Shadow Inventory

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Last Updated:April 23, 2024

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What Is Shadow Inventory?

Shadow inventory is a term in real estate referring to real estate-owned (REO) properties that are vacant or soon to be vacant and not yet on the market are referred to as shadow inventory.

This can apply to properties still going through the foreclosure process, those owned by locals or banks, and those awaiting a better selling environment.

A home listed as an REO property is owned by a mortgage lender, bank, or real estate investor after the foreclosure process failed to sell the property.

To sell REO homes as fast as possible, they may be sold at a reduced price before they are even placed on the market. It's intriguing to learn that others besides real estate speculators are paying careful attention to the shadow inventory.

For a number of reasons, economists are also keeping a watch on it. First, this is because banks are indicating their expectation that the housing market has already plunged and is about to rise when they start to release properties in significant numbers.

Additionally, a declining shadow inventory indicates a rising economy because housing is a significant component of the overall economy.

Key Takeaways

Shadow inventory refers to real estate-owned (REO) properties that are vacant but not yet on the market.
These properties include homes going through foreclosure and those owned by lenders or individuals, waiting for a better selling environment.
Economists track shadow inventory because its decrease signals a rising economy, indicating a housing market upturn.
Banks often wait to sell shadow inventory until the market improves to maximize profits.

Understanding shadow inventory

The phrase "shadow inventory" in real estate refers to homes held by mortgage lenders, banks, or homeowners for eventual release to the public but are not yet on the market.

Additionally, it can comprise distressed properties, houses that will go into foreclosure, or houses that a bank currently owns. Distressed properties are those which are on the verge of foreclosure by banks or financial institutions.

Since distressed properties often sell for lower prices, having more of them in the market tends to lower prices in the housing sector overall, reducing the possible return on investment for lenders.

Since banks sometimes buy the properties and store them for years out of sight of the general public, the term "shadow real estate" is employed. Eventually, they are put up for sale in an attempt to increase sales and attract fresh interest.

Effects On Real Estate

The existence of shadow inventory will cause the data related to actual supply homes to be skewed. This creates uncertainty regarding the availability and complicates the housing downturn.

A high level of shadow inventory may point out the economic challenges that homeowners could face. It also plays a crucial role in the aftermath of housing collapse, as lenders are left with real estate holdings due to foreclosures.

They can also have a considerable impact on the price of houses since distressed properties comprise a large portion of the market. If there were a higher number of such houses, real estate prices would be low, and investors would generally choose to hold on to such properties.

How Is REO Recognized?

Real Estate-Owned (REO) properties are recognized as under the category of real estate held by financial institutions for reasons other than conducting the business.

Real estate properties and REOs play a vital role in the financial sector. Most of the mortgages issued today are backed by valuable assets, like houses, at least partially owned by the lender.

It is also a well-recognized profitable method of investing money, as there is less risk attached as compared to trading stocks. Most investors spend money on such fixed assets when prices are discounted and have high probabilities of appreciation.

In the regulatory framework of financial institutions, REO properties are recognized, including

Real estate (other institution premises, actually controlled or owned by the financial institution and its subsidiaries),
Real estate property acquired through foreclosure or deed in lieu of foreclosure,
Collateral of real estate in an institution of possession,
Property acquired originally for future expansion plans but no longer intended for the original purpose, and
A foreclosed real estate property was transferred but unable to meet the requirements of sale accounting under the revenue recognition principle.

Foreclosure Process

A lender can repay a defaulted debt through the legal process of foreclosure; this involves seizing possession of and selling the mortgaged property.

The foreclosure process is governed by state-specific legislation, although lenders generally assist borrowers in catching up on payments to avoid foreclosure.

On the websites of banks, foreclosed homes are often readily available. These properties might appeal to real estate investors because, in certain situations, banks would sell them below market value, which is bad for the lender.

Inventory In Real Estate

Once a property is listed for sale, it is counted as inventory. It becomes a pending sale when it enters into a contract. Inventory is computed monthly by counting the number of active listings and pending transactions on the last day of the month.

Here is one of the examples of listing foreclosed properties by an established bank like Chase.

