Is the Massive Shadow Inventory Actually Shrinking?

Shadow inventory – the collection of homes that are either in the foreclosure process but haven’t been sold yet, or are being kept off the market because of low prices and market uncertainty – has grown tremendously over the past five years. While foreclosures have broken records – with over one million foreclosures in 2010 alone – the amount of homes that haven’t even been put up for auction or even repossessed at all is far greater.

Now, evidence shows it may actually be shrinking.

S&P, the credit rating bureau that is now infamous for last week’s downgrade of the American government, revealed a report stating that the shadow inventory lingering in the nation’s closet would now take just 47 months to clear out at present levels – down from the previous level of 52 months.

Five months may not seem like a lot, but it represents a 9.6% reduction from the peak. Furthermore, it is the first decline in the shadow inventory rate on a quarterly basis in years.

Not surprisingly, Florida and California have the highest shadow inventory rates in the country, followed by Illinois, New York, and Texas. At the opposite end of the spectrum, Wyoming has the lowest inventory rate, followed by the Dakotas and Alaska. Right in the middle are Connecticut and Oregon.

Shadow inventory is important for two reasons. The first reason is that it depresses home values because of the sheer number of homes in default and in foreclosure in given area. All things considered equal, a home in a neighborhood weighed down by delinquent homes will have its home value depressed compared to an identical house in a healthy neighborhood.

The second reason is more psychological. These shadow homes are homes that should be foreclosed and sold, but haven’t been. This generates an incredible amount of uncertainty in the market, which generates instability and further hinders the recovery of the market.

We are, of course, bullish on the long-term future of the residential real estate market. Shadow inventory will gradually decrease and has probably peaked. Plus, the abundance of super-affordable homes, coupled with low interest rates, makes a combination that will prove too tempting for investors and homebuyers to ignore much longer.