Ever since the coronavirus pandemic began, we have seen a resurgence in demand for single-family homes in the suburbs. Leading single-family REITs report that demand has never been stronger for suburban homes. Many of the biggest homebuilders reported that May and June were record selling months. This has stoked fears that the housing market is overstretched and heading for a crash. If so, how should investors protect their housing portfolio?
One counterintuitive way is through a mortgage real estate investment trust (REIT) -- specifically AGNC Investment Corp. (NASDAQ:AGNC).
The pieces just aren't in place for a crash
As they say, all real estate is local. This means that mass nationwide declines in real estate values are generally rare events. Aside from the housing bubble that drove the financial crisis in 2007-2008, the last time we saw such a mass decrease in real estate values was during the Great Depression.
This time around, we have seen none of the overbuilding that typically precedes a bust. Prior to the housing bubble, housing starts averaged around 1.5 million per year. The past 12 years have averaged nowhere close to that, as you can see in the chart below. Nor have we seen the mass relaxation of lending standards, since the memories of the last crash are still fresh in everyone's minds. The subprime market never returned, and even self-employed borrowers with good credit can struggle to get a mortgage. While a crash cannot be ruled out, the pieces don't seem to be in place for one.
One stock that would benefit from a crash
That said, if there were one stock in the housing ecosystem that could actually benefit from a crash, it would be AGNC Investment. AGNC is a mortgage real estate investment trust that invests in mortgage-backed securities guaranteed by the U.S. government. This means that it takes almost no credit risk.
If housing prices crash, we would probably see a recession as well as a wave of defaults. Residential real estate crashes are the 100-year storms of economies. They would cause major damage for homeowners, not to mention homebuilders, banks, residential REITs, and probably most of the mortgage originators. So how could AGNC actually benefit?
Pre-payment speeds matter
While AGNC Investment has limited credit risk, its portfolio of mortgage-backed securities is highly sensitive to something called pre-payment speeds. Homeowners in the U.S. have the right to pay off their mortgage early whenever they want without penalty, which usually happens when someone moves or refinances a mortgage. An increase in pre-payment speeds is a negative for a portfolio of mortgage-backed securities, so anything that prevents people from moving or refinancing their mortgage benefits investors in government-guaranteed mortgage-backed securities.
Why would a housing crash depress pre-payment speeds? Simply put, to move or refinance, you need equity in your home. No lender is going to refinance an underwater mortgage (i.e., when the appraised value is lower than the amount remaining on the mortgage). Most homeowners who owe more than their house is worth cannot afford to make up the difference in cash in case they sell the property. This means these homeowners are largely stuck where they are, and refinance opportunities fall. This is good news for holders of mortgage-backed securities since it means the securities become worth more. While a crash would hurt AGNC's credit assets, they make up only 1.3% of the investment portfolio.
AGNC Investment pays a monthly dividend of $0.12, which works out to a yield over 10%. And as of Thursday's close, the stock is trading at a 7% discount to last quarter's tangible book value per share. Between the dividend yield and the discount to book, AGNC remains one of my CAPS picks. While it is kind of hard to make an argument for an imminent housing crash, if one were to happen, AGNC would be one of the few stocks that would see that as a favorable event.