Monday, February 6, 2012

2012 Real Estate Outlook: Supply - Shadow Inventory

2012 Real Estate Outlook: Introduction
2012 Real Estate Outlook: The Rise (1980 - 2006)
2012 Real Estate Outlook: The Fall (2006 - 2011)
2012 Real Estate Outlook: Where We Are Today
2012 Real Estate Outlook: Where We Are Going
2012 Real Estate Outlook: Demand - Willingness
2012 Real Estate Outlook: Demand - Ability
2012 Real Estate Outlook: Supply - Local Market
2012 Real Estate Outlook: Supply - Shadow Inventory
2012 Real Estate Outlook: Conclusion
2012 Real Estate Outlook: Commercial Real Estate

The second portion of the analysis on supply focuses on the inventory that is unseen.  Driving down your street you may see three homes with a sign in the front yard.  This is "visible" inventory, which we discussed in the previous section.

However, there could be two additional homes on your street that have not paid their mortgage in six months, meaning they are delinquent.  The bank has not yet completed the foreclosure process, which is why you do not see a sign on the yard.

The foreclosure process moves like this:

Stage 1: Delinquent
Stage 2: Foreclosure
Stage 3: Bank Owned

There are currently millions of homes in America that are at some point of stage 1 and 2.  As you have read in the news, a large number of homeowners have been able to live in their homes for years without making a payment before the bank begins the foreclosure process.  Why?

When the bank takes ownership of the property through foreclosure and it becomes bank owned, the home will then put it on the market for sale.  Often the home will be sold for less than the value of the mortgage, and the bank will then have to write down that amount on their balance sheet.  Banks must keep a minimum capital requirement in order to keep their doors open. For this reason, many have let homes sit delinquent for years hoping that property values will return.

These homes sit hidden in the shadows, and have been properly named the "shadow inventory."

So the question is, just how many homes are currently in the shadow inventory pipeline (Stages 1 and 2) and how many more will be coming in the years ahead?

We know that when a home becomes "underwater" meaning that the value of the home is less than the value of the mortgage it is far more likely that a homeowner will default on a loan.  In fact, a new form of default has emerged called "strategic defaults" where homeowners have the ability to make payments but choose not to, feeling that they are throwing money into a pit with a home underwater.  Strategically defaulting and living payment free in your home for years has become the new cool trend, just like flipping condos in Miami was back in 2006.

There are currently 52 million homes in the United States that are owned and carrying a mortgage.  There are another 23 million homes that are owned free and clear (have no mortgage).  A large portion of these homes are owned by the baby boomers and will be hitting the market for sale, discussed in 2012 Real Estate Outlook: Demand - Willingness.

Of the 52 million homes that have a mortgage, over 10 million are currently underwater.  The FHA has issued 3.5% down payment loans all across the country the past four years at a time when home prices have experienced a steady month over month decline.  With only 3.5% equity in these homes at the closing table, only a small downdraft in prices will create an ocean of new properties underwater.

There are currently 4 million homes that are delinquent (not paying their mortgage) and another 2 million that have entered the foreclosure process.  These 6 million homes will be entering the third stage, bank owned (REO), and hitting the market like a never ending tidal wave over the coming years.

Behind them are the remaining homes that are underwater that are still making their monthly payment.  It is impossible to know how many of the 4 million that are delinquent are part of the 10 million that are underwater, but let's just say that they are all underwater to make the picture rosier.  That leaves another 6 million homes underwater homes ready to enter the delinquency stage and begin living payment free.

The numbers are truly staggering, and they are the reason why the Obama administration is desperately trying to put together a refinancing plan to get homeowners back above water and making their monthly payments to the banks.   

Remember that home prices are falling today with only the visible inventory entering the market in a slow trickle and interest rates artificially being pushed down by the Fed.  Imagine if this shadow inventory hit the market in force during a period when interest rates on mortgages were rising and lending restrictions were tightening.

I envision that scenario taking place in the years ahead, and it will bring the final downdraft in home prices.  This final plunge will coincide with the peak level of pessimism in the market.  You will hear people say that they will "never purchase a home again."

This period of time will provide the greatest real estate investment opportunity in history.

Next: 2012 Real Estate Outlook: Conclusion

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