A Housing Recovery? Consider XHB

| About: SPDR Homebuilders (XHB)

The ongoing foreclosure mess has acted as a large drag on the U.S. economy, preventing further GDP growth. The thesis of this article is to explore the potential bottoming and turnaround in the foreclosure market and hence real estate in general. This article will cite two recent developments that may dramatically speed up the foreclosure process, allowing the real estate market to arrest its declines.

The first development that will be cited is the national mortgage settlement that was recently agreed to by the five largest loan servicers in the country. The key takeaway from the agreement is that up to $25 billion will become available for what is termed "relief" for eligible homeowners. The defendants in the suit were eager to settle, which removes the threat of further regulation and penalties. The costs that will be incurred are manageable over time and can be worked into their forecasting models. By settling, the loan servicers will now be incentivized to arrest further deterioration in their loan portfolio by extending affordable terms to affected homeowners. While the settlement won't be a panacea for all that ills the real estate market, it will prevent a further downward spiral by preventing (where possible) further foreclosures.

Aggressive loan modification and HAMP by themselves won't cure all the ills of the real estate market. Further catalysts will be necessary to bring about an end to the declines. The next major catalyst is the sudden interest in private equity into the foreclosure market.

As recently reported on Bloomberg.com private equity has begun to aggressively enter the foreclosure market. The firm cited in the article is actively involved in purchasing foreclosed properties to be converted into rentals. The firm will acquire foreclosed homes at auction and will immediately rehab the property making it rental worthy. As of December 31, the firm was producing an attractive 8-9% return on equity.

The above average returns currently enjoyed will attract additional capital into the market. It is reasonable to extrapolate that as more competitors enter the market, prices paid for foreclosures will increase, leading to a healing of the overall market. With the new capital entering the market from private equity, combined with the major loan servicers aggressively modifying loans to prevent foreclosure, the overall available supply will shrink rapidly and lead to a firming of price.

From an investment perspective, which company or sector will be the largest beneficiary of this emerging trend? In my opinion, the homebuilders stand to benefit the most. The ETF that I will highlight is SPDR S&P Homebuilders (NYSEARCA:XHB). XHB consists of 37 holdings directly tied to the housing industry. For the purposes of this article I will be using XHB as a proxy for the housing market.

Charts courtesy of Bigcharts.com

As we can see from the charts above, XHB has outpaced the gains afforded by the S&P 500 over the last year. What is more telling is the significant outperformance over the last 6 months. Is it possible that the market is anticipating a turn in the fortunes of the homebuilders? While the gains seen by XHB are impressive, they pale in comparison to those seen by holders of Apple Inc (NASDAQ:AAPL).

In light of recent developments in my opinion, XHB has further upside ahead of it. With the economy slowly healing, combined with loan modifications and active participation by private equity, the amount of overhang caused by foreclosures is abating. Demand for new dwellings should continue to increase, providing a nice tailwind for the homebuilders. The major risk for this scenario would be for the economy to falter and enter into a sudden recession, which as of this writing seems unlikely.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in XHB over the next 72 hours.

Disclaimer: The above article is for informational purposes only. Thank you for reading and I look forward to your comments.