Overhang Hangover: The Housing Market's Future?

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Economists and real estate experts call it “foreclosure overhang,” and it is one of the big question marks that will determine when the housing market will truly recover.

The term refers to the number of foreclosed properties that will wind up on the for-sale market. In the worst case, millions of foreclosed homes offered at fire-sale prices will cause an excess supply that will dampen prices for years to come.

Lower prices are generally good for buyers. But if potential buyers worry that prices will keep falling they may shy away from the market, prolonging the problem.

So the big question is: How bad will the foreclosure problem be?

Eric Landry, an associate director of Morningstar Inc., (Stock Quote: MORN), a firm that tracks the economy and financial markets, argues that the foreclosure threat is serious, but perhaps not as bad as many people fear.

In a new analysis, he says it is a “foregone conclusion that at least four million housing units will be foreclosed upon in the next couple of years,” and he notes that other researchers put the number as high as seven million. Since annual home sales are running around 5 million, it looks like foreclosures could produce a terrible oversupply that would drive prices down.

But not all these foreclosures should be counted as new supply, Landry says. “The overwhelming majority of this inventory was built years ago and therefore is already part of the existing supply,” he says, adding that many homes likely to fall into foreclosure are listed for sale well before that happens.

At the same time, he says, construction of new homes is at the lowest level since at least 1959, which is as far back as the data goes. This helps put a lid on supply, he says, while the growing population pushes up demand. Although the owners of foreclosed homes are likely to become renters, reducing demand, other people will drive demand up by shifting from renting to owning, he argues.

The housing bubble encouraged excessive home building from 2000 through 2005, but most of that was in properties meant for home owners, while building for the rental market was “fairly subdued,” he says. That means the total housing market, with rental units included, is not as over-supplied as it appears to be when only owner-occupied homes are counted.

In many parts of the country, home prices have fallen to a level of 15 times the typical annual rent for comparable properties, a point at which a rough rule of thumb says prices should level off, Landry says.

“Even assuming lackluster household formation due to economic conditions persists for the next quarter or two, it’s very possible the excess number of homes could be soaked up by the end of next year if the employment base stops shrinking,” Landry write.

Home prices could stop falling well before that point is reached, he says, noting that in many parts of the country they may have stopped falling already.

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