on their books, and they have been renting that real estate to generate income in many cases. This has been widely known for quite some time, but what might not be known yet is their interests in selling those assets; this will especially be true if they perceive the values to reverse lower.

Hedge funds are paid based on performance, and many of them have "written up" the value of their real estate properties to reflect not only the fair value versus their purchase prices, but also to reflect the trickle-up that has happened afterwards in real estate prices on a nationwide basis. They have purposefully kept those properties off of the market until now, but that can change on a dime.

In the bond market we can estimate a price decline of about 4% if interest rates moved from 2% to 2.5%, so a similar relationship can be ascertained for real estate for this example. Again, the real estate market reacts slowly but it still is impacted by changes in yield.

Starting almost immediately, the hedge funds which determine that Interest Rates have indeed bottomed and yields are indeed going to continue to increase will be faced with the unenviable task of selling those properties. They will do this to prevent loss and because they know bonuses will not come unless they record a gain, some of them could be compelled to act quickly.

Beware of a flood of inventory as a result, and beware of larger-than-expected price declines in real estate in the year ahead. Real estate and real estate stocks are likely to come under severe pressure. PulteGroup, Inc. (PHM), Lennar Corporation (LEN), KB Home (KBH), and Toll Brothers Inc. (TOL) should all be avoided by long-term investors as a result, but these stocks are also likely to be extremely volatile in the days, weeks, and months that follow, so traders may have a field day with them.

Source: Hedge Funds Understand Real Estate Risk