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What is lurking in the shadows?

Many people have heard the term “Shadow Inventory” in connection with real estate. But, what exactly does the term mean?  In a nutshell, shadow inventory

“is the inventory of homes that are either owned by the bank (foreclosed upon but not yet listed for sale), or where the current owner is in jeopardy of losing his/her home to the bank in the near future”.

CNN recently released a report on this problem and in it described the long term effects it could have on our nation’s housing recovery.  You might be asking yourself how

homes that aren’t even on the market could have an effect on the market? There are two ways that this inventory can affect the market.

  1. Perception – This is when potential buyers read in the news about how bad the real estate market is, and decide to delay their purchase until they see more positive results.  I call these people the Lemmings. They blindly follow the crowds, listen and believe whatever they read and/or see on the news. Until this shadow inventory actually comes into the market, it is all speculation.
  2. Reality – When these homes are actually listed for sale and compete against other homes in the marketplace. The effect of this extra inventory causes downward pressure on the asking and eventual sales prices of other nearby homes. It is simply the law of supply and demand but with a twist…

According to some statistics provided to me at a recent seminar I attended, Short Sales (those sales where the sellers’ home will not sell for an amount high enough to cover the liens on the property) will generally net 70-88% of fair market value. REOs (bank owned property where the home has been taken back by the bank) generally net 40-60% of fair market value.

Here’s the problem if you actually think about it:

Fair market value is generally defined as the price at which a seller is willing to sell for, and a buyer is willing to pay in an arm’s length transaction. However, housing sales are not done in a vacuum. There are many factors that contribute to a property’s value, including but not limited to: location, condition, amenities, and much more. So let’s create a scenario which is pretty common right now…

A condo complex of 100 units with a historical average value of $250,000 (the price that many of the current owners paid for their homes just a few years ago) has one unit (fair market value) for sale at $250,000. What is the value of that unit? $250,000? Maybe a little less given the decline in the market?
Now let’s say that that unit sells for $200,000 and is recorded as a closed sale at that price. Another unit comes on the market for $225,000. Is that unit over-priced?
Then another unit (short sale) comes on the market at $150,000. Then another short sale at $140,000. Then another short sale at $130,000. Finally when all is said and done, you have 19 units for sale in the complex (out of 100 units = 19% of the total # of units, but 100% of the total units currently for sale) that are either short sales or REO, and with an aggregate average price of $150,000. What is the value of a unit in this complex now? This scenario is real, and happening in a condo complex in Lynnwood, WA. All of these short sale and REO properties have brought down the values of ALL units in the complex!

The end result of this glut of REO and Short Sale properties, is that those homeowners who weren’t “Short” before, may now become “short” as a result of the declining values in the complex brought about by the other short and REO properties, thus setting a new value benchmark, and exacerbating the problem further…

Current MLS statistics show that there are 2846 condos for sale in King County. Of those 2846 units, 623 are short sales, and 402 are REO properties. An astounding 36% of the total units for sale (1025 units) are NOT Fair Market Value properties. Imagine what is happening to the prices!

And those buyers? The savvy ones are jumping in and picking up one or more units to hold long term. The Lemmings stand on the sidelines because they fear that prices will continue to fall and their purchase will lose even more value. Just like the stock market, these buyers wait until the market has bottomed out and is on the rise before they jump in…

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