Beyond a shadow of a doubt

If you conduct a search for real estate news you’re more than likely to find a number of articles referring to shadow inventory.  Many of these articles have titles such as, “Shadow Inventory Causing Delay in Recovery” and “Shadow Inventory Hints that Real Estate Bottom is Near”.

Many of my readers have been asking me about shadow inventory, what it means for real estate investors, and how it’s affecting the recovery.  As hard money lenders who primarily lend to real estate investors we have been watching this situation closely.

What exactly is shadow inventory?

Shadow inventory in real estate refers to properties that are in default, foreclosed on, or already bank owned.  Basically, any property that is or was distressed that will be on the market in the future, but not yet, is shadow inventory.   The reason it’s called shadow inventory is because the properties lurk in the darkness of banks’ balance sheets waiting to be put on the market and sold.  Banks either can’t or don’t want to sell them yet (I’ll explain why below).

Who is looking to buy the shadow inventory?

Once the banks do decide to sell the properties, they are most likely going to sell for just below market value and they will most likely need repair or rehab. (Many properties have been vacant for months or years.)  Real estate investors have been chomping at the bit, waiting for banks to begin releasing the properties so they can get their hands on some and turn a profit.  Once the banks are ready to begin letting them go in large scale, there should be an influx of properties on the market ready for investors to make them livable again.

Homeowners too would like to get their hands on cheap properties but financing and other restrictions exist that prevent many from buying directly from banks.

But real estate investors aren’t the only ones watching the shadow inventory closely.  Economists are also keeping an eye of shadow inventory for a few reasons.  They know that when the banks begin to release the properties in large numbers, the banks are signaling their prediction that the housing market has already hit the bottom and is on its way up.  Also, because housing is such an important factor of the economy as a whole, shrinking shadow inventory means an expanding economy.

How can shadow inventory help recovery?

While it’s no secret that a growing housing market plays a huge role in the economy, the converse is also true; stagnant housing causes high unemployment and slow expansion of GDP.  Each property sold can add tens of thousands of dollars to the economy just in the form of furniture, fixtures and labor.  In addition to goods and labor, the economy is helped every time a bank makes a loan.  It’s called fractional-reserve banking.  (This is not a Macroeconomics course so I won’t bore you with the details but feel free to do some research on your own.)

So why don’t the banks sell the properties now?

The shadow inventory is so large now for 2 main reasons.  One reason is out of the banks’ control and the other is a business decision made by the banks.  First, many states and municipalities have enacted laws that slow the foreclosure process.  Mediation and modification attempts are required before the bank or loan servicer can reclaim the property.  In many areas this can take a year or more.  In addition to local regulations, the banks know that holding the properties will allow home prices to rise and therefore they can get a higher return when they do sell.  Most people understand the principle that banks are not in the business of holding properties for any longer than they have to.  Common logic would say that selling the properties and getting them off the books would benefit the banks.  For the most part, this is correct.  What needs to be compared is the price of a house if it sold today versus the price it will sell for in the future minus carrying costs.  I haven’t independently verified the figures but if the banks are intentionally holding properties, the expected future price (minus carrying costs) must be higher than today’s price.

If and when the banks decide to begin releasing the shadow inventory in large scale is anyone’s guess but once they begin to hit the market, expect to a positive swing in the economy.

Ready to start buying REO properties?  Check out Jason’s interview with a bank REO agent:

Click here to watch Part I

Click here to watch Part II

If you have questions or comments, please leave them below.

1 Comment

  • Ryan Hamaker

    My guess is that the banks will never allow a bulk of properties into the market to be sold. If the banks feel they can manipulate homes prices by containing the supply of REO homes in the market (basic supply and demand) then they probably won’t ever just dump a bunch of homes off to be sold. The interesting factor in all this is if mortgage rates climb after the debt talks fail or at least fail to influence those who are lending the banks their money. Substantially higher interest rates will almost assuredly push home prices down which will negatively affect the prices the banks are getting for their REO inventory.

    But we won’t know till we know, right?

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