JUN 25, 2013 9:48am ET

Does Falling Inventory Signal an End to REOs?

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With delinquency rates declining and an increased number of loan modifications and refinances taking place nationwide, one of the burning questions for Realtors who specialize in selling bank-owned homes is whether it is the end of REO properties?

REO inventory throughout the nation is falling at a precipitous pace—particularly in judicial jurisdictions where foreclosure timelines can take years—resulting in bidding wars on the assets coming into the market. While this is positive news for the housing industry resulting in rising home prices, it’s been a challenge for REO agents as well as REO-to-rental investors who are looking to find adequate discounts on these properties.

According to CoreLogic, through the end of March, the stock of distressed assets declined nationally by 23% with nearly 1.1 million homes in some stage of foreclosure compared to 1.5 million as of this time period last year. The Irvine, Calif.-based analytic provider said foreclosure inventory represented 2.8% of all homes with a mortgage compared to 3.5% a year ago.

One reason why there is a shortage of REO inventory for agents to sell and homebuyers to purchase is because of dual tracking—where a borrower going through the default foreclosure process is offered loss mitigation strategies at the same time. Government programs such as HAMP and HARP have had recent success keeping distressed assets off of the market and helping borrowers avoid foreclosure.

Additionally, a lot of loans are being transferred from some of the bigger servicers to specialty servicers who are more likely to execute a short sale rather than go to REO since it would be a lower loss outcome.

Another prominent issue causing inventory to shrink is the overwhelming backlog servicers are dealing with not being able to process foreclosure applications quickly enough. Therefore, as that process slowed down, more and more loans ended up becoming seriously delinquent which resulted in the properties not being maintained properly.

Joshua Rosner, managing director of Graham Fisher & Co., said at a REOMAC dinner held in New York in May that there are about 2.2 million loans, many of which are bank REO, which will probably never be available on the market because they haven’t been maintained in four to six years.

“The banks are showing them in listings but are holding them at prices that are 20% to 50% premium to market prices, and that’s just to be able to say to their regulator we tried to sell them but we can’t, so you have to give us another five years to hold them,” Rosner said. “Those ultimately don’t represent inventory that you (Realtors) are going to see. This represents inventory that results in bank losses and their trying to breathe those through as slowly as they possibly can.”

Meanwhile, between 25% and 30% of the bank-owned units listed on the open market are being purchased by institutional investors, Rosner said. The investors are bidding up on properties focusing on $150,000 sweet spots and the cap rates are suffering.

Despite optimism that there is a housing recovery taking place, Rosner said primary residential purchase property appreciation rates were 1% per year in 2012 while investor share property appreciation rates were 15%.

As a speaker at the REOMAC dinner, Chris Whalen, executive vice president and managing director at Carrington Investment Services based in Santa Ana, Calif., believes investor appetite in acquiring distressed properties will slow down because the cap rates are already in single digits. Whalen said the entities purchasing these assets are paying “real money” for capital and they don’t know what it takes to be able to manage single-family homes as rental units.

“If you buy a nonperforming loan at 50 cents on the dollar, you have the leeway to work with the borrower. That works for a rent strategy,” Whalen continued.

“But if you’re paying retail rates at public money, that’s not going to work.”

Whalen also said he is encouraged that banks will have to deal with second-lien loans this year, which he hopes leads them to handle the underlying first lien, too, because when there are two liens, it’s a “problematic” issue.

“We’re not allowed to restructure housing debt in bankruptcy. So because you have a second owned by the bank, and the first often owned by the federal government or investor, they couldn’t deal with it and the property is in limbo,” Whalen added. “That’s one of the biggest things that prevented the banks from dealing with REO in some of these states.”

Both Whalen and Rosner concur that rising interest rates are going to have a major effect for the near- and long-term housing industry.

“When we see interest rates move up significantly, you’ll see a lot more properties come into the marketplace,” Rosner stated.

In general, to speculate if the present times are possible signals for the end of REOs is unrealistic. Even though JPMorgan Chase recently noted that the amount of loans that are either 60 or more days delinquent, in foreclosure, or in REO is down by about a third from the peak a few years ago, there are still 4 million loans in this stage of distress.

The New York-based financial institution projects that it will take 10 years to work through all of these loans to get to a normal environment. Also, the bank forecasts a large foreclosure inventory should continue to exist for at least the next three years, particularly because of the delinquent loans that still have to be processed in judicial states.

Furthermore, there are still between 2 million and 3 million loans that are either seriously delinquent or in foreclosure which have to be processed, which is another positive sign for Realtors. “At the end of this year when the auditors have to review the books, you’re going to see a lot more properties be released because banks will have to realize their servicing operations losses on these assets,” Whalen said.

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