Home sales in the Twin Cities metro area increased for the third month in a row, fueling guarded optimism in a market that has been beset by declining prices and foreclosures.

Sales last month were up 26 percent compared with September 2010. Pending sales rose nearly 40 percent during that same period, according to a report from the Minneapolis Area Association of Realtors. Record-low mortgage rates and demand for starter homes helped to drive sales.

"It's hopeful that we're heading in the right direction," association president-elect Cari Linn said.

Yet serious challenges persist. Sales are still near historic lows, and with foreclosures dominating the market, prices on traditional listings are falling faster than normal. Also, although pending sales are up significantly, they don't always result in a closed sale.

Last month, short sales and bank-owned listings represented nearly 40 percent of all sales, putting significant pressure on prices. The median sale price of all closed deals last month was $155,500, almost 7 percent lower than September 2010.

Brad Fisher, president of the Realtor association, said the report was encouraging but it's going to take awhile for prices to reverse course.

"There is typically some lag time between improved market balance and price movement."

Last month, prices on traditional listings were down 12 percent while prices on foreclosures fell 8.2 percent.

"Hopefully that's an anomaly," said Herb Tousley, director of the real estate program at the University of St. Thomas.

Some are concerned that investors are driving the market and that sales for upper-bracket homes are much slower than for starter homes.

For much of the past year, the Twin Cities area has seen some of the nation's biggest annual price declines, ahead of even some of the worst markets. Those declines have left analysts scratching their heads, but some speculate that it's happening because the Twin Cities entered the downturn ahead of the nation and that the region might emerge from the downturn more quickly, as well.

Though the increases in sales during the past few months show some signs of progress, last month was an easy comparison to September 2010, which was hurt by the expiration of the federal home buyer's tax credit. The incentive ended in April 2010 and the effect of that was felt in the following months.

Aside from record low interest rates, the market is getting a boost from falling inventory, creating an unexpected challenge for buyers who thought that they'd be in the driver's seat. The number of new listings for the month was down almost 17 percent, causing the total number of houses on the market to fall 21 percent compared with last year. At the current sales pace the number of houses on the market would last almost seven months, a significant improvement over last year when there was almost a nine-month supply of listings.

The decline in listings, however, reflects the situation of many people who would like to move but can't because they owe more than their house is worth, creating an unknown backlog of prospective sellers.

"Some people are waiting for the market to bounce back to get more equity out of their home," Linn said. "People are going to wait to see what happens."

Jim Buchta • 612-673-7376