Low numbers of homes were sold in the last couple of years and, as a result, a real estate industry slump. Because of this, home builders throughout the nation have struggled to increase sales as planned.

This has created a sizable inventory of unsold homes. This housing is considered inventory in the world of real estate.

Challenges in Purchasing Distressed Properties

From a distance acquiring distressed properties can seem like a great investment deal. Many challenges must be cleared before buying such REO properties. Some of the challenges are mentioned below:

Uncertain Property Conditions: First, you must consider your preparedness for the delays, disappointments, and high repair costs frequently accompanying foreclosed houses.
- When distressed homes are offered at auction, inspecting them before the sale can be challenging; even if you are given a chance to look around the property, the vendor is cash-poor. In light of this, there is no possibility of repair negotiations.
Market Volatility: Distressed homes and properties are subjected to changes in the market and economy, which increases the risks involved in the transaction. In the case of auctions or online bidding, before the deal is sealed, you are not assured that you will be able to buy the house.
Identifying And Paying Off Existing Mortgages: One of the most important tasks when acquiring a distressed property is clearing the existing debt or mortgage on the property. This clearance of mortgage can help get the title as early as possible.
- The challenge lies in gathering information related to banks/financial institutions, which can be complex and time-consuming.
Legal And Financial Complications: Liens, title issues, and outstanding taxes are all time-consuming and resource-consuming activities associated with purchasing distressed properties, which can prevent a successful acquisition process.
Environmental Challenges: There can be many environmental considerations when acquiring distressed properties, such as environmental site assessment.
Code Enforcement Issues: The rules, regulations, and codes laid down by the local governmental bodies and municipalities should be followed regardless. Not abiding by such codes can lead to penalties, fines, interest on violations, and even disciplinary hearings, all of which add to the cost of acquisition.
Closing Time Of The Deal: While the typical closing time for a regular home is 6 to 8 weeks, the closing time for a distressed property might be 6 to 12 months.
- This is because the lender is generally the one you are working with, and they are frequently unconcerned with the length of the closing procedure. You may also have to clear a lot of hurdles before the sale is complete.

Handling the Shadow Inventory Issue

When a bank or lender owns a property, the purpose is to sell it at the highest feasible price. If the market is sluggish, a lender may decide to keep the property until the market picks up.

A thriving market might result in greater property values and profit for the lender. For instance, when the market skyrockets, there is likely to be less accessible shadow inventory because house prices and property values are greater.

Why Don’t Banks Sell Shadow Inventory Sooner?

There are two big reasons why banks and credit institutions do not sell these sooner than later:

As discussed earlier, one of the most significant reasons it takes longer is the process delay. This delay is due to some state laws forcing deals to take longer than usual, as the two parties must complete all the requirements and documentation.
Another reason this happens is that lenders may wait until real estate prices go up. So now, though the property will be sold at a discount, they will earn more money.

The Attraction for Investors

ROE has the potential to significantly benefit real estate investors. For example, they can engage with lenders and banks to purchase foreclosed properties from the shadow inventory at a discount before they hit the market.

This means there are plenty of opportunities for real estate investors to profit from deals.

Are REOs Attractive To Investors?

If the investor is sensible, knows the ups and downs of real estate, and is financially capable of acquiring a property at a reasonable price, they can stand to benefit. They are attractive investment opportunities because of the following reasons:

Potential Higher Returns On Investments
A Unique Investment Strategy
Diversification And Learning Opportunities
Steady Returns
Existing Opportunities In The Market.

What is a Short Sale?

A short sale occurs when a mortgage lender accepts a mortgage payback amount that is less than what is owed to enable the sale of the property by a financially troubled owner. The lender then forgives the outstanding loan sum.

Under a short sale, a lender must consent to accept less than the balance owed on the property. In contrast to a foreclosure, investors usually pay even less for the house because they are not responsible for repaying the current loan or making up for any arrears.

Instead of dealing with a foreclosure, investors are making a deal with the current lender to accept less than what the lender is owned.

Are short sales and ROE different? ROE is slightly different from a short sale in just one aspect. In a short sale, the property is owned by the borrower, whereas, in the case of an ROE, the house is owned by banks or mortgage lenders.