Toll Brothers Inc (NYSE:TOL) The Risks in Real Estate Stocks

The leading indicator that is the stock market often portends developments that are set to come in the open market, and what is happening to real estate and real estate stocks is a case in point.

In the effort of full disclosure, I issued a short recommendation on real estate using ProShares UltraShort Real Estate (ETF) (NYSEARCA:SRS) on March 24.  The entry price was $11.12.  The ETF split since then and the equivalent price (post split) is $44.48.  The ETF trades at $53.57 (when I wrote this), so we are already up about 20% in this position. 

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Real Estate stocks to watch:

I believe it will be important to monitor news stemming from the top real estate stocks on a regular basis, while taking note of their recent weakness, as interest rate risks increased.  Those are Toll Brothers Inc (NYSE:TOL), Hovnanian Enterprises, Inc. (NYSE:HOV), and PulteGroup, Inc. (NYSE:PHM).  Quite often we can better identify the direction of real estate in the open market from information disseminated by the public disclosures of these companies.

I initiated this position as part of a defensive portfolio, but also because it fit very well in the bigger picture that I was observing and still am observing.  I believe the stock market and other asset classes are in a bubble, and I believe housing prices and demand are sensitive to interest rates.

Prior to recently the latter of these two rationales was the sole catalyst to the gains in SRS, but just recently the stock market also has begun to break longer term support, bringing the market based catalyst into play as well.  The bond market in telling us in almost certain terms that interest rates are going higher, and I respect technical patterns so when breaks happened I respect those too, so I still believe in this position and we are holding (not buying), but what does this tell us about real estate prices int he open market?

The stock market is a leading indicator, and almost always acts before we see economic impacts, and that is because the stock market is efficient and fluid, but when we compare the two asset classes that were most supported by stimulus, namely the stock market and real estate, real estate prices tend to be the sloth at the other end of the spectrum.  Prices often move very slowly, but they do move, it is just often difficult for anyone to expect anything other than price increases given what has happened in recent years with stimulus.

This adds a variable to real estate in the open market, and I will touch on that, but the action in real estate stocks should indeed be considered a leading indicator as to what will happen to real estate prices in the open market soon. 

Real estate prices are likely to come under pressure too.

The most obvious rationale is that prices and interest rates are inversely related and potential buyers face lower qualification amounts if they are required to pay higher interest rates.  That means they cannot afford to buy the same priced home today that they might tomorrow if interest rates increase. 

If this were an isolated issue and only a handful of the respective market faced higher rates this would not impact the real estate demographic, but when this happens on a nationwide scale the impact is felt everywhere because the entire demographics' ability to buy a home gets ratcheted down.

In an environment like that real estate prices absolutely come under pressure and this will clearly happen as interest rates increase.  In addition, however, supply could also increase measurably.  Some of the largest owners of real estate are hedge funds who bought tens of thousands of properties in bulk from the banks in many lump sums back during the credit crisis.  They have not had any reason to sell these because there was not a real risk to prices until now.  It is very possible that many of those hedge funds attempt to get ahead of the curve and that means we could very possibly see a large addition to the otherwise restricted supply that seems to exist today if they decide to sell before prices get hit by higher interest rates (that means imminently).

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