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More Foreclosures Yet to Come?

U.S. News and World Report Smarter Investor

Some predictions about the housing market.

Late last summer, I wrote a Smarter Investor post under a similar title to this one. The thesis and conclusion of that post was simple: Credit delinquencies were dropping, and availability of credit was rising—both good signs for a continuing recovery in the housing market and in the broader U.S. economy. Now, more than six months later, those data points have proven (at least in the short term) to be valuable indicators of the direction of the markets.

Simply put, delinquent debt levels have continued to fall from the near-record levels reached in the fallout period after the 2008 credit crisis. Additionally, the affordability of housing has been driven both by the Fed’s easy money policies and the drop in house prices. The National Association of Home Builders/Wells Fargo Housing Opportunity Index measures “the share of homes sold in a given area that would have been affordable to a family earning the local median income, based on standard underwriting criteria” and has been posting record levels of affordability for more than 10 quarters.

There is good news embedded in the above information, but also bad news inherently built in, as well. The good news is that a large number of homes in many given local areas could be affordable to people in that same local area. The bad news is that the HOI could stay at the current record levels for an extended period of time. In addition to those pieces of information, there is still a tremendous supply of homes to be absorbed by the housing market.

As I wrote last year, it would make sense from the banks’ perspective to clear the non-performing loans and associated real estate off of their balance sheets and try to move on. The unfortunate reality is that it is likely to take a number of years to sell the inventory that U.S. banks have already accumulated from foreclosures. Additionally, there are still many outstanding loans that are delinquent and have not yet entered foreclosure. Finally, many prospective homeowners find it difficult to accumulate enough capital to afford the necessary down payment to qualify for the mortgage needed to buy one of these affordable houses.

What does this mean for the housing market and the economy?

There were roughly 500,000 new foreclosures per quarter between the first quarter of 2008 and the end of 2010. That’s roughly 6 million homes. Most of these properties have simply been shifted from the individual owners to the banks’ balance sheets and are now standing vacant. For the banks, this has been a drag on earnings and has boosted costs. For investors, however, these properties represent a scary possibility: a “double dip” in the housing market that could lead to another recession in the overall economy.

Several months ago, I had suggested that we evaluate the real estate market clues on this issue—the trends then supported the opposite view. Today, it seems even clearer. In addition to the lower home prices and less expensive credit in today’s market that offer large incentives for many individual buyers, there have been several institutional investors who are taking notice of the opportunity. As I referenced above, figures from the NAHB show that the HOI has rebounded from its lowest level (in 2007) to its highest level since 1992.

It is my view that while additional supply may well be added to the residential markets from bank foreclosures and other “motivated” sellers, most individuals have gotten back to the view that their house should be an investment in comfort—with the added benefit of holding value—rather than a financial asset. Additionally, the often-cited negative “Wealth Effect” of falling home prices is largely a psychological phenomenon. I don’t know of many people who have viewed the equity in their homes as a liquid asset—at least not since 2008. As such, I don’t believe that further price drops will lead to further deterioration in consumer confidence.

What to do now as a homeowner

Make personal real estate decisions based on personal real estate factors, not on short-term fears or conjecture about “the market.” If you need a larger house now, buy the best property you can reasonably afford. Don’t stretch because a mortgage broker says you can afford it. Get comfortable with your budget and what you can spend. If you don’t how much that is, engage a financial adviser to help you. If you don’t want to deal with maintaining a large house and grounds, maybe you should move to a condo. In either case, do yourself the favor of “right sizing” your real estate holdings.

What to do now as an investor

Consider staying away from bank stocks. Even if they can easily and efficiently remove the overhang of real estate property from their balance sheets (doubtful in my view), the banks still have a long way to go before they can see meaningful increases in loan volumes. Additionally, with interest rates at historically low levels, and likely to stay low not just for “an extended period” but at least through mid-2013, it may continue to be difficult for banks to squeeze profits from the lending market.

Consider the consumer discretionary sector. There is a diverse mix of companies that could benefit as the foreclosed homes are sold into the market and need to be “refitted” and upgraded. I would consider staying away from any one specific stock in the group, however; historically, the index tends to give you most of the upside potential, with much less downside risk.

Finally, depending on your specific situation, consider buying residential rental property. There are a couple of ways to do this. You could buy a multi-family-focused real estate investment trust (REIT). Or you could buy a rental house or apartment. The second strategy may require more elbow grease and a larger commitment of time, but there will likely be some great deals to be had in the near future as banks decide to get rid of their real estate inventory. See my comments above about budgeting and careful planning for the right property for your situation. Buying a house or apartment to rent can provide some great income, but it can also bring with it a long list of to-dos. Make sure to seek professional advice if you don’t have the experience yourself.

Timothy R. Lee, CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth, and on their Facebook page.

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