This Is the No. 1 Enemy of the Housing Market

Consider this a follow-up to my look into housing prices two weeks ago.

To quickly recap, I determined that, excluding the effects of rent, with at least 4 million more foreclosed properties set to make their way onto the market over the next couple of years, it seems highly probable that home prices are unlikely to rise. Considering that home prices only outperformed inflation by a paltry 0.21% in the 100-year period from 1890 to 1990, I concluded it could take 100 years before your home's value actually caught up with inflation in real-money terms.

The hamster in my head couldn't stop there, however. I was curious about what else could be behind the precipitous drop in housing prices beyond just the normal answer that "foreclosures are driving everything down." After some perusing that took into account what type of housing was selling, where it was selling, and what was facilitating those sales, I came to my conclusion -- and let's just say that it wasn't even in the same ballpark with what I was expecting.

It's the financing, stupid!
Before I get into what shocked me, let me first explain what I assumed was the natural cause for lower housing prices.

I predicted before I began my research that an inability to obtain financing by lower-to-middle-class prospective homebuyers was the primary culprit. In a way I was right, but it turned out to simply be a branch of the problem, not the root.

According to the Federal Financial Institutions Examination Council, more than 2 million people in 2010 were denied a mortgage loan. The Mortgage Bankers Association takes it one step further in its research, estimating that 50% of all home refinances and almost 30% of all home loan applications were rejected in 2010.

It'd be easy if there were one primary reason lower- and middle-class homebuyers and homeowners were being rejected, but there are myriad possibilities. Insufficient income, high debt levels, bad credit history, and even low appraisals are some of the most common culprits for denying a home loan or a refinancing; and here's a little secret, even I almost fell prey to one of them.

I recently refinanced my condo in Seattle, as I am part of the nearly one-quarter of Americans currently underwater on their mortgage. The appraisal of my condo had fallen so much from my purchase price that it put the loan-to-value ratio beyond the typical scope of what the bank was willing to refinance. It didn't matter that I more than met the income requirement, had no debt, and had immaculate credit while never missing a payment on the condo over the five-year period in which I owned it. All that mattered was the loan-to-value ratio. Eventually, I did get approved for my refinancing, but I can only imagine what ridiculous hoops homeowners are being forced to jump through to obtain a loan.

The real problem
This leads me to the real problem of why home prices seem doomed to continue to head lower: Wait for it... wait for it... Cash!

Yes, cash! Generally, cash is great because without it our stock markets would be illiquid. In addition, we all should have cash on hand for emergencies and to cover at least some of our daily expenses. But one place where cash is certainly not welcome right now is the housing market.

To say that all-cash home purchases are on the rise would be a gross understatement. In 2007, when the housing market was considered normal (though by whose standards?) all-cash purchases accounted for about 13% of all transactions. In Southern California, for example, the number of all-cash purchases had jumped to just shy of 28% in 2010 according to DataQuick. The trend is continuing to grow and expand with a whopping 74% of all fourth-quarter foreclosure purchases being conducted in cash and 33.2% of all sales nationwide in December being conducted in cash. A rise in the amount of foreclosures on the market might explain some of the rise in all-cash sales, but it's my contention that all-cash investors are driving this market, not an increase in foreclosures driving investors to use cash.

Here's why it's a problem
So why is cash bad news for homeowners and prospective homebuyers?

Let's first look at this from a homeowner's perspective. Given the documented tightness in lending practices by most financial institutions, cash is seen as the path with the least resistance. Cash deals are easily facilitated and can be closed quickly, but they come with a price. That price, according to a report from Fortune, is an average 10% haircut off the price of the home being purchased.

The same goes for real-estate-owned properties. As I discovered in my previous article, according to LPS Mortgage Monitor, the average home is taking an average of 611 days to repossess once a homeowner begins to miss payments to when the bank actually repossesses the house. With 1.35 million foreclosed properties already on the market and 4 million more waiting in the wings, banks are willing to accept a haircut in price in exchange for the guarantee of a cash payment.

From the perspective of a low-to-middle-class homebuyer, the rise of the all-cash buyer is very bad news. If you thought you had a lot to worry about with regards to income, debt, and credit in order to get a home loan, think again. All-cash buyers seem to be attracted most of all to the lower-priced foreclosure market -- perhaps one of the few areas where lower-to-middle-class-income individuals can meet the down payment required for a home loan. With all-cash investors moving in, middle-class America is being pushed further out of its niche territory.

Foolish roundup
The hardest thing to tell right now (and perhaps what I'll look at in a follow-up article to this one) is who exactly is doing the buying. It's clear we have individual investors with cash willing to buy properties right now -- especially foreclosures -- but what is their purpose? Are they buying them for rental income and betting on housing prices to rebound, or are these simply quick flips? I'm also curious about whether there's a large influx of foreign buyers who would be betting not only on a recovery in housing prices, but an appreciation in the U.S. dollar. If these investors are correct, they would profit from a boost in home prices and net a secondary gain when their U.S. dollar are converted to another currency.

What I can say for certain is the all-cash buyer is transforming the housing landscape, but not necessarily in the way most people would like to see. The disparity between the upper class and the lower/middle classes is growing, and this is another solid example of that trend in action.

Disagree with me? Tell me about it in the comments section below.

Fool contributorSean Williamshas no material interest in any companies mentioned in this article. He has been known to go weeks without using cash. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.

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