Feb282012

Dwindling resale supply will not cause house prices to appreciate

Where did the resale supply go? Will declining resale inventories cause prices to go up? Conventional wisdom holds that lower resale supply translates to high home prices. The months-of-supply metric developed by realtors to instill panic in potential buyers is based on this conventional wisdom. But the reason for the lower supply matters.

In an appreciating market, lower supply is caused by increased demand. Supply is absorbed which forces buyers to reach higher or accept less quality for the money. That isn’t what we have today. Demand is largely unchanged. Increasing demand is not absorbing the inventory, and sales volumes are still well below historic norms. The reduced supply results from an increase in approved short sales and a delay in lenders getting new product to the market. The organic seller is notably absent because few want to sell at what is widely perceived as a bottoming price.

In markets like ours where prices are only now reaching rental parity, buyers don’t have capacity to raise their bids. Perhaps in Las Vegas a reduction in supply might cause prices to rise because prices there are so far below rental parity that buyers have plenty of capacity to raise their bids. In Orange County, raising their bids is not an option. When supply of resale homes is thin, transaction volume drops off. We are more likely to see a decrease in sales volume than we are to see higher prices. In short, a lack of $500,000 homes doesn’t make $600,000 homes sell any better.

Published: Friday, 17 Feb 2012 | 4:46 PM ET
By: Diana Olick
CNBC Real Estate Reporter

For years now we have been harping on how distressed home sales put downward pressure on home prices all around them.

Close to twelve million borrowers are now in a negative equity position on their homes because so many other borrowers were unable to afford their mortgages. The logical assumption would then be that as foreclosures ease, organic home prices will rebound.

But what if the current, unique state of the housing market turns that assumption on its head?

Foreclosure sales now make up a full one third of the market nationally and far higher percentages in states like California, Florida, Nevada, and Georgia.

The supply of these properties has actually been dropping, pushing prices higher, even in the distressed category. There is huge investor and first-time home buyer demand for distressed properties at the low end of the market, and that has helped stabilize prices.

“We believe the distressed part of the housing market has already bottomed,” said Morgan Stanley analyst Oliver Chang on CNBC’s Squawkbox. “The bid that we see from the investor is the reason for this bottom.”

I am watching this happening in Las Vegas in real time. From why I have observed in my daily routine of pulling comps for dozens of properties is that Las Vegas’s housing market is likely to have its first spring rally in 6 years. In all likelihood each neighborhoods that springs back will likely get hammered down with more lender supply, but the balance of push and pull at below-median price points is reaching a point of balance. Investor demand is very high for low-priced properties with good cap rates.

He sees further declines in organic home prices.

Why?

Banks have been very slow to release their repossessed (REO) inventory onto the market, not to mention that foreclosure processing delays have literally millions of properties still sitting in foreclosure limbo.

The overhang of supply is very large. Unless 100% of this supply is sold as bulk REO with provisions to hold as rentals, the best case is zero appreciation. Worst case is a catastrophic collapse.

There is a dwindling supply of foreclosures and rising investor demand. Analysts keep pointing to overall falling inventories, but the current existing home sales pace doesn’t account for that drop.

The fact is that with so much of the supply distressed, and so few organic sellers putting their homes up for sale, the inventory drop is artificially skewed to the recent lack of movement in foreclosures and a crisis of confidence among potential organic home sellers.

Banks are slow to the market, and organic sellers aren’t motivated. If prices tick up, the organic sellers will change their minds and sell into any demand. They represent pent-up supply.

Okay, so what about the fact that banks are ramping up the process now, which could put more properties on the market? That could boost supply, were it not for a new government program to sell foreclosures in bulk to large investors.

I have been writing about this for the last several weeks. The bulk REO deals will take some of the excess supply off the market.

Chang says over $1 billion in investor capital has been raised over just the past six weeks to take advantage of this new program, and he claims this could add up to 1.8 million jobs. Property managers, renovators, rental agents, he says would benefit from these bulk rental investments.

Mortgage analyst Mark Hanson, however, disagrees.

He claims that individual investors will likely spend more on upgrades/renovations than bulk investors and will then sell to owner-occupants at a higher price, thereby not only stabilizing but increasing overall home values, while also juicing jobs.

Ordinarily I agree with Mark Hanson. His analysis is among the best in the industry. On this particular point, he is wrong. If too much product is sold to individual investors, these investors will flood the market and cause prices to crash. That’s what happened in Las Vegas. Flippers react to market prices, they don’t have the clout to move prices higher.

“Due to epidemic effective negative equity (not having enough equity to pay a Realtor and put a down payment on a new house) the repeat buyer cohort has been cut in half since 2007. They now make up the minority of national resales,” says Hanson.

Investors and first-time buyers ARE the real estate market,” he adds. “Investors and first timers want REO and short sales. Anything done to prevent the flow of distressed property will hurt the volume of existing home sales and all of the economic benefit that comes along with them. An REO-to-rent program will bring about record lows in monthly existing home sales volume. And volume precedes price.”Add an Image

Hanson believes that when the distressed supply is choked off, by selling REO in bulk to rent, not re-sell, then the only thing you have left is meager organic sales.

“The housing market will implode,” he adds.

On this point, I agree with Mark Hanson. If REO are removed from the market, sales volumes will plummet. This has been the problem in Orange County for the last 5 years. In Las Vegas where prices were allowed to crash, sales volumes are greater than they were at the peak of the housing bubble. Here in Orange County, sales volumes are 20% off their historic norms, and the sales activity has been concentrated at the low end of the market. There is very little high end activity because borrowers can’t afford the asking prices, and no matter how much the supply is restricted, buyers will not be able to increase their bids to absorb this supply. High end prices in Orange County must come down if it is to sell at all.

Yes, lower supply, in a normal market, would generally mean a return to home price appreciation, but that’s not the way today’s market is working because organic demand is still so weak and is hampered by tight credit.

Credit will remain tight for the foreseeable future. Lenders proved during the housing bubble that loose credit standards cause lender losses. What we are calling tight credit standards today were the prudent lending standards of the twentieth century. The financial innovations of the twenty-first century were folly.

There is even less demand for mid- to higher-priced homes.

“$200K to $300K is the new normal for home builders,” says Rick Palacios of John Burns Real Estate Consulting. “Since new home prices peaked in 2007, new single-family sales of over $500K have been more than cut in half, dropping from 13% to just 6% of all new home transactions.

The existing home market is much the same, with the bulk of sales and demand in the very low price tiers. It just goes to show that in the historic recovery from an historic housing crash, the usual rules just don’t apply.

The bottom line is this: buyers cannot raise their bids. They don’t have the equity, and they can’t borrow any more. Without increasing bids, prices won’t go up. The federal reserve has already lowered mortgage interest rates to historic lows, so there is little capacity to increase borrower bids on the finance side. What we need is robust job creation and wage inflation, and unfortunately, I don’t see that happening any time soon.