1 Very Promising Sign in the Housing Market

With every new data point released, the case for a housing recovery is growing ever stronger. One of the more promising recent developments is a tighter nationwide supply of homes and a declining "shadow" inventory. With more buyers chasing fewer homes, the supply demand picture for housing is starting to look a whole lot brighter.

A supply and demand equation
It is now well recognized that home supply grossly outpaced demand in the lead-up to the recent housing bust. The magnitude of this oversupply was one of the most visible indicators of a housing bubble, as it has been throughout history.

Whenever the stock of new housing units exceeds the number of households by a wide margin, there is good reason to be suspicious. For instance, even in the oft-forgotten housing boom of the 1920s, growth in housing construction and investment greatly surpassed demand.

Economist Robert Aaron Gordon, in Economic Instability and Growth: The American Record, argued that "houses, apartment houses, office buildings, and hotels were built with almost reckless abandon," fueled by "the ease with which securities could be sold to finance the cost of construction."

Clearly, we didn't learn much from the lessons of the 1920s, because that's almost exactly what happened starting in the early 2000s. From 2002 to 2007, a net average of 1.3 million households were formed each year, while an annual average of nearly 2 million new homes were built over that same time period. "That, in a sense, was the housing bubble," writes Fool columnist Morgan Housel.

But now, there's good news: This trend has reversed dramatically.

Supply, meet demand
Levels of supply have declined sharply over the past couple of years. The supply of for-sale homes has reverted back to its long-term average of 2 million. Meanwhile, population growth and a gradual recovery in the rate of household formation are boosting demand. In other words, more buyers are now chasing fewer homes.

The decline in supply can be seen in the most recent existing homes sales data, which show that sales of previously owned homes fell 1.7% in September. The stock of previously owned homes currently on the market fell 3.3% to 2.32 million, the lowest level for September in a decade. At the current pace of sales, this supply could be liquidated in 5.9 months, the lowest monthly inventory level since March 2006.

This fall in existing home sales last month suggests a combination of falling supply and improving demand, as well as owners' reluctance to sell before further improvements in prices. It may also reflect purchases of foreclosed properties by institutional investors seeking to convert the homes into rental properties.

But what about the shadow inventory?
While certain markets across the country remain unbalanced, the nationwide trend is toward a more balanced supply and demand picture for housing. Yet many remain concerned about a lurking threat in the form of the so-called "shadow" inventory of homes.

While there is no consensus definition of the shadow inventory, it is usually defined as the number of single-family loans that are delinquent by 90 or more days or involved in foreclosure proceedings. Using this definition, the shadow inventory has fallen substantially over the past couple of years.

According to data from the Mortgage Bankers Association, it has declined by 1.4 million units since 2009 and sat at around 3.6 million units as of the end of March. While this represents a meaningful improvement, it's important to note that this level remains significantly above those seen before 2008.

But as some housing analysts argue, the rate of decline of the shadow inventory is more important than the absolute number. And while calculations of the size of the shadow inventory vary widely, almost all estimates I've come across suggest it has declined substantially over the past couple of years.

A housing rebound full speed ahead?
The shadow inventory has long been touted as a major threat to a housing recovery. But as many experts and industry commentators suggest, its size and presence may not be as menacing as once thought.

Going forward, numerous other positive indicators suggest a slow and steady rebound in the housing market. Nationwide home prices are stabilizing, and even rising in some of the hardest-hit markets. Housing starts are up, and construction is rebounding. And while the economy remains sluggish, confidence in the housing market appears to be strengthening.

The Federal Reserve has also pledged its support for what it calls the "missing piston" in the economic recovery. The central bank's latest move, commonly referred to as QE3, aims to drive down mortgage rates even lower to further boost the appeal of buying a home. So far, it has succeeded in this respect.

However, while a boon to homeowners and banks that originate mortgages, QE3 hasn't been the best news for mortgage REITs. These companies have drawn significant investor interest over the past few years, largely due to their eye-popping dividend yields. For instance, Anworth Mortgage Asset (NYS: ANH) boasts a 9.9% yield, while American Capital Agency (NAS: AGNC) yields a staggering 15.5%.

But with QE3 likely to lower some of these companies' net interest margins further, some of those dividends may be at risk. Indeed, several mortgage REITs, such as Chimera Investment (NYS: CIM) , Annaly Capital (NYS: NLY) , and Invesco Mortgage Capital (NYS: IVR) have already been forced to cut their dividends multiple times in recent years.

To find out more about the risks facing mortgage REITs and whether or not your investment is safe, be sure to check out The Motley Fool's brand new premium research report on Annaly Capital Management. It outlines three essential points that all current and prospective Annaly investors need to know, as well as a host of other important information put together by our analysts. On top of that, the report comes with a full year of exclusive updates. To unlock your investing edge, just click here.

The article 1 Very Promising Sign in the Housing Market originally appeared on Fool.com.

Fool contributor Arjun Sreekumar has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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