Visible inventory of homes on the market has been falling repeatedly. Existing home inventories are at an 8-year low, while newly constructed home inventory is near a 50-year low. As we enter the winter months, inventories will fall even further. Very little gets listed after Thanksgiving, and not until March will inventory show some additional choices for buyers.

Just because we are able to see low inventory today does not automatically mean that inventory will be low in the near future. There is also shadow inventory to monitor. These are properties not yet listed on the market but will surely come on the market since there are still plenty of homeowners under distressed conditions. CoreLogic indicated the shadow count has fallen from 2.6 million this time last year to 2.3 million today, according to its definition. If the shadow is defined as those homes in the foreclosure process or where mortgages have not been paid for 3 months or longer, then the count is higher at 3.4 million in the shadow pipeline today, though it is less than the 3.8 million from one year ago. Since not all mortgages that are 3 months late become an REO because a good portion catch up on payment later or get a “cure” via loan restricting, the actual number of properties reaching the market for sale will be measurably lower than the shadow count. Though one can dispute the definition and the exact size of the shadow, one thing that is consistent is that the shadow is less threatening today than one year ago.

A steadily diminishing shadow will naturally shed more light on normal sales. From 2009 to 2011, roughly one-third of all home sales were distressed properties. Based on recent data, the distressed share will be around 25% in 2012. The figure will reach the teens next year and probably single digits in two years.

What impact do falling distressed sales have on home values? The median price will be pushed up. As everyone knows, foreclosed properties sell for less. However since this negative impact will be less strong in the upcoming years, the median price of all transacted homes will be higher than when compared to the past few years. So aside from the normal supply-and-demand dynamics that have been pushing up repeat-price indices such as Case-Shiller and government price data, the median price will also be rising and probably faster because of the fewer distressed over the horizon.

Two years ago, the scariest of Halloween costumes was dressing up as Shadow Inventory. Today, not only have people gotten used to the sight, it is a greatly diminished figure.

Postnote: Shadow inventory is not falling in some judicial foreclosure states where a foreclosure process takes an incredibly long time because it requires a court approval. These states include Illinois, New Jersey, New York, and Connecticut. Though the intent is to keep financially troubled families from being forced out, there are increasing stories of gaming the system, where a homeowner does not pay the mortgage and collects money by renting out the property. As a result, any home price gains in these states will likely perform a “dead cat bounce” because of the very long shadow looming over them.