Conventional wisdom wrong, foreclosures don’t reduce neighborhood values

Conventional wisdom is that foreclosures reduce neighborhood values. It turns out, that isn’t the case. It’s easy to see why people come to this erroneous conclusion. Properties that go through foreclosure often sell for less than recent comparable sales, particularly after the peak of the housing bubble when values were grossly inflated and ripe for a serious correction. However, it wasn’t the foreclosure that caused the discount, it was a motivated seller dealing with a property in poor condition that ultimately caused prices to fall.

You wouldn’t know it by the huge inventories they currently manage, but lenders are not in the real estate business. They don’t profit from the real estate they own. They only obtain real estate when the profitable loan they made turns bad. The asset management departments of major banks are supposed to be capital recycling units who extract the original loan capital from a bad loan through orderly disposition of real estate owned. Obviously, it hasn’t worked out that way over the last six years.

As the toxic loans from the real estate bubble caused wave after wave of defaults, lenders began acquiring properties at unprecedented rates. In fact, they obtained so much property so fast, that their resale activities began to negatively impact market pricing. It got so bad in 2008 that lenders collectively decided to withhold their own real estate owned from the MLS, and they decided to stop foreclosing on delinquent mortgage holders and allow them to squat in their homes without making payments. With their own visible inventories of real estate owned ballooning and an even more massive shadow inventory building, lenders had a real problem.

Lenders would like to wait until prices recover to peak values before liquidating their real estate owned. Any liquidations carried out at lower values cause significant losses. Too many of these losses, and lenders go bankrupt. To raise property prices and lower lender’s cost of capital, the federal reserve has lowered interest rates to zero. Lenders can borrow money at little or no cost from the federal reserve and depositors, so the pressure to liquidate is greatly reduced. The lower interest rates raises thresholds of affordability and allows buyers to borrow large amounts to make the inflated prices of the housing bubble relatively payment affordable.

With no cost push and high payment affordability, the only thing preventing house prices from going back up was the supply of houses requiring liquidation. Beginning in early 2012 across the Southwestern United States, lenders slowed their foreclosure rates and dramatically decreased the rate at which they acquired new properties at foreclosure auctions. This has enabled them to reduce the number of real estate owned properties on their books. Lately, real estate owned has not been a bargain because lenders have quite a bit less of it.

If foreclosures caused neighborhood values to drop as many contend, why are recent bank liquidations fetching prices higher than comparable resales? The problem was never foreclosures, it was always an issue of seller motivation and property condition. Previously, lenders had so much property they needed to discount it in order to find a buyer. Currently, lenders don’t have so much real estate owned, so they don’t need to discount it in order to sell. Since lenders have less supply to liquidate, and since they have no cost pressure or regulator pressure to liquidate, they can hold out for higher prices.

Another major reason lenders used to discount their prices on real estate owned is due to its poor condition. No borrower facing foreclosure spends any money on upkeep. One of the biggest fallacies of shadow inventory is that it’s better to have an occupant in a property than leaving it vacant. Perhaps in rough neighborhoods prone to property crime this may be true, but for the most part, occupants break things and don’t repair them. Houses deteriorate when occupied by delinquent mortgage squatters because they are loathe to spend a penny keeping up a property they are doomed to lose. As a result, when lenders finally take back these properties in a foreclosure auction, they are run down and in poorer condition than a traditional sale. Further, lenders who are already going to take a large loss rarely spend money fixing a property even when it is cost effective to do so. Lenders sell their run down real estate owned “as is,” which usually means “as is trashed.”

The bottom line is that seller motivation and poor property condition are largely responsible for lower resale values of bank-owned properties. Once these properties are brought back to the standards of the neighborhood, their resale values are indistinguishable from other properties. In fact, if these properties are improved, they actually increase neighborhood values. Most third-party purchases at auction are bought by flippers who improve the properties and sell them for a premium. The success of these entrepreneurs is testament to the fact that foreclosures do not reduce neighborhood values.

