* Housing starts rise 3.6 percent; a drop was expected
* Permits fall 2.7 percent; multifamily units weigh
* Data adds to signs housing recovery gaining momentum
WASHINGTON, Nov 20 (Reuters) - U.S. housing starts rose to their highest rate in more than four years in October, suggesting the housing market recovery was gaining steam, even though permits for future construction fell.
The Commerce Department said on Tuesday housing starts increased 3.6 percent to a seasonally adjusted annual rate of 894,000 units - the highest since July 2008.
The report was the latest to show the broadening housing market recovery was now entrenched. Economists, who had expected ground breaking to slow to an 840,000-unit rate, said the housing strength laid a foundation for faster economic growth next year.
"The broad improvement in home prices, home equity, starts, and inventory clearing are key developments that position the economy for stronger growth next year, and beyond," said Eric Green, chief economist at TD Securities in New York.
The housing market has decisively turned around after an unprecedented collapse that landed the economy in its worst recession since the Great Depression. The recovery, marked by rising home sales, prices and building activity is being driven by pent-up demand and record low mortgage rates.
Homebuilding is expected to add to gross domestic product growth this year for the first time since 2005. Although home construction accounts for only about 2.5 percent of GDP, economists estimate that for every new house built, at least three new jobs are created.
Last month's data led some economists to raise their fourth-quarter growth estimates. Even so, growth in the last three months of the year is expected to be soft, largely because businesses appear reluctant to invest given the prospect for deep government spending cuts and higher taxes next year.
Fourth-quarter growth forecasts currently range between an annual rate of 1 percent and 2.2 percent.
The Commerce Department said superstorm Sandy, which slammed the East Coast in late October, had a minimal impact on the data. Economists expected the storm to weigh on homebuilding in November, with rebuilding in the months ahead mitigating the impact.
The upbeat homebuilding report buoyed housing-related shares on Wall Street, with PulteGroup Inc - the second-largest U.S. homebuilder - soaring more than 5 percent.
The overall housing sector index ended up 2.45 percent, outperforming a broadly flat share market. U.S. Treasury debt prices fell, while the dollar was little changed against a basket of currencies.
NO LONGER A HEADWIND
The Federal Reserve has targeted housing as a channel to boost U.S. growth, announcing in September that it would buy $40 billion in mortgage-backed securities per month until the outlook for employment improved substantially.
It hopes the purchases will drive down borrowing costs. Fed Chairman Ben Bernanke on Tuesday acknowledged the housing market improvement, but said stricter lending practices remained an obstacle to a faster recovery.
"It seems likely that, on net, residential investment will be a source of economic growth and new jobs over the next couple of years," Bernanke said at the Economic Club of New York.
A steady rise in the number of U.S. households, which fell during the 2007-09 recession as financially strapped Americans moved in with friends and family, is also supporting the housing sector.
"The amount of construction now is below the level to maintain housing for the population as a whole. The trend (in housing starts) will continue to rise as the housing stock is absorbed by population growth," said Robert Gray, managing principal at real estate investment firm TerraCap Management Corp in New York.
Economists at Goldman Sachs estimate that household formation - the net increase in the number of households each year - will increase to a 1.2 million rate in 2013 from 1 million currently.
They forecast housing starts rising to a 1 million rate by the end of next year and 1.5 million by the end of 2016.
Groundbreaking for new homes has risen 41.9 percent over the last year, but starts remain about 60 percent below the peak of 2.27 million reached in January 2006.
Last month, groundbreaking for single-family homes, the largest segment of the market, slipped 0.2 percent to a 594,000-unit pace. Starts for multi-family homes surged 11.9 percent to a 300,000-unit rate, reflecting increased demand for rental apartments.
Building permits fell 2.7 percent to an 866,000-unit pace in October after jumping 11.1 percent the prior month, in line with expectations.
The drop last month was concentrated in the multifamily segment and is likely to be short-lived. Permits to build single-family homes rose 2.2 percent last month to a 562,000-unit pace, while permits for multifamily homes fell 10.6 percent to a 304,000-unit rate.