Seeking Alpha

Low Rates Will Reverse Real Estate's Malaise

Includes: ITB, IYR
by: Clif Droke

U.S. housing market slowdown is finally showing signs of reversing.

Near-record low mortgage rates will stimulate sluggish home prices.

Real estate equities have priced in a sustainable housing market recovery.

Earlier this year, it looked like the U.S. real estate market was headed back to earth after an impressive 4-year run. Homebuilding activity was on the wane, as was new home sales. And while mortgage rates have fallen, this wasn't enticing enough for buyers to enter the market. But as we head into Q4, it appears that both buyers and builders are finally responding to the lower rates. While there's still a lot of room for recovery, the latest data suggest that lower rates will gradually boost home sales in the coming year. Here, we'll examine the signs which point to the continued recovery of the nationwide housing market.

Many investors viewed last year's slowdown in the housing market as a sign that real estate was on the precipice of yet another major bear market. Home price increases in several major metropolitan markets entered a steep slide with some even posting negative year-over-year changes in median sales prices.

The year-over-year (Y/Y) slowdown in home prices is clearly illustrated in the graph of the Case-Shiller 20-City Home Price Index. Although home prices were up 2% on a Y/Y basis as of July, there has obviously been a steep slide in home price growth since the last major peak in early 2018.

Case-Shiller 20-City Home Price Index

Source: St. Louis Fed

Analytics firm CoreLogic (NYSE:CLGX) meanwhile reported on Oct. 1 that home prices increased 3.8% Y/Y for August. Home prices increased 0.4% in August on a month-over-month basis, according to the firm. CoreLogic said that of the top 50 markets based on housing stock, 40% were overvalued, 16% were undervalued, and 44% were fairly valued. The firm defines an "overvalued" housing market one in which home prices are at least 10% above the long-term, sustainable mean. Undervalued homes, by contrast, are considered to be those at least 10% under the sustainable level.

Most major metro markets for U.S. real estate, however, continue to show positive yearly growth - even if the rate of growth has dramatically slowed since 2017. One way of looking at this rate of change slowdown is to view the past 18 months as a consolidation of the real estate bull market which began in 2012. That's the view that economist Scott Grannis articulated in a recent blog posting. Grannis points out that while housing starts are weak by historical standards, they're still at levels that indicate a sound, bubble-free real estate market.

It should also be noted that U.S. home construction for August grew at its fastest rate in 12 years. This was a big improvement over the last several months and a promising sign that the housing market recovery is still alive. Housing starts rose 12.3% to a seasonally adjusted annual rate of 1.364 million units in August, the highest level since June 2007, according to the U.S. Commerce Department. The long-term trend for housing starts, meanwhile, continues to trend higher as can be seen in the following graph.

U.S. Housing Starts

Source: St. Louis Fed

The implication of the latest housing start statistics is that lower mortgage rates are finally having a stimulating effect on the market. Heading into 2018, the steady rise in interest rates was a major contributor to the real estate market slowdown. Yet, in recent months, we've seen a rapid drop in rates. While the damage inflicted by the 2017-18 rate increases hasn't been reversed yet, there is every reason to believe that near-record low mortgage rates will attract a growing number of home buyers in the coming months.

In fact, the last time the 30-year fixed rate mortgage average (below) was as low as it is now, was during the 2012-2013 years when the previous real estate bear market bottomed out and a new bull market began. There's no disputing that lower rates always eventually attract homebuyers, and this time around should prove to be no exception.

30-Year Fixed Rate Mortgage Average

Source: St. Louis Fed

Confirming this optimistic viewpoint, real estate-related equities have enjoyed an impressive relative strength position versus most market sectors this year despite the slowdown in physical real estate activity. The outperformance of the real estate stocks is surprising to many, yet, the real estate stocks have evidently discounted the slowdown in U.S. home sales and are looking forward to a stronger market in the coming 6-9 months.

Shown here is the iShares U.S. Home Construction ETF (ITB). As you can see, it continues to trend above its widely watched 50-day moving average and is just under its most recent 52-week high. On a strategic note, if ITB maintains its relative strength through the current broad market internal correction, we'll likely have another entry signal in this ETF soon.

iShares U.S. Home Construction ETF

Source: BigCharts

On a related note, the iShares U.S. Real Estate ETF (IYR) has established a similar pattern of ascending tops and bottoms and is near its yearly high as of Oct. 9. Falling interest rates are almost certainly major reason behind the impressive performance of the real estate stocks in recent months. More importantly, the bullish trend in home construction stocks reflected in the above-mentioned ETFs should serve to encourage real estate investors. Home construction stock prices have historically been useful as a leading indicator for future housing market sales.

U.S. Real Estate ETF

Source: BigCharts

While the slowdown in U.S. home sales which began in early 2018 isn't entirely over yet, there are promising signs that the housing market is turning around. Lower mortgage rates will almost certainly attract fresh buying in the months ahead. What's more, the remarkable strength reflected in real estate equities suggests that informed investors are already acting on this assumption. Based on the evidence reviewed in this report, real estate investors should maintain an optimistic outlook and expect that the housing market recovery which began in 2012 will continue well into 2020.

Disclosure: I/we 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.