When Foreclosure Supplies Fall, the Bottom Falls Out of Housing

Growing activity in the spring housing market brought new growth in home prices, but those gains are growing ever more precarious because they are dependent on low-priced, distressed properties.

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Foreclosure

While prices in the past three months rose 1.7 percent on a national average from a year ago, according to a report from Clear Capital, the biggest gains were out West, where foreclosures and short sales are often the majority of a local market’s activity.

In Minneapolis, Minn., for example, 35 percent of home sales are foreclosures; prices there rose just over 13 percent from a year ago. The same in Columbus, Ohio where prices rose 14 percent, given that nearly 34 percent of sales were of foreclosed properties.

While foreclosures brought home prices down initially, they are now driving them up because there is so much demand from investors and first time buyers, looking for bargains. Supplies of these cheap homes are also dwindling, because banks are still working to modify many troubled loans, and states that require a judge in the foreclosure process are still facing a huge backlog.

The poster child for this new dynamic is Phoenix, Ariz. Prices there are up a whopping 20 percent from a year ago because so much of the market was foreclosures. They used to make up more than half of all sales, but now they’re down to about 23 percent because there are just not that many foreclosures left to buy. Investors honed in on the market, buying properties in bulk and putting them up for rent. Some investors are already cashing out and selling them, but not many.

This new lack of distressed supply may lead to what housing analyst Mark Hanson calls, “an investor gut check.” He sees early results that sales volume in many of the markets that were deemed to be “recovering” are actually falling.

“First is the artificial lack of distressed supply, which is the market in all of the miracle 'recovery' regions. As I have pounded the table over for years ... 'investors and first timers are thin and volatile cohorts that have been known to up and leave markets in a matter of a month or two leading to a demand collapse'. But equally responsible are Zombie Homeowners; those without enough equity to pay a Realtor 6 percent and put 20 percent down on a new house and/or good enough credit or strong enough income to secure a new mortgage loan,” writes Hanson.

Hanson calls the lack of distressed supply “artificial” because he believes banks are holding back some distressed inventory and/or that many of the loan modifications being worked out will inevitably fail. He points out that distressed supply is vital to a market like Phoenix, because 66 percent of its current borrowers owe more on their mortgages than their homes are currently worth, and are therefore stuck in place, unable to buy or sell.

“Without repeat buyers in the market leaving a unit of supply when they move up, laterally or down (in the case of empty nesters), supply is simply removed from the market and not replaced,” notes Hanson.

Phoenix is not unique. California, Florida, much of the Midwest will likely see the same, as will Atlanta, which is still mired in a foreclosure crisis with recovery nowhere in sight. Given that supply scenario, it is likely that many of these national gains (which as I’ve argued before are artificial anyway) will give some back before finding solid footing.

Bottom line, until this housing market is no longer dependent on distressed supply to support overall home sales, calling a bottom to the national housing market is premature.

- By CNBC's Diana Olick

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