The Myth of the 'Shadow Inventory'

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Many U.S. real estate executives sound like bad mystery writers these days. The hot topic of discussion is "shadow inventory," a mysterious and frightening figure hovering around the corner ready to stick a shiv in the recovering residential market.

Recent debate focuses on a report from Standard & Poor's, which suggests that it may take three years to absorb the current shadow inventory of distressed properties.

More than $480 billion property falls into this category, which Standard & Poor's defines as "outstanding properties that are (or were recently) 90 days or more delinquent, in foreclosure, or real estate owned (REO), but haven't yet hit the market inventory."

Without a doubt, the prospect of these shadow properties hitting the market sometime soon is casting a dark pall over the market (sorry, couldn't resist). As foreclosed and "must sell" properties enter the market at steep discounts, the deals will conspire to keep average prices low and ensure supply outpaces demand.

To a degree, that's undoubtedly true. But it may not be time to build the bomb shelter quite yet.

Dive deeper into the numbers and the shadow inventory is not nearly as scary.

For one, the size of this shadowy inventory is, in fact, shadowy. Nobody really knows how big it is, with estimates ranging from 2 million to 8 million homes. That's a big difference, and it's worth noting that many of the owners who fit Standard & Poor's description may not end up putting their homes on the market

And Standard & Poor's report makes it clear the problem differs wildly from market to market. In New York, for example, the analysis estimates there is 103 months of supply in shadow, light years ahead of the 34-month national average. In contrast, Phoenix, the lowest of the 20 markets studied, showed only 16 months of inventory.

In fact, in many markets the inventory of publically available properties is shrinking. In Miami, for example, the number of residential listings in May was down 19.3 percent from a year earlier and 43 percent below August of 2008. Nationally, total inventory was down 3.4 percent in May, according to National Association of Realtors data.

While the spring numbers were certainly skewed by consumers rushing to buy before the expiration of the federal tax credit, they don't suggest that there is a flood of listed property lingering on the market.

No one denies that a rush of foreclosed and "must sell" properties coming on to the market could change the game and quickly dampen any price tension. But there is no guarantee all the distressed properties will hit the market at once. If anything, properties tend to hit the market in drips and drabs, especially as lenders look to hold property rather than sell it at an embarrassing discount.

That is certainly what is happening, to some degree, in commercial markets, where thousands of buildings and shopping centers are in the shadow inventory, analysts say. While many believe the commercial markets woes could easily dwarf the sub-prime crisis, it hasn't happened (yet), in part because the property hasn't hit the market in one big wave.

The residential inventory is a different beast. But it also represents several classes of product, and not every sector will be affected when the distressed properties come on the market. In many markets a large percentage of the inventory is almost certainly low end and tear-down properties, which may not affect the higher-end of the market.

Standard & Poor's looked at the national shadow inventory numbers and issued a stern warning, part of the new-found hard edge adopted by the ratings agencies in the wake of the mortgage crisis.

"Given this backlog, we believe that average home prices could fall again if demand doesn't rise in step with the potential influx of supply," Standard & Poor's credit analyst Diane Westerback said in a statement.

But that's a big "if." A reasonable uptick in demand--fueled by, say, low interest rates and tax breaks--could easily offset the impact of the distressed properties, opening the possibility that the shadow inventory may turn into the equivalent of a dangerous hurricane that never hits land.

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