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Short Sales Will Continue to Grow as REO Shadow Inventory Brings Further Home Price Drops

- Monday, September 20, 2010

Approximately 2.5 million American homes are currently under foreclosure, and another 2.5 million homeowners are more than 90 days delinquent on their mortgages and likely to face foreclosure, according to a report released last week by John Burns Real Estate Consulting.

According to the report, about 562,000 homes are currently Real-Estate Owned (REO). They form a “shadow inventory” of homes for sale - an inventory that is sure to rise as the current glut of real estate, a total of 5 million homes that are either under foreclosure or likely to face foreclosure, hits the market.

The Burns report predicts that this REO inventory will affect home prices in two main ways:
1. It creates a more-than-one-year supply of homes on the market. Simple laws of supply and demand mean that prices will likely drop.
2. Banks are more likely to drop prices on bank-owned homes in order to ensure a quick sale, which will negatively affect home prices throughout the region.

Many analysts attribute the increase in foreclosures to the failure of the loan-modification program. While loan modifications have seen better performances through the first quarter of 2010, with less than 10% of loans processed through the program becoming more than 60-day delinquent through that period (data from FHFA 2Q2010 report), for many homeowners loan modifications have only delayed their path to foreclosure, leading to the recent rise in foreclosure starts.

Aside from the specter of a growing REO inventory of homes for sale, factors external to the real estate market itself may also bring home prices down, such as: greater levels of unemployment, and rising interest rates. Just how much home prices could fall depends upon local market conditions; the Seattle market, for example, is one that is currently considered overvalued and so has the potential to drop more.

More and more homeowners are working to avoid foreclosure by taking preventative action. Where market conditions have forced homeowners into a negative equity situation, rather than waiting for foreclosure, an increasing number of homeowners are choosing to short sale their home.

A short sale is a loss mitigation measure; the homeowner negotiates a discount on the amount owing to the bank, and pays off that amount to relieve himself or herself of the loan. In markets that have the potential for further declines, it is a strategy for the homeowner to escape the risk of even further losses. Short sales are one of the fastest-growing categories of foreclosure-prevention actions, having grown from 11,700 in the second quarter of 2009 to 29,400 in the same quarter this year. The Burns report predicts that short sales will continue to grow, as homeowners strategize in order to protect themselves from further losses due to continued home price declines.

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