How 'Shadow Inventory' Hurts the Housing Market

There were high hopes that 2012 would be the year when the housing market, battered by the explosion of the real estate bubble, would finally begin to recover. But any good news on the housing front has quickly been followed by negative news.

[See Taming Investors' Primal Instincts.]

For instance, it was reported in February that foreclosure rates were down and the number of new houses being built was up. For the first time since 2006, housing prices in some markets actually rose.

But February's optimism is fading fast. One of the main reasons for this is what is referred to as a "shadow inventory" of houses, or foreclosed homes that remain on the market. And according to a recent report, an additional 1.25 million foreclosed homes are set to flood the market following a year-long investigation into lending practices.

This is horrible news for the housing market, as it will push prices lower and lower. According to the Federal Reserve Bank of Cleveland, foreclosed homes that have been on the market for less than a year sell for 35 percent below value. If homes remain on the market for more than a year, their price drops 60 percent.

"The shadow inventory remains persistent even though many other metrics of the housing market show signs of improvement," says Anand Nallathambi, president and CEO of CoreLogic, a consulting firm that closely tracks the real estate market. "As we move into what is traditionally the peak selling season for real estate, servicers will certainly be watching closely to see if now is the time to move more inventory out of the shadows."

[See 10 Rookie Home Buyer Mistakes to Avoid.]

A persistent problem. Walter Molony, a public affairs officer at the National Association of Realtors (NAR), says the shadow inventory problem has been a prime factor in the inability of the market to gain traction.

"The high level of foreclosures in recent years dampened overall home prices, and they have now over-corrected in most areas," Molony says. "Homes are selling for less than replacement-construction costs in most of the country, and in most areas, it's now cheaper to buy than rent a comparably-sized property."

Molony adds that he believes the market is in a "period of transition" and that signs point to a sea change in shadow inventory. "Inventory levels have been trending down since setting a record of just over four million in July 2007. Currently, there are 2.43 million homes on the market, which is 19.3 percent below a year ago," Molony says. "Shadow inventory ... also is declining. Currently, it's projected at 2.1 million, down from 2.5 million two years ago."

A shadow inventory explosion? Roger Staiger, an adjunct faculty member of the Johns Hopkins Carey Business School, warns that the numbers cited by the National Association of Realtors are too low. He believes the shadow inventory is going to get much, much bigger.

"I'm predicting another 2 million homes to be foreclosed," says Staiger. "I would say there are about 3 million homes close to foreclosure or in distress, meaning owners are 90 days delinquent on payments."

[See How Buying a Home is Likely to Change.]

According to Staiger, two factors will contribute to the explosion of the shadow market. The first is a tepid economic recovery. "If you look at wage growth over the last five or six years, it's almost nonexistent," he says. "We are on the way to $5 gas. Things are not getting better. Unemployment is getting better because more people quit looking for jobs."

The second factor is what he characterizes as a repeat of the mistakes that led to the subprime crisis. Right now, the U.S. government is offering loans with interest payments of less than 4 percent in an attempt to spur real estate growth. Buyers are not required to provide large down payments to qualify for these loans.

"The bank owns the home and we're renting from the bank," Staiger says. "We're renters masquerading as owners. Ownership is a state of mind. People convince themselves, 'I'm underwater, but I'm still an owner.'"

A buyer's market. While the shadow inventory is bad for the broader housing market, it's an advantage for buyers. As long as there are foreclosed homes on the market, prices will be depressed. According to NAR's Molony, these low prices will help to clear out homes stuck in the shadows.

"Foreclosures are selling quickly because they are heavily discounted," he says. "Investors and first-time buyers are competing for lower-priced homes in most of the country, with frequent reports of multiple bidding in the low price ranges."

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