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Will shadow inventory derail housing recovery?

(MoneyWatch) Home sales and home prices are up, even as the stock of available housing shrinks, a trend that could get derailed if looming foreclosures and other new homes suddenly hit the market.

Existing home sales increased in October 2.1 percent to a seasonally adjusted annual rate of 4.79 million units, according to a report from economic forecasting and analysis company IHS Global Insight.

In fact, most of the major house price indices report that prices are going up, including the monthly Case-Shiller report and the Federal Housing Finance Agency, which recently reported year-over-year price increases of nearly 4 percent.

What's driving this increase in home appreciation? According to IHS Global Insight economist Patrick Newport, low prices and low interest rates have led new buyers to chip away at a much smaller housing supply, driving up demand and prices.

Inventory is down to its lowest level since December 2002, and that number is likely to drop over the next three months during winter, which is traditionally the low season for home sales. The low inventory is a sign that housing markets are tightening, due in part to the overall slowdown in building new homes. In fact, the Economics and Statistics Administration reported today that sales of new homes in October slowed fractionally from September, to 368,000 on a seasonally adjusted annual rate.

"What's driving the market right now is the fact that we haven't been building at high levels for a long time," Newport said.

Up until about 2004, Newport estimates that overbuilding led to about 2 million excessive homes on the market and that over the years buyers have purchased at least three-quarters of those homes.

While home prices have increased across the board, there are six Northeastern states where the prices haven't gone up. Most of these are judicial foreclosure states, where foreclosures go through the court system, lengthening the amount of time it takes to close on a foreclosure.

With a larger inventory of foreclosures for sale, these states haven't yet seen the same kind of growth in home prices or sales that the rest of the country has experienced. This is where the looming specter of shadow inventory comes in.

Analysts have been talking for years about the emergence of a shadow inventory, the catalog of homes that are teetering on the edge of foreclosure or are in the beginning stages, destined to be bought by the banks and then re-marketed to home buyers and investors down the line.

But questions about the true state of the housing recovery go beyond that -- there's a whole new form of shadow inventory, driven by investors who have been snapping up homes as prices bottomed out, but have not yet put those homes back on the market to buy or rent. Add to that the homeowners that want to sell but are waiting for their homes to increase in value and you have a potential glut of new homes that, if they suddenly come on the market at the same time, could potentially derail the housing recovery.

Recent figures from CoreLogic show shadow inventory decreasing 10.2 percent in July over last year to 2.3 million units, but it's a tough number to pinpoint, which leaves opinion on the true impact of shadow inventory scattered.

"I think it's a problem, but it's probably not as big of a problem as many people have thought," Newport said. "We've heard about the shadow inventory for a couple of years and so far it has yet to show up."

He sees an oncoming increase in the rental market as families move out of their foreclosed homes and into single family rentals, which investors are offering at record numbers. This keeps the homes owned and occupied and off the market, leaving minimal impact on the overall real estate market, he said.

As long as interest rates remain low along with inventory we may continue to see an improvement in housing. But there is a limit to how far an investor-driven recovery can take us. We still need to see a resurgence of first-time home buyers that have good-paying jobs who plan to live in these homes, stabilizing both the housing market and the neighborhoods where they live.

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