by Calculated Risk on 2/23/2012 02:54:00 PM

Analysts are trying to explain the recent sharp decline in existing home inventory and trying to estimate the impact of less inventory on house prices. As an example, Goldman Sachs economist Zach Pandl wrote yesterday:

Inventory of existing homes on the market declined by 21% in the year to January, or by 600,000 units. The “months supply” of existing homes—homes for sale divided by the current sales pace—fell to 6.1 in January, the lowest level since April 2006. Although we consider these declines a modest positive for the housing market outlook, we also think they exaggerate the improvement in excess supply.
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Active listings—which are what the existing home sales report measures—decline if a house is sold, but also if a current homeowner pulls their home off the market. They can also be held down by prospective home sellers who decide not to sell due to weak demand conditions. Available data suggest that the latter two factors may have been an important reason behind the improvement in existing home inventory and months supply.

Click on graph for larger image.

Here is a graph showing the months-of-supply and the year-over-year decline in inventory.

The two factors that Pandl identifies - homeowners pulling their homes off the market and prospective sellers not listing - can be grouped as 1) sellers waiting for a better market.

There are probably a large number of sellers "waiting for a better market", and we could call this pent-up supply (I've even included it is part of the "shadow inventory" in earlier posts). When the market eventually improves, this pent-up supply will come on the market and probably keep prices from rising - but having less inventory means less downward pressure on prices now.

There are other factors pushing down inventory and months-of-supply too:

2) There is a seasonal pattern for inventory, and usually December and January have the lowest inventory levels for the year. Although there is some variability, usually inventory increases about 10% to 15% from January to mid-summer. That would put inventory at around 2.55 to 2.65 million by July (up from 2.31 million in January). At the current sales rate, this would push the months-of-supply measure up to 6.7 to 7.0 months from the current 6.1 months.

The second graph shows nationwide inventory for existing homes and shows the seasonal pattern.

So some increase in inventory and months-of-supply is expected just based on seasonal factors.

3) The NAR reports active listing, and there a large number of "contingent short sales". This is another key point. The NAR reports active listings, although there is some variability across the country in what is considered active, most "contingent short sales" are not included. These are strange listings since the listings were frequently NEVER on the market (they were listed as contingent), and they hang around for a long time - they are probably more closely related to shadow inventory than active inventory.

When we comparing inventory to 2005, we probably need to remember there were no "short sale contingent" listings in 2005 - so with the same inventory now, we probably shouldn't expect prices to increase by 16% in 2012! (just joking of course, but this is reminder that with just a little less listed inventory - and no distressed sales - prices increased 16% in 2005 according to Case-Shiller - and of course insanely loose underwriting too and a bubble attitude - This is a joke!! that I know some people won't understand).

And finally, in the areas I track, the number of "short sale contingent" listings is down sharply year-over-year.

4) The number of completed foreclosures declined in 2011 and are expected to increase in 2012. This will probably lead to more REO (lender Real Estate Owned) listed for sale and an increase in the level of inventory. Tom Lawler and I have both mentioned this before.

Jonathan Miller mentioned this yesterday at the Big Picture:

Declining foreclosure volume is one of the key reason inventory levels are dropping. The 1/3 decline in foreclosure volume in 2011 has resulted in a sharp drop in foreclosure inventory resulting in a sharp drop in total inventory. ... With a 2 million more homes expected to go into foreclosure over the next 2 years, a year long internal review of procedure after the 2010 “robo-signing” scandal and the 50 State AG settlement with the largest services/banks, distressed inventory is expected to rise sharply over the next several years.

Although the number of completed foreclosures declined in 2011 from 1.07 million in 2010 to 843 thousand in 2011 (see here), the number of short sales increased - and increased significantly in Q4.

Also the number of lender REO declined sharply in 2011 (listings are a portion of REO owned, not all REO is listed immediately since it takes some time between acquisition and listing the property to make sure the property is in OK condition). So what would happen if completed foreclosures increased by 200 thousand units in 2012? Or by 400 thousand units? At most that would increase listed inventory by 200 to 400 thousand units and probably by much less since the lenders are currently selling REO faster than they are acquiring REO.

If we add 200 thousand most listed REO to the expected seasonal increase that would put listed inventory at 2.75 to 2.85 million in mid-summer - or about 7.2 to 7.5 months-of-supply at the current sales rate. That is higher than normal, but still well below the 9.3 months in July 2011, and the lowest level for July since 2006 (or even 2005). As I mentioned yesterday, Michelle Meyer and Ethan Harris at Merrill Lynch expect months-of-supply to reach 8 months this year (I think that is a little high).

The bottom line is the decline in listed inventory is a big deal, and will lead to less downward pressure on prices. Just like last year, inventory will be something to watch closely all year.