Foreclosures’ small effect on nearby prices

A foreclosure in the area won’t bring prices down that much: report

Aug. 6, 2012, 5:18 p.m. EDT — By Amy Hoak, MarketWatch

CHICAGO (MarketWatch) — Recent research suggests that properties near foreclosures normally suffer falling home prices, but a new paper from the Federal Reserve Bank of Atlanta challenges the claim.

It’s the condition of the distressed property progressing through the foreclosure process that weighs most heavily on home prices in the area, not the finality of foreclosure itself, the study found. The negative effect on nearby home prices actually peaks before the distressed property even completes the foreclosure process.

After foreclosure, when a lender-owned property is in below-average condition, nearby houses will trade at lower prices; when it’s above average condition, nearby homes will trade at higher prices.

But even then, if there’s a delinquency or foreclosure down the street, there’s not a huge economic effect on the prices of nearby homes.

When a large number of neighborhood properties are occupied by delinquent mortgage squatters who won’t maintain them, then the condition of the entire neighborhood deteriorates. That will lower neighborhood values. A small number of bad loans in a desirable neighborhood will not.

The study found that a property in serious delinquency for less than a year or a property foreclosed on and now owned by the bank reduces values of homes within a tenth of a mile by about 0.5% to 1%, “an amount that would most likely go unnoticed by the typical seller who does not have many distressed homeowners living nearby,” according to the report. Researchers analyzed housing information, including public records in 15 metropolitan areas, with a focus on single-family homes.

“We find that while properties in virtually all stages of distress have statistically significant, negative effects on nearby home values, the magnitudes are economically small, peak before the distressed properties complete the foreclosure process, and go to zero about a year after the bank sells the property to a new homeowner,” the authors wrote in the report.

Once a property losses is identity as a distressed sale, the value get’s merged into the values of the surrounding neighborhood. Just because a property sold at a discount once doesn’t mean it will be permanently value impaired, particularly if the new owners make improvements to bring it back up to neighborhood standards.

In 2010 Las Vegas, I used to see resale properties selling for 20% to 30% less than new houses in close proximity. I never understood why anyone would pay such a huge premium for a new house. Within a year or two, the values of these properties will equalize, and the purchaser of the resale will be significantly better off than the buyer of the new home.

“The estimates are very sensitive to the condition of the distressed property, with a positive correlation existing between house price growth and foreclosed properties identified as being in ‘above average’ condition.”

It’s assumed that the owners of the distressed properties aren’t making as much investment in their properties or are doing as much general upkeep as foreclosure looms. And that’s what’s impacting nearby prices.

“The most important take-away is the effect [on nearby home prices] starts when the property is delinquent. It’s not the foreclosure itself that is the problem,” said Paul S. Willen, an economist at the Federal Reserve Bank of Boston and co-author of the report, in an interview.

This would suggest that lenders should clear out their shadow inventory. The properties occupied by squatters for as long as five years are going to be run down. These properties will require discounts when they finally get recycled, not because they’re foreclosures, but because they are in very poor condition.

In order to minimize the effects that foreclosures have on the surrounding area, it’s best to minimize the time that a property spends in serious delinquency and in bank-owned status, the authors concluded. To do that means accelerating the foreclosure process and putting pressure on lenders to sell bank-owned properties more quickly.

Unfortunately, we all know this isn’t going to happen. Lenders are going everything they can to kick the can down the road in hopes that prices will recover.

Moreover, policies that delay foreclosures, slowing down the transition from delinquency to foreclosure, don’t protect the neighbors, Willen said. These policies are exacerbating the effect of distressed properties.

“When you talk with community groups… they’re aware that long, drawn-out foreclosures are not good for the community,” Willen said. “The first choice is for the foreclosure to be prevented in a way that is good for the investor and the homeowner. Failing that, it’s good to get this process done it a faster, more humane way.”

Perhaps if the general public understands delinquent mortgage squatters bring down neighborhood values, they will be less tolerant of this practice. Right now, most believe these squatters are helping their values by keeping these properties off the MLS. In reality, these squatters are running these properties down so they will require a larger discount when they finally do hit the market.