The Phoenix Housing 'End Game'

Includes: DHI, KBH, TOL, XHB
by: Michael James McDonald

Three months ago I wrote Signs of a Phoenix Housing Recovery Good for Homebuilders, which presented evidence that a Phoenix, Aris., housing recovery would start next year. Data flow over the last three months continues to confirm this forecast. This has made us look more closely at a possible Phoenix “end game.” The “end game” is the specific sequence of events that should occur as the Phoenix market transitions from distress into recovery. The transition should not be a gradual change but events should occur very rapidly and in a particular sequence. We think this is important for investors to know.

Why Phoenix was Chosen

Phoenix was chosen for this study for two reasons:

  1. We believe Phoenix is a proxy for many distressed markets throughout the country and so what’s happening in Phoenix is probably a good indicator for other regions.
  2. The depth of data needed to completely analyze and wrap one’s mind around the problem is available. In this I have to thank Cromford Associates LLC, licensed by ARMLS to provide subscribers and all 30,000 agents with detailed resale and foreclosure data, the “Information Market”, which counts and categorizes on a daily basis the status of every piece of distressed property in Maricopa County, and Corelogic, which also provided vital distressed market data.
The Probable Sequence of Events of the Phoenix “End Game”
Using this data we think the following forecast and “end game” is highly probable for Phoenix:
  • The inventory of distressed homes in Phoenix should deplete to normal levels by sometime next year – probably by mid-summer.
  • At that time sales of distressed homes should fall off rapidly leading to an almost immediate 20% rise in the median home price.
  • This sudden price “pop” should not happen everywhere or at the same time. It should occur intermittently, region by region, throughout Maricopa County as distressed inventory is depleted at different times for each region. This price “pop” should begin first with less expensive homes and then move upward.
  • This price rise should drop the number of homes with negative equity, further slowing strategic defaults and unfreezing thousands of marginal equity homeowners. This process – price rise and unfreezing - should become “self-sustaining” and help fuel the recovery and broaden the market.
It all starts with distressed inventory depletion.
Phoenix Distressed Inventories are Declining in All Categories
Both real and shadow inventories of distressed homes in Phoenix, continue to rapidly decline.These inventories are:
  1. Loans delinquent 90 days or more, which have not yet received a Notice of Trustee Sale (NOTS)
  2. Delinquent loans that have received a NOTS
  3. Accumulated Bank or Agency Owned property called REOs
The graph below plots inventory categories #2 and #3 from November of 2010 to September 2nd of this year for Maricopa County:
The purple area represents the number of homes with notices of Trustee Sales (#2). The three colors at the bottom represent different categories of REOs (#3). Inventories #2 and #3 have declined from 52,000 to 32,000 homes or 40% in only ten months! This rapid decline has occurred from a combination of short selling, loan adjustments, third-party purchases at trustee sales and finally, REO sales. If it continues at this same rate Maricopa should be down to only 12,000 distressed homes by next summer.
This drop in inventory is often met with the comment: “Yes, but this decline is simply because banks, for a variety of reasons, have slowed their issuance of Notices of Trustee Sales. These numbers obscure the huge, growing inventory of delinquent loans yet to receive a NOTS (#1 inventory).”
This comment, however, is incorrect; there is no inventory build-up in category #1. Using data from Corelogic we estimate that category #1 (90 day plus loans without a NOTS) declined from 42,000 to 34,000 between May of last year and May of this year. This is very important. Data is showing all three categories of distressed and shadow inventories declining and declining rather rapidly and, at a straight line rate of decay, project depletion by mid next year.

Watch "Distressed Inventory" not "Distressed Sales" However, if this is true, it begs an obvious question. Why, after such a rapid decline in distressed inventories, have distressed sales as a percentage of total sales stayed so high? We see this fact plotted in the next graph.
This graph shows that for the last six months normal sales (center line) stayed between 30% to 35% of total sales, while total distressed sales (REO and Short) remained between 65% and 70%. This confirms that distressed sales have remained extremely high even as distressed inventories dropped 40%!
However, we think this is what is fooling most people. They see distressed sales remaining extremely high and, since they expect a recovery to be a long, gradual affair, believe the recovery must be a long way off. But we think they’re expecting the wrong thing and looking at the wrong item. They’re looking at distressed sales and not the declining inventory these sales are coming from. Our model says distressed sales should do exactly what they’re doing - stay high up to the very end, then plunge.
Our Model

Our model treats housing like a fluid flow problem with distressed homes moving from one reservoir to the next and bank foreclosure departments acting like pumps, moving the houses along. This model says that distressed sales will remain high (and might even increase) right up to the very end. Then the transition from distress to recovery will occur suddenly, much like how a pump sputters and spits right as it runs out of water.
At this point – the point where inventory depletes and distressed sales rapidly fall - the median price should “jump” and the “end game” sequence listed above should begin.
Why the Median Price will "Jump"
One point that I want to make very clear is why the median and average home prices will "jump" when distressed sales rapidly decline at the very end. It’s rather interesting. Let’s look at the current situation.
In mid-August in Phoenix, REOs accounted for 44% of sales and sold for an average of $59 per square foot (sf). Short sales were 23% of sales and went for $74 per sf., and normal sales were 33% and sold for $105 a sf. A rough mathematical average of these three categories is $78 per sf., which is pretty close to the actual average for Maricopa County in August of $79 per sf.
Now, let’s assume that distressed inventories suddenly deplete and distress sales just as suddenly decline to 25% of the total. Even with no change in the selling price of any home (just changing the mix of normal and distressed sales) the average price per square foot should suddenly rise to $93, which is a 20% increase. If distressed sales became only 5% of sales, the average price would jump 32%. This change in the paper value of all homes would have very positive repercussions, especially for homebuilders.
Other Opinions
Other Phoenix experts see a similar picture but have their own particular ideas about it. In a phone interview I had with Mike Orr of Cromford Associates, he said, “There is a widespread belief that a huge shadow inventory looms over the housing market caused by the robo-signing scandal and foreclosures delayed by the banks and/or the judicial system. However careful research shows that in non-judicial foreclosure states like Arizona, the bulk of the foreclosures tsunami is already behind us and the supply of lender-owned homes is likely to fall away much faster than most people realize.”
In a phone call I had with Tom Ruff of “Information Market” he said he thinks the Phoenix market is about 75% of the way through its housing problem, which he considers began in mid-2007. He cautions, however, that some of the inventory may be around longer than expected, held there by individuals gaming the system i.e. using legal challenges and other techniques to impede the liquidation process to gain free rent or some financial advantage.

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

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