‘Shadow market’ may undercut real estate rebound

Only 30 percent of foreclosed homes are currently on the market nationwide. Could the backlog of hundreds of thousands of empty or rented homes swamp recovery?

Brian Mehigan, the self-described “Mayor of Tara Lane,” knows all too well the rise and fall in real estate prices that he calls, simply, “the madness.”

One of a handful of original owners left in this decade-old Phoenix-area subdivision, the freelance plumber can tell you the fate of homes up and down his street. He points them out one by one: That one’s for sale, that’s now a rental, rental, foreclosure, short sale, foreclosure, original owner.

“Who knows what’s going to happen,” says Mr. Mehigan, as he keeps a watch on the street. “All I know is I’m not going anywhere.”

In the cookie-cutter burbs ringed by saguaro groves here in the shadows of the White Tank Mountains, there’s new hope for neighborhoods in disarray after the housing quake. Plumbers like Mehigan are busier, and Phoenix real estate is suddenly red-hot as buyers snap up bargains.

But, despite the short sales, foreclosure sales, and the burgeoning rental inventory, there’s also a massive “shadow market” of empty or rented homes yet to come on the block, as banks try to optimize returns on failed investments and homeowners hold off, waiting for a rebound.

In this foreclosure capital – over 75 percent of homes on the market in Phoenix are owned by banks – such a big backup of inventory could affect streets like Tara Lane for years to come. And it could dramatically impact the trajectory of the much-awaited recovery.

“Taking a house in foreclosure but not putting it out on the market, that’s common right now,” says Rajeev Dhawan, a real-estate economist at Georgia State University in Atlanta. “Short term, it’s good, but long term you’ve got a problem. When the market starts to recover, they’re going to dump the inventory,” pushing prices down again.

As many experts glimpse a possible bottom to the housing market, theories diverge about the potential impact of the shadow market.

Sudden boom

For now, investors are wading into the Phoenix real estate market in droves. Foreclosures are leveling off, sales are being bid on by five to 10 buyers, and more homes are being bought than any time since 2006. Home prices in the Phoenix area have slid nearly 34 percent since the mid-2006 peak and are still falling at about 3 percent a month. More than half of all home sales in the first quarter of this year were made by first-time homebuyers, reflecting affordability that’s at a 20-year high in many parts of the country.

The positive sales numbers and the slowing price slide – mirroring trends in California and Florida, two other housing-crash epicenters – is a sign that the real estate market may finally be shoring up, said Arizona State University real estate professor Karl Guntermann in a recent report.

"It appears that we're turning," said Professor Guntermann.

Housing investor David Isom has seen the buying craze firsthand. Despite being able to offer cash, he bid unsuccessfully on 15 homes in the past few months before scoring one with a pool in nearby Glendale, Ariz.

“I don’t follow the herd, man, you're talking to a different guy,” says Mr. Isom, explaining his foray into the market. “Most people are reactive. I go against what most people do. It's the only way to be successful.”

A ‘phantom inventory’

Despite such exuberance, many real estate experts are predicting more of an L-shaped recovery than a V-shaped one, as properties glut the marketplace in response to home-buying activity.

Only 30 percent of foreclosed homes are currently on the market, meaning that some 500,000 sit vacant across the country, part of a vast “phantom inventory” that the market has yet to grapple with.

“There’s a frenzy for bank properties right now, and as a consumer, I’m likely to say, ‘Wow, that’s got to be an indicator of the bottom,’ ” says Brett Barry, a real estate agent at HomeSmart in Phoenix. “But a lot of us expect a tsunami of foreclosures to come on top in June, July, or August, because at some point the banks are going to release this stuff.”

Reasons for the backlog vary. For one, the sheer number of complex foreclosure proceedings – six times the average in the past year – has overwhelmed many mortgage-servicing companies. And some banks may find accounting advantages to delaying the loss they’ll have to book when they ultimately sell the property at prices below the value of the principal.

But Alexis McGee, a real-estate blogger at ForeclosureS.com, wrote earlier this month that banks may also be gaming the market so as not to depress prices – especially as bidding wars are heating up in places such as Surprise.

There are some indications, too, that the Obama administration may have leaned on banks not to release the entire foreclosure inventory at once in order to preserve neighborhood values.

That’s not necessarily a bad thing, argues Rick Sharga, a vice president at RealtyTrac.com, a real estate tracking firm in Irvine, Calif.

“The L-shaped prognosis does not offer much hope, but hopefully it will turn into a U or something,” says Mr. Sharga. “The counter argument [is that] … if they manage the inventory back into the marketplace, they can actually contribute to a quicker stabilization. The question is, will the rest of the dynamics in the marketplace allow the buyers to absorb this inventory in a manageable way, or will something else come along to throw the equilibrium off again?”

The shadow may stretch beyond foreclosures. Zillow.com, a real estate tracking firm, revealed in a survey this week that a third of the nation’s 55 million homeowners would be somewhat likely to try to sell their homes in the next 12 months if the market improves. A large chunk of those are likely to be the 15 million or so US homeowners currently “underwater” on their mortgages – owing more than their home is worth.

“[A] lot of these home sellers will also be buyers so they will help some of the inventory,” writes Stan Humphries, a vice president in Zillow’s data-analytics division. But it’s also likely that some sellers will become renters or will downsize, so “this ‘shadow inventory’ represents more supply … than demand.”

The impact of short sales

So far, political appetite for a nationwide “principal reduction” bailout – forcing banks to reset principals to current, depreciated values – has waned. In its place, the Obama administration on May 14 outlined new rules for so-called “short sales” to help homeowners who don't qualify under last year's Help for Homeowners program, which Congress bolstered this week.

A short sale is a complex, acrimonious, and often unsuccessful process that allows homeowners to sell homes for less than they owe, while reducing the amount of credit damage to two years instead of five to seven years in a foreclosure.

The short-sale gambit “will push prices up, because people know that it’s a viable sale that will take place,” says Ron Farber, whose website, shortsaleplan.com, aims to help put the new Washington rules into play. “This’ll be helpful to the borrower, the real estate agent, the bank, and it’ll really help the economy.”

Whether it will help Tara Lane is another question, says Mehigan, the Surprise plumber. The one short sale in his quiet neighborhood led to a group of rough characters moving in. Mehigan called the police, and they retaliated after moving out by busting his windows and scrawling graffiti on his house.

Looking out on the empty street of low-slung adobe-style homes, Mehigan says, “This used to be a nice neighborhood where people got together, but now it’s a ghost town.”