Recently, I spoke with two friends who work in the banking and real estate industries about the future of the housing market. One friend asked the other: "Are we going to see more banks foreclosing on delinquent mortgages?" The reply came back without hesitation: "Yes."
It is hard to say if my friend is correct about whether banks will accelerate the number of houses they foreclose on in the near future. There are a huge number of delinquent home loans outstanding, secured by residential real estate. However, another important and less known fact is that delinquencies, foreclosures, and bankruptcies are dropping—and dropping quickly.
From the banks' perspective, it makes sense 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 loans outstanding that are delinquent and have not yet entered foreclosure.
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 been shifted from the individual owners to the banks' balance sheets—and are now vacant. For the banks, this hurts earnings, and increases costs. For investors, however, these properties represent a scary possibility—a "double dip" in the housing market that could lead to another recession.
However, if we look to the real estate market itself for a clue, the trends support the opposite view—the lower home prices and less expensive credit in today's market are providing an incentive for many buyers to step into the market. Data from the National Association of Home Builders' (NAHB) Housing Opportunity Index (HOI) has rebounded from its 2007 low to its highest level since 1992. This index is compiled from data on current median home prices and current mortgage interest rates.
While additional supply may be added to the residential markets from bank foreclosures and other "motivated" sellers, most individuals have reverted 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 view the equity in their homes as a liquid asset—at least not since 2008. As such, further price drops probably won't lead to further deterioration in consumer confidence.
Here's what to do now:
As a homeowner. Make personal real estate decisions based on personal 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.
As an investor. Consider staying away from bank stocks. Even if they can remove the overhang of real estate property from their balance sheets, banks still have a long way to go before they see meaningful increases in loan volumes. Additionally, with interest rates at historically low levels, and likely to stay low 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 are a diverse mix of companies that could benefit as foreclosed homes are sold into the market and need to be upgraded. Stay away from any one specific stock in the group, however, as historically the index tends to give you most of the upside potential, with much less downside risk.
Consider buying residential rental property. There are a couple of ways to do this. You could buy a multi-family focused REIT. Or, you could buy a rental house or apartment. The second strategy may require more elbow grease and more time, but there will likely be some great deals 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 income, but can also bring a long to-do list. Make sure to seek professional advice if you don't have experience.
Timothy Lee, CFP®, is a Managing Director and co-founder of Monument Wealth Management located in the Washington DC area. Monument Wealth Management is a full service wealth management firm and is backed by LPL Financial, the independent broker-dealer and Registered Investment Advisor. Tim and Monument Wealth Management can be followed on their blog at "Off The Wall", their Twitter accounts @MonumentWealth, @TimothyLee and on their Facebook page. Securities offered through LPL Financial, Member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. All performance references are historical and are not a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.