Tuesday, September 28, 2010

Real Estate Market's Ugly Secret

USA Real Estate Market
The Real Estate Market's Ugly Secret: Shadow Inventory

By D.R. Barton, Jr. of Van Tharp Institute


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Back in December of 2005, I wrote a series of articles on the pending real estate bubble. Several key factors stuck out back then, not the least of which was the unsustainable leverage being offered to home buyers. This meant that more folks could buy more house with less money. That process drove up home prices at a dizzying pace for several years.

As prices continued to climb, the game seemed like a sure thing. More leverage and lower qualifications led to even higher prices, and the spiral continued. We all know how it ended.

I have heard renewed interest in real estate investing lately, with phrases like, “prices are firming up” and “the worst is behind us.” However, I really don’t think it’s that easy. Just as the data in late 2005 was waving huge red flags, today I think there are some serious issues with the so-called real estate recovery.

First and foremost, a “shadow inventory” of houses has a vast effect on the national housing market. The phrase refers to houses that are destined to be sold on the open market but are not yet formally listed—they are in the shadows still.

The shadow inventory numbers are overwhelming. In fact, several different studies show that the shadow inventory is many times that of the actual listings. That’s a big red flag for real estate recovery if there ever was one.

What Is Shadow Inventory?

Let’s start with an explanation of shadow inventory. This phrase was only coined a few years ago so people have yet to agree on a definition or specific statistics for it. This means real estate professionals, economists, and talking heads will continue to debate for some time on the exact definition and number of houses that fall in this category. The term generally represents houses that are not formally listed for sale but are distressed in some way and will be coming to market soon.

For the most part, shadow-inventory houses fall into two groups. Many foreclosed houses or houses under a short sale contract are already in the “real” inventory, meaning they are included in the public MLS listings. (A short sale is a house that is worth less than the outstanding mortgage where the borrower and lender make a settlement contract to sell the house for less than what is owed.) The difference owed by the borrower is then a term of negotiation as part of the settlement. Many houses in foreclosure, however, are not in the real inventory because banks and other holders of these properties have not publicly listed them (for a variety of reasons).

I’ve seen a number of estimates for the size of this portion of the shadow inventory. The most conservative figure I’ve seen for this portion is half a million houses, though it’s likely much bigger.

The second main component of shadow inventory is properties in default. Banks have started the foreclosure process on these houses but have not yet listed them for sale. This number alone is staggering—one trade journal has it calculated above two millions houses in the US.

Those are some of the less debatable portions of the shadow inventory. In future articles we’ll look at other, all too real “houses not yet for sale” groups that should be considered part of the shadow inventory.

Bottom Line Implications

This lurking problem could make the recent home price slide look like just the tip of the iceberg. Some estimates have the shadow inventory at around seven million houses, which is many times larger than the number of houses officially listed for sale. We’ll dig into those numbers and the implications for traders and investors in the coming weeks.

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