Demand for distressed properties is driving up prices for the first time in two years as investors from Blackstone Group LP to Colony Capital LLC chase shrinking inventory.

The average sales price on homes in the process of foreclosure or already owned by banks rose 7 percent in the second quarter from a year earlier, the biggest annual increase since 2006, RealtyTrac Inc. reported today. The number of those deals dropped 22 percent, the most since 2010, the Irvine, California-based data provider said in a statement.

“There’s virtually no supply in a lot of markets right now,” Michael Krein, president of the National REO Brokers Association said in a telephone interview. “What we’re finding nationally is that 50 percent of all purchasers are investors because they can outbid the owner occupant buyers. Investors are bidding up anywhere from 5 to 25 percent over the list prices.”

Investors are taking advantage of home prices that are about 31 percent below the 2006 peak and growing demand for rentals from people with damaged credit, limited savings or lack of confidence in owning a house. Firms including Blackstone, Colony and Oaktree Capital Group LLC plan to spend about $8 billion buying single-family homes to rent, according to company statements and interviews.

Investment in rentals, most of which is coming from small groups rather than Wall Street funds, is filling vacant homes and improving rundown properties while spurring demand for construction jobs, said Tom Shapiro, chairman of GTIS Partners, a New York-based investment fund that plans to spend $1 billion in the next five years on rental housing.

Silver Bullet

“The housing market is turning around,” Shapiro said. “Maybe the silver bullet for housing is the single-family-for- rent, because it’s underpinning the market. It’s sopping up the excess.”

Government-controlled mortgage guarantors Fannie Mae and Freddie Mac have been slow to unload foreclosed homes, also known as real estate owned or REOs, through bulk sales. That has limited the number of properties available for private-equity firms, hedge funds and pension systems to purchase.

Krein said he receives about 20 phone calls a week from large investors and hedge funds interested in Nevada properties.

“There’s almost no product left to buy right now,” he said. “A couple of years ago you might have had four or five major players that would bid on non-performing loans and REO pools. Now there are probably 50 or 60 that can bid on these.”

Bank Settlement

Compounding the shortage is fewer bank-owned homes coming to market as lenders comply with terms of a $25 billion February settlement with state and federal regulators to resolve allegations with the five-largest home lenders over faulty practices. In the first quarter, foreclosure filings in the U.S. fell to the lowest level since 2007, RealtyTrac said in April.

Banks increasingly approve transactions for less than the amount owed on the mortgage, known as a short sale, or modify loans for borrowers struggling to keep up payments, including by reducing the principle owed.

The gap between short sale prices and prices obtained by banks selling seized properties narrowed to the smallest in almost five years, RealtyTrac said today.

“The shift we’ve been seeing in the last few quarters that continued in the second quarter is short sales are catching up with bank-owned sales,” said Daren Blomquist, a RealtyTrac spokesman.