August was a busy month for Standard and Poors. The huge ratings agency downgraded the debt of the United States, the first such decline in modern history.
Less noticed was another pronouncement from the S&P: The shadow inventory of distressed homes is getting smaller.
“It’s good news that things are starting to slow down and we’re getting closer to the end of the problem,” said Diane Westerback, S&P’s Managing Director of Global Surveillance Analytics. Speaking to CNN, Westerback added that “it could mean a gradual recovery for the market.”
Can this be true? Has the housing market finally reached bottom?
Just-issued S&P numbers do show that the shadow inventory has shrunk from $433 billion in the first quarter of 2011 to $405 billion in the second quarter.
That’s still a lot of real estate. The National Association of Realtors reported that in July the typical home sold for $174,000. Distressed homes sold with “deep discounts,” roughly 20 percent, according to NAR spokesman Walt Molony, or about $139,200 apiece.
If we divide $405 billion by $174,000 it means the shadow inventory today includes nearly 2.4 million homes.
At current sale rates S&P says it will take 47 months to clear out today’s inventory of distressed homes. Some areas will take longer. For instance, the New York City metro area has so much unsold inventory and so few buyers that it will take 144 months to clear out, according to S&P.
The ratings firm also says something else: the “shadow inventory will continue to jeopardize the housing market’s recovery until servicers are able to improve liquidation times. However, if and when that happens, an influx of homes will likely enter the market, increasing supply and driving prices down further.”
How is it possible that faster sales will push down home values and increase the shadow inventory? That doesn’t seem to make a lot of sense — shouldn’t the faster sale of low-priced distressed properties help clear out the supply and improve the housing market?
It should, but at this moment it won’t. Here’s why:
The Speed Paradox
If the sales pace for distressed homes picks up the number of troubled homes should decline, all things being equal. But all things are not equal because today’s shadow inventory — as big as it is — should actually be larger.
Late in 2010 foreclosure filings began to decline. The fall-off in foreclosure actions was not the by-product of better economic times or more employment, instead it was caused by a combination of actions and events:
- In many states it was found that clerks had signed foreclosure affidavits — sometimes hundreds per hour — without checking to see if the information was correct, meaning that some homes may have been improperly foreclosed. As a result courts in many states established stricter paperwork standards, thus slowing the process.
- The foreclosure process has become longer in many jurisdictions because state legislatures have imposed new requirements before a property can be taken. For instance, borrowers must be given the opportunity to modify their loans or engage in mediation with the lender.
- In a number of cases lenders have been unable to prove they actually own the note after a series of electronic transfers and assignments. Without proof of ownership lenders have no standing to foreclose.
Now imagine what would happen if the problems of the past year were overcome and the foreclosure process returned to the norms of mid-2010. Foreclosure processing would be much faster, REO inventories would swell and a bigger shadow inventory would push down home values.
Regardless of whether we are at or near the bottom of the real estate meltdown, a view which is hard to justify, it’s plain that depressed values will be with us in most markets for several years even in the best case. Is there any part of this picture which seems alluring?
Actually yes. Selected real estate investments. For cash.
Unlike real estate’s go-go days where the goal was to buy with as little down as possible, buyer thinking today has been reversed. NAR says that nearly 30 percent of all homes sold in July were bought outright for cash.
Why cash? Several reasons:
First, large numbers of properties are available at discount. With an all-cash offer, the cost of acquisition can be further reduced because there are no mortgage points or fees to pay.
Second, the all-cash buyer has leverage in the marketplace because the transaction is not dependent on lender approval. That can mean more bargaining power and a lower purchase price, better terms or both.
Third, rent can readily produce a positive cash flow because there’s no monthly cost for mortgage interest or principal.
Fourth, investors can defer taxes on much of their return with write-offs for depreciation. When they sell they can get the benefit of long-term capital gains rates.
Fifth, in the event of vacancies there’s no mortgage to pay from other sources and accounts.
“The marketplace is plainly telling us that large numbers of investors and homebuyers are purchasing real estate for cash,” said James J. Saccacio, chief executive officer of RealtyTrac. “In an economy which features minimal and even negative returns for traditional investments, buying selected real estate for cash and generating spendable income is a strategy with a lot of attractions.”
At this writing a 5-year CD pays about 2 percent. Given that the most-recent monthly inflation rate is better than 3.6 percent, it means a CD investor is losing buying power.
Or, consider this example: Imagine that you have $50 million sitting around. That’s a lot of cash. It makes you very important in the financial world. Deposit that money with a bank and you should get preferred treatment, lots of toasters and maybe a free safety deposit box.
At least that’s the way it used to be. Now, according to the The Wall Street Journal, the Bank of New York Mellon has a new policy which says customers who place $50 million in their accounts “will face an annual fee of at least 0.13% of the excess deposits. The fee would rise if the one-month Treasury yield dips below zero.”
In other words, there’s a $65,000 annual charge for the bank to hold your money. Why? Because the world is awash in cash, the reason interest rates reached a 50-year low in August.
Meanwhile, even though times are tough and likely to remain tough rents are rising and vacancies are down. People need someplace to live and ownership is increasingly not an option: ownership rates have now declined to levels not seen since 1965 so there are more renters competing for good properties.
Positive cash flow. It’s a wonderful thing.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.