By Lucia Mutikani

WASHINGTON (Reuters) - U.S. homebuilding fell more than expected in March as the construction of single-family homes in the Midwest recorded its biggest decline in three years, but an increase in building permits suggested the housing market recovery remained intact.

Housing starts decreased 6.8 percent to a seasonally adjusted annual rate of 1.22 million units, the Commerce Department said on Tuesday.

February's starts were revised up to a 1.30 million-unit pace from the previously reported 1.29 million-rate.

Economists had forecast groundbreaking activity falling to a 1.25 million-unit pace last month. Homebuilding was up 9.2 percent compared to March 2016.

The dollar held at lower levels against a basket of currencies after the data, while prices for U.S. government bonds were little changed. U.S. stock futures were lower.

Unseasonably warm temperatures buoyed homebuilding in February, but temperatures dropped in March, with a storm lashing the Northeast and Midwest regions. Bad weather could have accounted for some of the drop in homebuilding last month.

Single-family homebuilding, which makes up the largest share of the residential housing market, fell 6.2 percent to an 821,000 unit pace last month, retreating from a near 9-1/2-year high.

Single-family starts in the Midwest declined 35 percent, the largest drop since January 2014, to their lowest level since August 2015. Single-family starts in the Northeast were unchanged. They rose 3.2 percent in the South, but fell 5.5 percent in the West.

Last month, starts for the volatile multi-family housing segment dropped 7.9 percent to a 394,000 unit pace.

Pointing to underlying strength in the housing market, building permits increased 3.6 percent, driven by a 13.8 percent surge in the multi-family segment.

While single-family permits fell 1.1 percent last month, they were not too far from the more than nine-year high reached in February. A tightening labor market, which is generating steady wage growth is underpinning the housing market.

The sector, however, remains constrained by a dearth of properties available for sale. Builders have failed to bridge the gap, citing a range of problems including shortages of labor and land as well as rising material prices.

A survey on Monday showed homebuilders confidence slipped in April from a near 12-year high in March. Still, measures of current sales and sales expectations remained at lofty levels.

(Reporting By Lucia Mutikani; Editing by Andrea Ricci)