State Of The Real Estate Union: Recovery On The Way

Includes: BAC, GS, ITB, LEN, WFC, XHB
by: Remy Raisner, CFA

It took long enough. After years of struggle, the national real estate picture of the United States seems to be brightening. The housing market (single-family homes, townhouses and condominiums), the multifamily real estate market (apartment buildings and garden-style apartment communities) and the lending industry all appear to be turning the corner, slowly.

Getting out of the water

While 24% of mortgages are still underwater, home values are rising across the country for the first time since 2007, albeit at different paces depending on local factors. Prices in Phoenix have recently posted the largest gains (with home prices that increased by 12% in a year). At the other end of the spectrum, prices in Atlanta are still declining (home values have decreased by 6% in a year). Within cities, buyers cluster around sought-after neighborhoods; sales in exurbs and "up-and-coming" areas are lagging.

Reasons for this uptick include the decrease in the number of existing homes for sale; that figure is now close its historical average of 6 months. Many investors who bought foreclosures are renting them out instead of flipping them for a profit, capitalizing on the strength of today's rental market as well as the rock-bottom interest rates available on long-term mortgages. In addition, banks are increasingly holding onto distressed properties instead of bringing them to market. But overall, the largest driver of this reduction in inventory is perhaps existing owners unwilling to sell today and hoping for a better price tomorrow.

A decrease in the supply of homes bodes well for the homebuilding sector. Demand from home purchasers, in addition to the low-interest rate environment, could soon fuel construction and therefore boost earnings for homebuilders, especially the large ones, such as Lennar (NYSE:LEN), which are in the best position to cater to the potential upcoming demand. Such a development would enable homebuilding companies to fully put the crisis behind them. Investors seeking to invest in the housing market while at the same time avoiding exposure to a single company might be tempted by homebuilders ETFs in lieu of issuer-specific securities. The iShares Dow Jones US Home Construction Index Fund (NYSEARCA:ITB) and the SPDR S&P Homebuilders ETF (NYSEARCA:XHB) have been popular with investors.

Multifamily strength

The multifamily market has been stronger than the housing market, and the sector seems to be the first to transit to expansion from recession. Distressed real estate transactions are disappearing: only 1 in 8 trades involves a sub-performing or non-performing asset in 2012, as opposed to 1 in 3 in 2009. In some cities, prices have reached their highest levels again. The tight supply of apartments, combined with the demand from some homeowners who are becoming renters as the result of a foreclosure, have pushed up rent levels dramatically (rents reach as high as $2,935/month on average in New York City). The national vacancy rate is at its lowest level in 11 years at 4.7%. The rental market is white hot in several parts of the country such as San Francisco, where rents increased 7% since last year. More development projects than before are planned or are breaking ground, including some spectacular ones such as the One57 tower in Manhattan, which will be tallest residential tower in the U.S. Capitalization rates across the nation now hover around 6.1% for multifamily properties.

Banks are back (somewhat)

Banks are recovering too and are again well-capitalized and profitable. But while they are gradually increasing their supply of real estate loans, lending standards are still tight. Obtaining a mortgage currently requires a strong credit history and a large down payment. Consequently, Bank of America (NYSE:BAC), like numerous peers, showed improved credit quality during the second quarter 2012.

Nevertheless, foreclosure-related liabilities are still an important question mark. Even though Goldman Sachs (NYSE:GS) has just won the dismissal of a lawsuit linked to the "robo-signing" scandal and mortgages securitization, banks are still ensnared by the housing collapse and are setting aside reserves for losses from legal, mortgage-related issues. Bank of America has set $15.9 billion aside, Wells Fargo (NYSE:WFC), $2.6 billion. Bank officials are worried that their institutions might be forced to take back delinquent mortgages that they had sold to investors. The U.S. federal government has kept pressure on lenders, even though the largest ones settled a lawsuit related to foreclosure wrongdoings for $25 billion in February of this year. The government is seeking additional compensation for homeowners who were victim of abuses and violations during foreclosure proceedings. Individual states across the nation are proposing a variety of new rules that would make it more difficult for banks to sue homeowners that have fallen behind mortgage payments. As recently as in July, the city of Los Angeles sued U.S. Bancorp for being a "slumlord" and failing to maintain foreclosed properties in good physical condition. Several Californian municipalities have even sought to use eminent-domain powers in order to seize defaulted mortgages and write down the principal owed by the borrower.

Rising home values led Fannie Mae (OTCQB:FNMA) to post its largest profit since it was bailed out by the U.S. government in 2008. Freddie Mac (OTCQB:FMCC), also bailed out, is stabilizing too. Even if a large part of the profit is due to an accounting gain, Fannie and Freddie finally improved their earnings and balance sheets by tightening lending standards.

Threats to the housing market still exist. Rising unemployment could hamper the recovery; so could flagging consumer confidence. Banks still have a shadow inventory of 3 million non-performing properties that they need to dispose of. Nevertheless, prospects are finally looking up for the housing market nationwide.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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