07/05/2012 08:58 am ET Updated Dec 06, 2017

Negative Equity and Inventory Shortages: Why the Housing Bottom Won't Be as Boring as Expected

Our operating thesis about what the bottom in the housing market would look like is changing now that we're having a good look at markets that have bottomed like Miami and Phoenix. For much of the housing recession, we looked at rapidly rising levels of negative equity and foresaw a long, flat bottom fueled both by increased foreclosure rates (which would increase supply levels and push more cheap inventory into the market) and by the direct suppression of housing demand due to people trapped in their homes, unable to buy the next one.

What markets like Miami and Phoenix may now be showing us is that negative equity has another very powerful effect on the supply side beyond increasing the flow of foreclosed homes onto the market: all the households that we predicted would be trapped in their homes and unable to buy new ones are similarly unable to sell their current homes, severely decreasing the overall supply of homes on the market. Of course, we knew that trapped homeowners represented both a loss of supply and demand; we just tended to focus on the demand side of the equation more than the supply side. From an economic perspective, this wasn't crazy since we expected that any increase in demand could easily be satisfied by "sidelined sellers" - people who tried or wanted to sell their homes during the recession but were unable to - being enticed back into the market by rising home values.

Well, it turns out that many of those sidelined sellers may no longer be able to sell their homes because they are underwater on their mortgages now. And negative equity may well be so constraining the supply side of the housing market that it's creating acute inventory shortages that are bidding up prices. In a sense, because of such high levels of negative equity, the housing market may have become a bit like a publicly traded stock with a very small float (percentage of outstanding shares that are freely tradable). And, like a stock with a small float, prices can be very volatile.

Figure 1 shows, at the metro level, the relationship between negative equity (specifically, the percent of homes that are underwater) and the change over the past year in inventory of for-sale homes on the market: the higher the level of negative equity, the larger the drop has been in inventory.

Looking at Phoenix specifically, there's a clear pattern between large inventory declines and price appreciation as shown in Figure 2 which shows the change in inventory, by price tier, over the past year and the corresponding monthly home value appreciation rate for each price tier. The bottom price tier of homes have seen a 66% decline in inventory over the past year, resulting in a 1.8% increase in home values between March and April. Conversely, homes in the top tier of home values have seen only a 33% decline in inventory, resulting in a much smaller monthly increase in home values (1.0%).

In Phoenix and other hard hit metros, the bottom tier of homes is seeing strong demand relative to the higher priced homes for two chief reasons. First, home values in the bottom tier have fallen farther from peak levels, thus making them more affordable than the middle and top tier. In Phoenix, for example, the bottom tier has fallen 64% from peak in May while the top tier has only fallen 44%. Second, the bottom tier of homes is particularly attractive to investors interested in converting homes to rental use.

What does all of this imply for the housing bottom? Our emerging hypothesis is that, instead of a long, flat bottom with price appreciation constrained by weak demand and elevated foreclosures, we might end up in an environment in which constrained supply (due to negative equity), together with robust demand from investors and first-time home buyers (not weighed down by negative equity), combine to create cycles of home value spikes followed by cooling periods. These cooling periods are created once local home values have risen enough to free some homeowners from negative equity at which point some of these resurfacing homeowners attempt to sell their homes, thus creating additional supply which tempers price appreciation.