Imagine you just bought a new house in the perfect neighborhood. A few months after you move in, you receive a letter from a roofing contractor informing you that there’s a lien on your house because of an unpaid bill. What’s worse, even though you didn’t own the house when the bill was due, the seller is nowhere to be found and you’re liable for the unpaid bills. Sound scary?

If you’re like most lenders and buyers, then this scenario is very frightening. That’s precisely why almost all real estate transactions in the U.S. (and in most developed countries) involve title insurance. Title insurance companies look for what’s known as "title defects" on real estate properties. Title defects include items such as unpaid real estate taxes, unpaid bills from contractors, and outstanding loans collateralized by the property.

Once a title insurance company is satisfied that a particular title deed is unencumbered by such defects, they will then issue a title insurance policy. This type of policy protects both the buyer and the mortgage lender from liability if any title defects are uncovered in the future. Most title insurance policies also protect the buyer and lender against fraud by the seller. In other words, if the seller tries to hide certain defects when the sale is completed, then the insurance firm will cover the damages. Of course, the title insurance company charges a fee for underwriting the insurance policy.

Interest Rate Woes
A popular criticism of the title insurance business is that it’s extremely sensitive to rising interest rates. And to some extent that’s true. The profitability of title insurance is directly related to the volume of real estate transactions. When interest rates rise, that makes housing less affordable. As a result, the volume of real estate transactions usually falls as well.

And there’s a good historical reason investors take a dim view of title insurance when interest rates rise. Interest rate hikes in the early 1990s and again in 1994 prompted significant declines in real estate transaction activity. In both periods, the title insurance business got hit hard; in 1990 and 1991 and again in 1994 and 1995, the title business as a whole lost money.

However, this is a highly oversimplified view of the title insurance industry. The best in the business today are capable of maintaining solid profitability even as the red-hot housing market starts to cool and rates begin to inch higher. Let’s consider a few of the positive developments in the industry since the mid-1990s:

Consolidation
One problem with the title insurance industry in the mid-1990s was that there were too many competitors in the space. This led all-too-often to cutthroat competition and reduced profitability, as insurers tripped over each other trying to win new business. However, over the past decade a wave of merger and acquisition activity has resulted in significant industry consolidation.
There are still around 65 title insurers in the U.S., down from around 85 twenty years ago. Although the overall number of insurers may have dwindled only slightly, there are far fewer dominant players today than there were even 10 years ago. A small handful of big players in the group, formed mostly by recent mergers, now control the lion’s share of the market. That would include the 1999 mega-merger between Fidelity National Financial (NYSE: FNF) and Chicago Title, a deal worth about $3.4 billion at the time.

These larger, merged firms have done a lot to boost efficiency. Not only did the industry undertake massive staff cutbacks in the mid-1990s, but it also spent big on technology to automate clerical functions. The offshoot of all this consolidation: more efficient companies with better pricing power.

New Business Lines
One big advantage of greater size is better diversification. The bigger insurers have made a point of diversifying their business out of simple title insurance and into new, related business lines. These include real estate appraisal, credit reporting, insurance underwriting and loan servicing.
Like title insurance, most U.S. lenders require appraisal services as part of each and every property transaction. Lenders simply need to know how much a piece of property is worth before loaning money collateralized by that real estate. Title insurers have found this business line to be a relatively easy fit. After all, with every transaction insured, the insurers add to their database of property information. This allows them to keep detailed records of property valuations in particular regions.

The story is much the same when it comes to the credit reporting market. Many companies in the title insurance business have collected vast databases of information on consumers -- information that’s extremely useful for lenders. Some companies, like First American Corp. (NYSE: FAF), have carved out particularly profitable niches in the credit reporting business.

The fastest growing market for credit in recent years has been in sub-prime lending, essentially lending to borrowers with less-than-perfect credit. This is a profitable business for banks because they can charge much higher interest rates to such customers. However, it’s also risky -- sub-prime credit carries a much higher-than-average risk of default. That puts a real premium on the value of quality credit information that can help determine if a particular borrower is a reasonable risk or a bad loan in the making. First American is a leader providing detailed information and credit analysis to lenders. Because most other major credit agencies don’t have access to information on such borrowers, the company stands nearly alone in this profitable niche market.

While First American has focused on providing sub-prime credit information, other title insurance companies have specialized in loan servicing. Fidelity National Financial, for example, has expanded into outsourcing. The company will take on back office operations -- such as payment processing and escrow services -- from banks on an outsourcing basis. That can help smaller financial institutions cut costs while allowing more focus on new loan origination.

Meanwhile, PMI Group (NYSE:PMI) has been strong in software development. The company sells a model that helps predict default risks for consumers with different credit histories. This critical information helps banks price their loans more effectively.

All of these various business lines are related to the lending market in one way or another, and they provide a measure of diversification out of the more cyclical title insurance business.

Technology Changes
Recent technological advances have been a big tailwind for the title insurance group. By the mid-1990s, most large cities had already placed their property record information on electronic media. This enabled title insurance firms to rapidly search property records for title defects.

However, that wasn’t always the case with smaller towns and counties. In these areas property records were often held in paper form -- this meant hours of labor-intensive work before the validity of a certain title could be established. That clearly added to the cost of doing business.

The good news for title insurance firms is that this situation is rapidly changing. As more and more of the country’s records become digitized, title insurers have been able to perform more of their searches electronically. This technological improvement has led to a direct decline in the total cost of doing business.

Valuable Databases
All of these recent changes -- greater diversification, reduced competition and technological improvements -- have been important steps for the title insurance industry in recent years. However, even more important than this is the value of title insurance databases. As we mentioned above, most title insurers collect all sorts of consumer information and then hold this information in electronic databases. Most have developed sophisticated software systems for collecting, searching, and displaying such data. This includes transactional data on real estate sales, appraisal data, homes available for sale and even consumer-related credit information.

To develop a database that contains such records for millions of consumers and real estate transactions is by no means an easy task. The benefit here is that it’s very difficult for a new competitor to break into the business -- the cost of gathering all this data is prohibitively high. The result: most title insurers have an extremely wide economic moat.

Long-Term Housing Trends
Many investors also tend to oversimplify the relationship between rising interest rates and the housing markets. The aging of the U.S. population and increased immigration are both likely to act as huge demographic tailwinds for the housing market for many years to come.

The biggest trend of all will be the retirement of the enormous 70 million strong Baby Boomer generation over the next 20 years. As the Baby Boomers retire, their housing needs will change -- but not necessarily for the worse. U.S. Census Bureau data suggests that modern retirees are better off financially than ever before. As such, it’s likely that Boomers will continue to demand high-quality housing.

Immigration also remains a big positive for the housing market. Statistics from the Census Bureau suggest that immigrants wait 10 to 15 years before buying a house in the U.S. The 90s brought a huge immigration boom; look for these new immigrants to start buying houses in earnest over the next few years.

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