Debunking the Housing Recovery Story (Part 1 of 5)

Ahhh, Spring is here. Each year around this time, the flowers push up through the soil, the trees begin to bud — and the Real Estate recovery stories start to appear.

It is a perennial rite of Spring, not remotely slowed down by such niggling factors as consistently being wrong year after year, unsupported by data, and ignoring key factors that strongly suggest “Not this year.”

All this week, we are going to review the many factors that are overhanging residential housing. Each of the following 5 factors will be discussed. By the time Friday rolls around, I expect you will be looking at those calling for a Housing recovery a bit more skeptically.

The factors we will be discussing include:

-Shadow Inventory (REO + Investors)
-Pricing Mean Reversion/Foreclosure Overhang
-Home Affordability/Employment & Wages
-Psychology of Renting
-Mortgage Rates

This morning, let’s discuss Shadow Inventory. This is important, as we have heard from Housing Bulls as part of their recovery thesis that the decrease in inventory of homes for sale is a net positive.

I would argue that the massive supply of homes in the Shadow Inventory make this judgment premature. There are numerous definitions floating around, but I prefer to start with the following: Ordinary Inventory are homes that are listed for sale with either MLS or privately (FSBO) or are in some public way known to potential buyers as for sale. These are what are counted in the official inventory.

Shadow Inventory includes: Bank owned Real Estate (REOs), distressed homes not yet for sale, including short sales and delinquencies not yet defaulted. Various properties in different stages of Foreclosure are also in the shadow inventory.

This definition still yields a broad range of potential shadow homes that will eventually become part of the total supply. Michael Olenick (at naked capitalism) puts the range of potential shadow inventory from 1.6 million homes(CoreLogic) 8.2-10.3 million (Laurie Goodman, Amherst Securities).

But even those numbers do not represent the complete picture. I include in my definition of shadow inventory the enormous overhang of underwater homes — these are the houses that don’t qualify for a mortgage mod, but whose owners are still making most of their payments. They have minor delinquencies, but are not in default. The owners are frozen — economically immobile — since they cannot move to a different area to take a job.

The problem is the homes are worth anywhere from 5-25% less than their mortgage. A sale will not be possible without lender permission or a large check to make up the shortfall.

About a third of homes (30-40%) in the US have no mortgage — cash purchases or paid off mortgages mean they are owned outright. Of the remaining homes, estimates range from 21% to 29% are worth less than their mortgages. That’s between 12 – 18 million houses as potential supply at higher prices.

The key question for the Housing Recovery case: What happens if and when prices begin to rise? Do these underwater owners relax, feeling better about their positions? Or, do they finally hit the bid when the opportunity presents itself?

The truth is that we simply do not know. But is is reasonable to assume that many of these homes would be put up for sale and become inventory. If only a third do, that is another 4 million homes for sale.


Tomorrow: Pricing Mean Reversion/Foreclosure Overhang

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