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Home prices rose for the third consecutive month in July, bolstering the view that the long free fall in the housing market may be history. But consumer confidence fell unexpectedly, modestly pushing down stocks.

Housing prices ticked up 1.6% from June, according to the Standard & Poor’s/Case Shiller home price index, which tracks 20 large cities. Low mortgage rates and bargains on foreclosed homes are attracting buyers.

Home prices rose for the first time in three years in May. And after falling 12% from October through April, prices climbed 3.6% from May to June.

“I think we’ve made the turn,” says Joel Naroff of Naroff Economic Advisors.

Values rose in 18 of the 20 cities, with only Las Vegas and Seattle posting monthly declines, of 1.1% and 0.1%, respectively. Thirteen cities have had at least three consecutive monthly gains.

The residential real estate market is still weak. Home values in the 20 cities are off 13.3% from July 2008 and 33.5% from their 2006 peak. Prices are now about where they were in fall 2003. But the year over year declines have been steadily shrinking in each of the past six months.

In some cities, the housing market is almost stable year-over-year, with prices in Cleveland, Dallas and Denver dipping 1.3%, 1.6% and 2.9%, respectively.

Yet some economists say the recent run-up is a brief reprieve, and home prices have yet to hit bottom. Patrick Newport of IHS Global Insight says the market will swoon again after housing inventories are fattened by a new wave of foreclosures and an $8,000 tax credit for first time home buyers expires Nov. 30. Newport says prices will likely fall 6% before mounting a more sustainable rebound in mid 2010.

David Blitzer, chairman of Standard & Poor’s index committee, says, “The numbers are very encouraging, but it will probably take some time before we have convincing data that we’re past the bottom.”

Meanwhile, a closely watched consumer confidence index dipped to 53.1 in September from 54.5 in August, the Conference Board said. Analysts expected it to rise to 57.

Ian Shepherdson of High Frequency Economics noted most of the drop stemmed from consumer attitudes about current conditions, which reflects high unemployment. The more critical “expectations index” was stable, sliding to 73.3 from 73.8. The overall index is up from a record low of about 25 in February.

Still, “With the holiday season quickly approaching, this is not very encouraging news,” says Lynn Franco, head of the board’s consumer research center. The Dow Jones industrial average closed down 47 points at 9742.

Foreclosures are continuing at a rapid fire pace that may accelerate in 2010, driven by rising unemployment and more adjustable rate loans resetting to higher monthly payments.

Foreclosure filings were reported on 937,840 properties in the third quarter, an increase of nearly 23% from the third quarter of 2008, according to a report today by RealtyTrac.

The number of properties in some stage of foreclosure was 5% higher than in the second quarter.

One in every 136 U.S. housing units received a foreclosure filing during the quarter, the highest quarterly foreclosure rate since RealtyTrac’s reports began in the first quarter of 2005.

“We’d hoped this year would be the peak as far as foreclosures, but we’ve since concluded it will not be,” says RealtyTrac’s Rick Sharga. “We should see a peak in foreclosures at the end of 2010.”

Several factors are behind the expected rise in foreclosures. Many lenders have opted not to pursue foreclosures while they consider delinquent homeowners for a mortgage modification. As those moratoriums end, more borrowers who don’t qualify for modifications are likely to face foreclosures.

A large number of adjustable rate loans are slated to reset, which means they can bring higher monthly payments for homeowners. Higher payments, coupled with a 9.8% unemployment rate that is expected to rise above 10%, could also cause a growing number of borrowers to lose their homes.

This could amount to a sizable second wave of foreclosures.

There are presently 2.8 million active interest only home loans with an outstanding principal balance of $908 billion, according to First American CoreLogic. Interest only loans produce low monthly payments based on the loan’s interest for five to seven years, but then payments jump when the principal is included.

“Foreclosures should remain really high as long as unemployment is rising, and that is through next spring,” says Mark Zandi of Moody’s Economy.com. “They should be very high into spring.”

Zandi estimates there were 3.8 million notices of default filed this year and that in 2.1 million cases, borrowers will lose their homes to foreclosures, short sales or banks taking their deeds in lieu of foreclosure. He expects notices of default to decrease next year but foreclosures to rise.

Some geographic areas are seeing notably high rates now.

California, Florida, Arizona, Nevada, Illinois and Michigan accounted for 62% of the nation’s foreclosure activity in the third quarter, according to RealtyTrac.

A federal program announced in March to help homeowners get more affordable monthly payments has now put 500,000 borrowers into three month trial modifications.

But foreclosure filings were reported on 343,638 properties last month alone, giving September the third highest monthly total behind July and August. The number of properties receiving foreclosure filings last month did drop 4% from August.

A slew of financial heavy hitters, including Starwood Capital’s Barry Sternlicht, Colony Capital’s Thomas Barrack Jr., and Apollo Global Management’s Leon Black, are piling into the distressed mortgage market.

They and other savvy real estate investors have been setting up real estate investment trusts to raise funds to buy mortgages and mortgage backed securities. But is the timing right for these REITs?

Since the start of the year, four new real estate investment trusts have raised $1.8 billion, according to Renaissance Capital, a Greenwich (Conn.) firm that tracks initial public offerings. An additional 18 are in the works, with plans to raise $6 billion. Investors should proceed with caution, says financial planner Harold Evensky. He adds: “I get nervous whenever Wall Street touts something as the hot product.”

Distressed investing requires a strong stomach. More than 13% of home loans were delinquent or in foreclosure in the second quarter, according to the Mortgage Bankers Assn. For subprime loans, that number was 40%. Meanwhile, delinquencies of commercial mortgage loans which tend to trail their residential counterparts topped 4% in August, compared with less than 1% the year before, according to Trepp, a provider of data about commercial mortgage backed securities (CMBs).

Adding to risk now is that the market for residential and commercial mortgage bonds especially, the AAA rated ones has rallied strongly since its March lows. “A lot of money is chasing an asset whose fundamentals haven’t changed,” says Thomas Atteberry, co-manager of FPA New Income Fund. “We think it is somewhat early to do this.” But while AAA-rated bonds are up sharply, many BBB-rated ones still trade for less than 20 cents on the dollar. As Manus Clancy, a senior managing director at Trepp, says of the low rated CMBS: “I think people are pricing them to the worst case scenario.”

While the spotlight has been on the residential market, the commercial market may offer better opportunities. One reason is uncertainty over how the government’s role in home loan modifications might change. Two of the most experienced distressed investors, Colony and Apollo, target commercial mortgages.

An alternate, far riskier approach is the one taken by PennyMac, which is run by a former executive of onetime mortgage giant Countrywide Financial. It buys portfolios of home loans from banks and the Federal Deposit Insurance Corp. PennyMac has its own loan servicer, which seeks to renegotiate its distressed loans to avoid foreclosures.

Investors should check the manager’s expertise, of course particularly if it will need to negotiate with homeowners facing foreclosure. They should also consider that some REITs have hedge fund like fees -1.5% management fees plus a significant share of any profits.

A more cautious way to invest is through mutual funds such as TCW Total Return Bond Fund. It returned 14.6% over the past year. Perhaps tellingly, manager Jeffrey Gundlach has been reducing exposure to riskier nonagency bonds (bonds not backed by Fannie Mae or another quasi-governmental institution) as the mortgage market has rallied.