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The Shadow Inventory Debate

Ryan Hinricher
3 min read

I’ve been tracking what people are saying about the shadow real estate inventory that many economists, real estate professionals, and bankers are frightened of.  Seems there’s some debate if the shadow inventory, will stymie the housing recovery.

First the definition of shadow inventory is up for debate.  Depending on who you’re listening to it can mean many different things.  The different definitions are some of what’s causing people to debate the subject.

What is Shadow Inventory?

Definition 1 – Foreclosed but not listed.  Some analysts say the “shadow inventory” is the homes which the has bank foreclosed on but not sold.  These are homes that are not on the market but owned by the bank (REOs not listed on the market).

Definition 2 – Homes in the foreclosure process as well as delinquent mortgages where foreclosure proceedings are imminent.

Definition 3 – All homes delinquent, short sales not on the market, REOs not on the market, and anything in the foreclosure process.

Definition 4 – All of the above plus modified loans (as they have a large percentage of failing anyway, pay option-arms about to be reset, and lots sitting idle with builders in trouble.

I’m going to go with Standards & Poor’s definition which most similar to Definition 3, all delinquent loans, not just REO’s.

If you go with this definition, then naturally your focus is to look at delinquency rates which are widely published.  So to say we have no way of knowing the true size of the shadow inventory is false.  The mortgage banker’s recent survey with data ending in the 4th quarter shows that 9.47% of all loans are delinquent.  Yikes!  That’s a scary number; however the number was down slightly when seasonally adjusted.  Also according to this recent survey 50% of all past –due mortgages were 90 days or further past due.  This is the highest number in the history of the mortgage banker survey.  Usually you’d see a large glut of 30-day past-due balances, which becomes smaller at the 60-day mark, and there would be smaller yet number of 90-day balances (assuming homes were being liquidated with efficiency).

With fewer loans at the 30-day mark, it seems the glut of sub-prime loans is being flushed through the system but only so slowly that it is creating the large inventory (the 90-day past due loans).  The government and banks are trying loan modifications, short sales, and foreclosure work outs to reduce these properties flooding the market.  Unfortunately distressed assets are distressed assets, especially when they have negative equity.

Standard & Poors sees this shift in lender strategy as temporary as lenders will realize that these toxic assets are unredeemable in most cases.   Therefore these homes, estimated at 33 month’s supply or 5-7 million, will eventually hit the market.   If they do, home prices could head lower because of increased inventories.  The saving grace for the market could the limited new home construction, recent loss in builder confidence, a growing economy, and continued political pressure on banks to keep foreclosure as a tool of last resort.

Nothing to Worry About?

Some believe the shadow inventory isn’t a big concern.  Steve Cook of Real Estate Economy Watch points out that total housing inventory is at a 7.8-month supply, slightly up, but overall way down over 1 year ago.  “The huge shadow inventory of 1.7 to 7million properties first forecast more than a year ago has yet to materialize-and may be a myth,” said Cook recently in blog post challenging the shadow inventory concerns.  I tend to agree.  Although my credentials aren’t as serious as Standard & Poor’s rating system, there is great pressure on the banks to work with owners to work out, modify, short sell, or salvage these loans in some way.  Side note; a friend of mine recently modified his loan from 7% to 2% for the next 5 years and had his payment sliced in half.  The odds of him paying this back are good.  Market absorption is continuing to happen as well.  In my market, Memphis, inventories are down 30% from the peak, so it’s hard to comprehend prices dropping much further.

delinquent loans
New Delinquencies Waning

I think inventories are set to rise in the upcoming months because foreclosures are expected to peak this winter .  I’m looking closely at mortgages headed into delinquency for the first time to gage how much time the crisis has left.  Those and past-due loans headed into serious delinquency are in decline.  This summer will be critical for the market as the government intervention is nearly over.  If the builders continue to hold off building, the market should absorb much of the shadow.  Some markets have further to correct of course, but I think we’re unlikely to see home prices drop more than another 5% nationally.  My last caveat is this; banks are getting smarter.  They were dumping properties for next to nothing a year ago and now that they’ve used their free passes for Wall Street, they’ll be making more prudent pricing decisions for the homes they’re marketing.  Shadow inventory yes.  Should we dig bomb shelters and buy survival seeds?  NO.  Continue to accumulate real estate (today) at or near the bottom.

Photo: Hannah J.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.