The Housing Market is Finally Bottoming – Here's How to Play It

The housing market remains a drag on the economy, but there are indications that it is finally starting to bottom.

Prices have stopped declining, and there is even some sign of life in sales.

Not all the news is good, of course. New home sales dropped still further in August from July, falling to a pathetic 295,000 annual rate compared to the 1 million-plus in the good years. And housing starts fell to an annual level of 571,000 from 601,000 in July – that's 12% below their August 2010 level.

Still, this is to be expected. The new home sector should be the last to turn up. There is a massive overhang of existing homes, both through foreclosures and through suppressed sales from homeowners that are "under water" on their mortgages and can't afford to sell.

With the exception of a very few markets – such as North Dakota (4% unemployment and new jobs appearing from the Bakken oil shale) and the overstuffed bureaucrat haven of Washington and its surrounding suburbs – there should be very few new homes built for the next several years.

In the early part of the downturn, production was inflated by the big homebuilders' land banks. But no sensible homebuilder has been expanding its land holdings for four years, so that pressure is much less.

The pressure of existing housing inventory overhang eventually will wear off, and homebuilding will accelerate again – but that's probably several years off. In the interim, there is some demand for apartments, as the rental market is picking up, so sensible homebuilders are concentrating most of their efforts on that sector.

The recent good news came in the form of prices. The S&P/Case-Shiller 20-city index in July rose marginally for the fourth straight month, suggesting that the long decline may have ended.

More importantly, existing home sales rose 7.7% to a seasonally adjusted annual rate of 5.03 million – 18.6% above the August 2010 level. The average sales price was down 5% from the previous year, closely tracking the 4.1% year-over-year fall in the July Case-Shiller index.

Meanwhile, the inventory of unsold homes fell by 3% to 3.58 million homes, which now represents 8.5 months of supply.

This is what you would expect at the bottom of the market. Break Here: To continue reading, please click here…While the market for new homes remains weak, the market for existing homes expands as buyers are attracted by the available bargains, especially in the foreclosure market. The price decline slows, while the working off of inventory and price stabilization increases market confidence.

The only negative factor in the picture is that mortgage rates are still close to their all-time lows. Thirty-year fixed-rate mortgages fell to an average of 4.01% in the week ending Sept. 29, down from 4.09% the previous week. The average rate on 15-year fixed-rate loans last week fell to 3.28%. Both are the lowest levels since the Federal Home Loan Mortgage Corp. Freddie Mac (OTC: FMCC), Freddie Mac, began keeping track.

That's close to the level of inflation and far below the levels that would prevail in a free market absent the influence of the Federal Reserve's lax interest rate policy and the government's home mortgage guarantees. If mortgage rates had risen while home prices were still above their long-term average (in terms of earnings) they would have held back the housing market. However, with houses cheap in most markets, they will have less impact.

The other hopeful sign for the housing market is an uptick in rentals. August's consumer price index showed a 0.4% rise in rent levels, following a 0.3% rise in July. This corroborates anecdotal evidence of rent increases around the country.

This, too, is to be expected. The home ownership rate has declined sharply in the last five years, and people have to live somewhere. A strong rental market will both boost prices and help absorb the inventory of unsold homes. Owning rental housing in areas such as North Dakota, with sound economic fundamentals and low unemployment, thus looks attractive.

The implications of stability in the housing market are very positive for the economy as a whole. If the U.S. falls into a "double dip" recession, the second dip will be a shallow one as the majority of consumers who have jobs gain confidence and push the economy into recovery.

For investors, it's too early to buy housing stocks. However, apartment real estate investment trusts may be attractive, with rentals rising, interest rates low, and construction focused on this sector.

Valuations in the sector are on the high side, with many companies paying dividends in excess of earnings, but Equity Residential (NYSE: EQR), with a 2.5% dividend yield well covered by earnings, looks to be a good value. And AvalonBay Communities Inc. (NYSE: AVB) began construction on $800 million worth of new developments in 2010, which is a smart strategy. Its 3% yield, which will be well covered once its new projects come on stream, also adds to its attraction.

Still, as an investor more used to lower price/earnings (P/E) ratios, I have to say the sector looks too pricey for more than a small flutter.

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