Explaining the 'Other Housing Supply Problem'

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by: Scott Sambucci

In our Q4 webcast earlier this month - "When Does the Housing Recovery Start?" - I discussed how the "other housing supply problem" will drag prices lower in 2011 and into the next couple of years. Allow me to elaborate...

Defining "The Other Supply Problem"

It's not just the raw number of homes entering the active market each week, but the quality of these homes. Specifically, when foreclosures and REOs enter the market - shadow inventory that becomes real inventory - they are typically of lower quality than the "standard" or "normal" homes for sale. This sub-set of available homes for sale are more becoming an increasingly larger part of the active housing market. More and more, there's talk about a bifurcated housing market with some investors developing separate forecasting and valuation models to account for this perceived bifurcation.

Examining the number of weekly new listings over the past 16 months shows that every week, more homes are persistently entering the market in the bottom quartile, defined as the least expensive 25% of homes (black line):

click to enlarge images

Weekly Count of New Listings by Price Quartiles: Altos 20-City Composite (10/01/09 through 12/24/10)

Zeroing in on just on just the Q4, 2010 values from the above chart - more new listings are entering the market in the bottom quartile at an increasing rate. Notice how the gap is widening:

Weekly Count of New Listings by Price Quartile: Altos 20-City Composite (9/30/10 through 12/24/10)

The price implications are stark - the new sellers hitting the market each week are doing so at lower and lower prices, with the price gap between new sellers and existing sellers widening as well:

Price of New Listings weekly vs. Active Market Prices (90-day rolling average)

Prices are moving lower because of both the generally weak market environment (low demand, rising mortgage rates, end of the tax credit) but also, and perhaps more importantly, because the quality of these newly listings is much lower.

Modeling Implications

Think Chinese water torture. It's the slow drip of these foreclosed properties, not the tsunami predicted a couple years ago, that will drown any short-term hopes of a housing recovery. As banks choose to slowly drip these lower quality homes over several years, even if the number of transactions increases, prices will remain relatively low and flat for several years. This is already showing up in NAR's existing home sales figures. Transactions are rising month-over-month since July 2010, with prices falling during this same period:

Median Sold Prices & Transaction Counts since November 2009 (Source: National Association of REALTORS)

Like it or not, the net result will wreak havoc on valuation models based traditional HPIs such as the S&P/Case-Shiller or the FHFA. Both are a form of repeat sales modeling (see their methodology documentation - S&P/Case-Shiller here and FHFA here). For example, FHFA includes these sales only if the buyer purchases the property with a loan that is bought or guaranteed by Fannie Mae or Freddie Mac.

Because of the generally low quality of these homes comprising the active market, it is all too possible that many of these homes will not show up in the FHFA index because the borrower using an FHA loan backed by Fannie and Freddie likely does not have the disposable cash required to make the property livable. While banks do invest some money into the REOs that get marketed and sold, often these properties have major issues that require immediate cash investments by the buyer. A first-time home buyer using a 3.5% down payment loan likely isn't the person that has the $10- $20-, $30k necessary to sink into the home right away. If these homes are instead purchased by investors and then resold to "traditional" buyers (as shown here), the FHA may omit these sales from their index.

I already have some more thoughts on modeling implications which I suspect I'll bang out in another post in the coming days, so stay tuned... For now, as always, comments and scathing criticisms are wholly welcome.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.