The percentage of homeowners who are "underwater" shrank in the third quarter of this year, an encouraging sign that the residential real estate market may be stabilizing.

However, the good news comes with a significant downside - the decline is due in part to underwater homeowners losing their properties to foreclosure, and thereby being taken out of the mix.

The percentage of homeowners who are underwater, or owe more on their mortgage than their property is worth, fell to 21 percent in the third quarter of the year, according to the foreclosure data company Zillow, compared to 23 percent the quarter before. The company attributes the decline to stabilizing home prices, as well as to foreclosures among underwater homeowners.

"Overall, the third quarter saw pretty encouraging performance; in fact, very encouraging performance considering the recent context," said Stan Humphries, chief economist for Zillow. " Home values nationally basically tread(ed) water, which they haven't done in quite some time, and lots of our large metro areas saw big reductions in their annualized depreciation rates, with many now showing a string of positive monthly changes in home values."

Foreclosures threaten to drag prices down again

Even so, Humphries said there are still significant reasons to be concerned about the future direction of the real estate market. Chief among these is foreclosures - Zillow estimates there are still 3 million foreclosures in the "foreclosure pipeline," properties that are seriously in default but have not yet been foreclosed on. In addition, he said, banks appear to be holding an unknown number of foreclosed properties off the market due to low prices and an oversupply of bank-owned properties.

Rising unemployment rates and continued high levels of negative equity (i.e., owing more on mortgages than the property is worth) threaten to continue to feed more foreclosures onto the market, according to Zillow, which could undercut housing prices again. The company also expressed concern about possible defaults on FHA mortgages, given the large share of new home purchases the agency now accounts for and relatively generous lending terms it offers, including minimal down payments.

On the other hand, Humphries said it is unclear what will be the impact of extending the $8,000 first-time homebuyer tax credit through late April and offering a $6,500 credit to repeat home buyers as well. While that could help stabilize the market through the next two quarters, Humphries said there's also the possibility that the repeat buyer credit could bring more properties onto the market, as repeat buyers sell their existing homes, exerting further downward pressure on home prices.

Overall, Zillow reported that national home prices were relatively flat in September, declining only 0.1 percent compared to August, but down 7 percent from one year before. In an encouraging sign, prices in some markets that have seen the sharpest declines since the top of the market have been rising, with San Francisco, San Diego, San Jose, Los Angeles and Boston all showing four consecutive months of increases in home values.

On the other hand, other depressed markets continue to fall, with home values in Miami-Ft. Lauderdale, Phoenix, Law Vegas and Riverside, Calif. all declining in the month of September, on the heels of large annual declines as well.

Published on November 9, 2009