Shadow Inventory Now Much Less Of A Threat To Homebuilders

Jan.23.12 | About: SPDR Homebuilders (XHB)

Earlier this month, I argued that 2012 is the year to start betting on a bottom for housing in 2013 (see "Time to Buy the Dips in Homebuilders"). One of the knocks on any bullish thesis for housing has been the persistent overhang of "shadow inventory" of homes that are not yet on the market as they await official foreclosure. According to another detailed analysis from my brother, it seems that this argument has finally become much less relevant. I present his thesis and data below with his permission and some editing. His analysis covers the Atlanta housing market, one of the country's metropolitan areas hardest hit by foreclosures. Last year, some prices in the Atlanta metro area tumbled to levels last seen in the 1990s. So, I am taking careful note of this evidence that the problem of shadow inventory has likely receded.

I continue to recommend buying the dips in homebuilders like KB Home (NYSE:KBH) or sticking with the SPDR S&P Homebuilder ETF (NYSEARCA:XHB) to minimize the impact of company-specific risks. The steady run in these stocks since the October, 2011 lows has produced some very rich valuations. For example, Toll Brothers (NYSE:TOL) has a forward P/E of 31 and a price/sales ratio of 2.6. The realization of macro-economic risks throughout 2012 are likely to motivate profit-taking and retrenchment. These moments will produce ideal buying spots.

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By now, just about everyone knows about the shadow inventory of 5-7 million homes that are currently delinquent and headed towards foreclosure. This threat alone has delivered a sufficient scare to many potential home buyers such that they believe a housing bottom is many years into the future. Similarly, many investors have stayed away from buying housing-related stocks.

A significant part of my recent bullishness on homebuilders rests on my conclusion that shadow inventory is not a threat for new home sales. I use the Atlanta metro area as a case study to demonstrate the source of my conviction.

To test my thesis, I looked at real estate owned (REO) homes for sale on Fannie Mae's website and compared them to homes for sale in the Multiple Listing Service (MLS) in the four core counties in the Atlanta region: Fulton, Cobb, Gwinnett, and Dekalb. Fannie Mae is the largest holder of REOs in the country and maintains a reasonably updated list of homes for sale on its website. Local MLS data come from the GA MLS website. The MLS typically represents over 90% of all homes for sale in major metropolitan regions. This analysis is current as of January 11, 2012.

I used the average for sale price in the MLS data because it was already calculated and easy to use. I used the median for sale price for Fannie Mae REOs because it was easier to extract from the Fannie Mae listings than the average. The search functionality of the Fannie Mae website provides a listing for each individual home for sale in a county. Calculating an average would require extracting each listing, one-by-one. There are 502 homes for sale just in Fulton County. Calculating the median only requires sorting the list by price and then scrolling to the 251st house for sale.

This chart summarizes the key results.






Number of MLS Homes for Sale





Number of Fannie Mae REO homes for sale





Average for sale price in MLS





Median for sale price of Fannie Mae REOs





Click to enlarge

These results were stronger than I could have imagined. The median for sale price of the REOs is not even half of the mean for sale price of the total homes for sale in any of the four counties. In Fulton and Dekalb counties, REO prices are about a quarter of average prices.

While we might expect discounted REO prices relative to non-REOs, the above table demonstrates that the REO inventory is not comparable to the larger MLS inventory. More importantly, the table shows that very few of the REOs could be considered potential substitutes for typical shoppers looking for new homes. In other words, the shadow inventory should not be considered a threat to new home sales in the Atlanta region.

This analysis needs testing in several other cities to generate definitive conclusions for the entire country. However, the Atlanta results are overwhelming and all the more suggestive given Atlanta was one of the hardest hit cities in terms of foreclosures. Atlanta provides an ideal case study for the impact of foreclosures on new home sales.

Here are a few other notes:

  • The REO homes for sale are actually a subset of the MLS homes for sale, weighing down the mean and average prices for MLS homes. Therefore, the difference between REOs and non-REOs is actually much greater than what is shown in the chart.
  • Using the average REO for sale price rather than the median would have expanded the difference between REOs and MLS prices because the REO price distribution is bottom-weighted.
  • It is pragmatic for Fannie Mae (along with Freddie Mac, the Federal Housing Authority {FHA}, and the banks) to foreclose on higher valued properties first and then follow with less valuable properties. If a $1 million house and a $100,000 house default at the same time, the creditor wants to foreclose the $1 million house because it has more to lose in delaying the process. This reality suggests that the inventory in the foreclosure pipeline is likely more biased to the low-end than the current batch of REOs.
  • It makes sense that the Federal Reserve is now proposing to sell REOs in bundles unlike three years ago. The transaction costs associated with unloading low-value properties consume a substantial portion of the sale price. It is more profitable to sell these properties in a bundle at a deep discount, reducing transaction costs.

Bottom line: In the current bull-bear debate on homebuilder stocks, do not let the shadow inventory scare you into the bear camp.

On a related note, an incredible development has unfolded in the Atlanta metro market. The number of homes for sale is equal to about six months worth of sales for all homes - new and used. It will be interesting to see whether a bunch of people put their homes on the market this spring and summer. This behavior is the normal seasonal trend, but in the spring and summer of 2011, the number of homes for sale did not go up dramatically. I suspect the same will be true this spring and summer. In other words, everyone who absolutely had to sell, has already sold. Homebuyers in Atlanta are going to be very disappointed when they go shopping this spring/summer. The number of homes for sale is tiny relative to the last four years. Prices may show signs of stabilization…maybe even increase if shoppers remain active despite the lack of bargain basement steals.

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Be careful out there!

Disclosure: I am long KBH.