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What You Don’t Know About Home Prices Can Hurt You

Finance

What You Don’t Know About Home Prices Can Hurt You image 210313 IC cekerevacAs the rebound in home prices continues, many people are trying to determine what the best investment strategy is at this point in time.

Let’s take a look at what has happened and what is most likely to occur in the future for home prices to help create a long-term investment strategy.

At the end of 2012, due to the increase in home prices across the nation, 1.7 million homeowners, who were underwater (meaning their mortgage was worth more than the value of their homes) a year ago, had positive equity, according to CoreLogic. (Source: Gopal, P., “U.S. ‘Underwater’ Homeowners Regain Equity as Prices Rise,” Bloomberg, March 19, 2013.)

The rise in home prices continues, as January saw a 9.7% increase over year-ago levels. According to CoreLogic, if home prices rise by five percent more, an additional 1.8 million homes will return to positive equity.

Clearly, there is no doubt that the proper investment strategy over the past year has been to gain exposure to the real estate market, as home prices have increased substantially.

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Part of the rise in home prices is due to institutional investors who also have foreseen this investment strategy and have set out to purchase thousands of homes to convert into rental units. Because of the low yields on government bonds, many institutional investors are attracted to the high margins from renting units out as an investment strategy.

As I’ve mentioned in these pages several times before and when the stock was trading much lower, The Blackstone Group L.P. (NYSE/BX) is a great company that has aggressively bought in excess of 20,000 single-family homes and converted them into rental properties.

Not only is Blackstone benefiting from higher home prices, but the yields on renting units are also significantly higher than comparable fixed-income investments. This type of investment strategy has been so successful that the company is now expanding its credit line from $600 million to $2.1 billion in order to accumulate even more homes.

However, even though I have been bullish on Blackstone for quite a long time, there are clouds on the horizon. The first storm could come when the Federal Reserve begins to tighten its loose monetary policy. This doesn’t seem likely to happen anytime soon, and I think we could see an additional 10%–15% increase in home prices until the end of 2015.

The real issue now is that home prices have risen far above rental rates. As an investment strategy for purely yields, rents are either flat or actually decreasing in many markets, while home prices are increasing at substantial rates.

In Phoenix, the asking level for home prices rose 25% in February, as compared to year-ago levels, while rents are up only 1.3%, according to Trulia, Inc. (NASDAQ/TRLA). Asking prices in Las Vegas increased by 18%, while rents have dropped 1.7% during the same period. (Source: Gittelsohn, J. and Gopal, P., “Blackstone Crowds Housing Market as Rental Gains Slowing,” Bloomberg, March 18, 2013.)

The fact is that there is such a supply of rental units that rents are flat, and in some markets they’re declining. This combined with higher home prices means an investment strategy of buying to rent will now offer much lower yields than it would have just one or two years ago.

An investment strategy to accumulate homes for resale, I believe, will remain an effective tactic as long as the Federal Reserve keeps rates low. However, if all of these institutional investors decided to sell, this would severely affect home prices.

In addition, going forward, the yield obtained from rents will be much smaller, as home prices continue to move up with rents remaining flat, squeezing this investment strategy, and having much smaller returns.

As long as the Federal Reserve has a loose monetary policy program in place, look for home prices to continue moving up and pay attention to companies that can take advantage of this investment strategy. Once the economy regains enough steam that the Federal Reserve can pull back on its unprecedented aggressive monetary policy stance, I would look to exit.

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