Investors buying REO crippled the move-up market
Prices crashed in 2007 and 2008 down to levels of relative affordability due to shrinking loan balances from the withdrawal of toxic loan products. Each of the loan owners who used unstable loans lost their houses and their creditworthiness. As a result, millions of foreclosures hit the market and there were not enough buyers to support prices at historic levels of affordability, so many markets crashed well below fundamental values.
The group who ordinarily take equity from a previous sale to support a move-up market is absent because they have neither the credit nor the equity to complete the sale. The absent move-up buyer is keeping sales volumes relatively low as compared to historic standards. realtors have been touting the strength of home sales recently by comparing them to the record low sales volumes of the last three years. In truth, we are still about 20% below the average sales volume of the last 20 years, mostly due to the lack of a viable move-up market.
Over the last few years, much of the housing market sales volume came from cashflow investors seeking better yields. The small investors are being joined by large hedge funds to buy properties to hold for their rental income. These buyers do not favor move-up markets because prices are still inflated, and the cashflow returns don’t make sense. Some speculate in these move-up markets, but few professional investors place money there. Most of the investor purchases have been below-median properties with good rental yields.
The reason this opportunity exists for investors is because there simply aren’t enough first-time homebuyers to absorb all the inventory. Some have postulated that investors are driving prices up for owner occupants. That isn’t the case. Cashflow investors don’t typically crowd out families. Someone buying a property as an owner occupant typically bids more aggressively than an investor because they are not worried about the rental returns. Cashflow investors are bottom feeders looking for bargains, so they are less prone to get caught up in bidding wars.
One result of all the investor activity at the bottom of the housing ladder is that first-time homebuyers who are the backbone of tomorrow’s move-up market are fewer in number. When prices start going back up, the equity which ordinarily would have supported a move up market will instead add to the wealth of an investor who won’t be selling the property to port the equity into a move-up house. As a consequence, the move up market will languish for much longer than most realize.
Published: Tuesday, 10 Jul 2012 | 1:04 PM ET
Growing activity in the spring housing market brought new growth in home prices, but those gains are growing ever more precarious because they are dependent on low-priced, distressed properties.
While prices in the past three months rose 1.7 percent on a national average from a year ago, according to a report from Clear Capital, the biggest gains were out West, where foreclosures and short sales are often the majority of a local market’s activity.
In Minneapolis, Minn., for example, 35 percent of home sales are foreclosures; prices there rose just over 13 percent from a year ago. The same in Columbus, Ohio where prices rose 14 percent, given that nearly 34 percent of sales were of foreclosed properties.
While foreclosures brought home prices down initially, they are now driving them up because there is so much demand from investors and first time buyers, looking for bargains. Supplies of these cheap homes are also dwindling, because banks are still working to modify many troubled loans, and states that require a judge in the foreclosure process are still facing a huge backlog.
The below median market is certainly seeing price pressure from the lack of inventory. Prices are still low enough that investors are interested, but if they rise too far or too fast, many investors will lose interest and stop buying them.
The poster child for this new dynamic is Phoenix, Ariz. Prices there are up a whopping 20 percent from a year ago because so much of the market was foreclosures. They used to make up more than half of all sales, but now they’re down to about 23 percent because there are just not that many foreclosures left to buy. Investors honed in on the market, buying properties in bulk and putting them up for rent. Some investors are already cashing out and selling them, but not many.
The increase in prices in Maricopa County, Arizona, has been remarkable, and it isn’t due to a change in the product mix. Prices of individual houses are rising. Of course, more than two-thirds of the county’s mortgages are underwater, and many delinquent loan owners are waiting in the wings for their foreclosure, so the dramatic run-up is not likely to continue much further this year (note the declining asking prices already signalling a shift), but it would take quite a flood of REO to push prices back below the 2011 lows, and that doesn’t seem very likely given the banks behavior of late. Despite the apparent strength, sales volumes are down 17.4% from last years levels, and inventories are starting to rise again. There will likely be a pullback this fall and winter.
This new lack of distressed supply may lead to what housing analyst Mark Hanson calls, “an investor gut check.” He sees early results that sales volume in many of the markets that were deemed to be “recovering” are actually falling.
“First is the artificial lack of distressed supply, which is the market in all of the miracle ‘recovery’ regions. As I have pounded the table over for years … ‘investors and first timers are thin and volatile cohorts that have been known to up and leave markets in a matter of a month or two leading to a demand collapse‘.
Professional cashflow investors will only remain interested in a market as long as the yields are good. Once prices rise too high relative to rents, professional investors stop buying and start looking for the exits. The hope of every professional investor is to see a frenzy like the run-up in Arizona so they can offload their cashflow properties to a speculator and make extra on the appreciation. Speculators are the chumps professional cashflow investors sell to.
But equally responsible are Zombie Homeowners; those without enough equity to pay a Realtor 6 percent and put 20 percent down on a new house and/or good enough credit or strong enough income to secure a new mortgage loan,” writes Hanson.
Hanson calls the lack of distressed supply “artificial” because he believes banks are holding back some distressed inventory and/or that many of the loan modifications being worked out will inevitably fail.
Let me clarify one point about how the banks are withholding inventory. First, they are not keeping many REOs off the market. In fact, banks have been reducing their REO inventories steadily all year.
What banks are doing is allowing delinquent loan owners to squat in houses they are not paying for to prevent those properties from coming to the market. This is an important distinction because this future inventory hiding in the shadows is still out there. Either through short sale or foreclosure, those properties will eventually be recycled. If prices keep rising, lenders will begin to process these properties to recover their capital.
He points out that distressed supply is vital to a market like Phoenix, because 66 percent of its current borrowers owe more on their mortgages than their homes are currently worth, and are therefore stuck in place, unable to buy or sell.
“Without repeat buyers in the market leaving a unit of supply when they move up, laterally or down (in the case of empty nesters), supply is simply removed from the market and not replaced,” notes Hanson.
The same problem impacts the demand side of the market equation. When a property is purchased by an investor today, five years from now when that investor liquidates for a profit, the equity from that sale is not put toward a move-up property. The demand is simply removed from the market and not replaced.
Phoenix is not unique. California, Florida, much of the Midwest will likely see the same, as will Atlanta, which is still mired in a foreclosure crisis with recovery nowhere in sight. Given that supply scenario, it is likely that many of these national gains (which as I’ve argued before are artificial anyway) will give some back before finding solid footing.
Bottom line, until this housing market is no longer dependent on distressed supply to support overall home sales, calling a bottom to the national housing market is premature.
That’s the same argument I have made as well. Perhaps 2012 will be the bottom, but we may revisit that bottom in 2013 and 2014 before embarking on substantive and sustained market appreciation.