Shadow inventory measures the amount of distressed property that will eventually sell into the market
Shadow inventory is an estimate of the supply of distressed homes that are in foreclosure or 90-days delinquent but are not yet bank-owned. It’s an estimate of the number of homes that are coming up for sale in the next year. Real estate owned (REO) isn’t counted because those homes are usually already for sale. Analysts will focus on shadow inventory in order to gauge supply going forward. Distressed supply will put a damper on pricing as the discount for a property in foreclosure is around 18%, and the discount for a short sale is in the low to mid teens. Distressed sales put in low comparables (comps) which reduces the value of the properties around them.
Shadow inventory so far has been the dog that didn’t bark
Although the shadow inventory has fallen pretty far from its heights, it’s nowhere near normalcy. Pre-bubble, the typical shadow inventory level was about 1 million units. Shadow inventory peaked at 5.4 million units in Q110, and has been falling steadily ever since; it ended 2012 with 3.7 million units.
Real estate market watchers have been confounded by the current market, where supply is constrained in the face of high shadow inventory. Part of the reason for this has been a divergence between the judicial states, where a judge has to approve a foreclosure, and the non-judicial states, where no judge means faster timelines. For non-judicial states, the foreclosure pipeline has been largely dealt with and prices are rising at a fast pace. For judicial states (New York and New Jersey especially), the pipeline is still full and prices have been more or less stagnant.
Many investors had raised capital for the huge flood of supply that never materialized. Many hedge fund managers who started their careers in the late ’80s with the Resolution Trust Corp were waiting for the government to force banks to sell their underwater mortgages, which never happened. Instead, the government forced banks to hold off foreclosures, which may have temporarily held up prices, but elongated the process. Many of those investors have ended up in the rental business, where they pay cash for distressed properties and rent them out.
Impact on homebuilders
Increased foreclosure activity affects homebuilders, like KB Home (KBH), Toll Brothers (TOL), PulteGroup (PHM), Meritage (MTH), and Lennar (LEN), by depressing real estate prices and competing with new homes. Lower home prices mean lower average selling prices for builders, appraisal difficulties, and a glut of foreclosures resulting in lower sales. So the slow drop in shadow inventory is good news for homebuilders. For homebuilders in non-judicial states, shadow inventory isn’t really going to affect them. For homebuilders in judicial states, another year of sluggish pricing may be on the horizon until shadow inventory is worked off.