How Rising Home Prices May Actually Stall the Recovery

How Rising Home Prices May Actually Stall the Recovery
Phillip Spears | Digital Vision | Getty Images

Home prices have been rising steadily for the past several months, but some fear the rapid increase could actually start hurting the housing recovery.

The reason is that the rise in prices is mainly due to investors, mostly large hedge funds, that have been swooping into the most distressed markets and inhaling properties as fast as their plentiful cash will allow. They are turning those properties into rentals, and getting anywhere from 8 to 12 percent returns on their investments, thanks to still hot demand. The trouble is, as home prices rise, those returns shrink.

"The worry with investment demand is that the very recovery in prices that it is driving will eventually reduce rental yields and undermine the investment case," warns Paul Diggle of Capital Economics.

Today's housing recovery, much like the recent crash, is like no other. While home prices fell nationally for the first time in history, they are recovering locally at drastically different paces. Some markets are still in the red, while others are surging forward with double-digit gains. Those that are seeing the biggest jumps are largely the markets that saw the deepest losses. Witness Phoenix home prices up over 20 percent from a year ago on the S&P/Case-Shiller home price index. The huge influx of investors there shrunk inventories and created bidding wars, hence the price gains.

(Read More: Housing Recovery Is Leaving Behind First-Time Buyers )

But even outside those hot markets, this national housing recovery is dependent on investors, who are largely all-cash buyers. The mortgage market is still too restrictive to support the kind of bulk-buying that needs to occur, and many potential buyers either lack the credit scores or the confidence to jump in. Another 14 million borrowers still owe more on their mortgages than their homes are worth, according to Zillow, and are therefore unable to move.

(Read More: Foreclosure Discounts Drying Up )

Five million properties are either in the foreclosure process or their owners are delinquent on their mortgages. That means foreclosures will remain elevated for the foreseeable future, and investors will be necessary to absorb them. Another concern is that home prices are rising faster than income, which could push potential owner-occupants away just as they were starting to dip their toes in again.

(Read More: Yes, Housing Starts Surge, but Rentals Are the Drivers)

The risk of sales dropping as investors leave is obviously higher in the markets that saw the biggest drop in home prices during the crash, again, like Phoenix. Other markets, such as Chicago, Atlanta, and even parts of Florida, where prices are still weak and distress is still a large share of the market, are still seeing improved sales, as investors shift their sights and cash to more yield-worthy ground.

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