Today I came across a recent study on foreclosure sales and house prices by an MIT economist and two Harvard researchers. MIT just issued a press release so the study is now making headlines.The researchers looked at 1.8 Million transactions in Massachusetts over the last 20 years and came to the conclusion that homes sold after foreclosure sell at a particularly large discount of 27% on average. Further they find that “each foreclosure that takes place 0.05 miles away lowers the price of a house by about 1%”. Wow. I sure hope there haven’t been 100 foreclosures near you.
I’ve long believed that foreclosures DO NOT cause price declines, and after reading this study my view has NOT changed. My view instead is that price declines cause foreclosures, but there’s a twist to this view, that I believe threw these researchers off track and led them to a faulty conclusion despite an otherwise interesting paper. They are not alone. I think most people actually believe foreclosure cause prices declines. The key to the author’s error, I believe, can be found in the following sentence: “To the extent that house prices drive foreclosures, low prices should precede foreclosures rather than vice versa.” Through various regression tests they found this NOT to be the case, which would seem to strongly support their conclusion over mine.
Here’s the rub – home prices are a function of income and loan terms. As such the price buyers in a given area can afford to pay often declines PRIOR to being actually reflected in market sales. Massachusetts unemployment went from 6 to 9% in 1990, hitting many households and leaving them unable to pay their mortgages, and impacting what potential buyers could afford to pay as well. In 2007 over-indebted subprime borrowers with 100% LTV, teaser rate, neg-am, loans and no skin in the game began walking away as builders started discounting the same homes those borrowers were told would only go up in value. Those subprime defaults led lenders to pull the exotic loans that previously enabled buyers to “afford” twice as much home as they could using more traditional loan products. Sales then stalled as unforced sellers were unwilling or unable to drop prices.
This leads to the part that seems to confound everyone, including this study’s authors. Banks taking back foreclosures are forced to sell at the price buyers can afford. Thus foreclosures are the first sales to begin occurring in large numbers at the price level that buyers can now afford. As they do, nearby unforced sellers come to grips with the new market reality, while others that don’t have foreclosures nearby cling to the hope that their home won’t be affected. That hope is kept alive by a trickle of sales that continue to occur at prior price levels as not all buyers are impacted by economic changes equally.
Thus even though foreclosures are the first to sell at lower prices, they are not the CAUSE behind those lower prices.
I’ll leave you with this simple example: there was little decline in California’s median price, despite mounting foreclosures and an increasing percentage of foreclosures sales, until the September 2007 credit crisis. At that point the median price began to rapidly tumble to a level the median income family could afford using the more traditional loan products that remained available in the market. Bottom line, the typical homebuyer can only afford as much home as their banker tells them they can afford. As such changes in household incomes typically due to rising unemployement and/or the tightening of loan terms used to qualify buyers are what cause price declines, not foreclosures.
Here are a few foreclosure facts that may have been overlooked in the study just like my favorite incorrect value estimate site Zillow. No one doing the study, just like those folks at Zillow, ever saw any of these homes. The majority of foreclosures are trashed, stripped, and in very poor condition. The lenders insist on selling them AS-IS for the most part and so much of the decline in value can be directly attributed to condition. Maybe they should have REALTORS do the studies and they would get a more accurate picture of why a home sells for 30% below market value. HVCC then send in an apprasier from over 60 miles away that somehow can not see the leaking roof, broken windows, etc. Next lets stop blaming the sub prime market for all our woes. It’s like blaming W for the failure of all the bail outs that came after he left office. There are plenty of 780+ FICO score buyers who are stregically walking away from their homes (notice I did not say houses). Good old fashioned pay your mortgage for the privilage of owning your own home has flown the coop. Raise your family and spend 10-15 years has been replaced by the mad refi market that allowed everyone to buy fancy cars, plasma TV’s, elaborate vacation cruises, and every new gadget known to man and has now become the new normal of what to do with your home. When it is all used up and the value is upside down 40-60% simply walk away…after you have lived there on the rest of bill paying tax payers for say 12-24 months. The most recent wave of price depreciation in California is in homes over $1Million and those buggers had to qualify at some point so speculation be darned full speed ahead. My fear when looking at the recent trend of more Trust Deed sales than Notices of Default is that we are in for a new wave of foreclosures later this year and next that will make the last one look like a pebble in the pond. Especially if those who can pay their payments simply choose not to do so.
CJ you are brilliant! Also, I would be curious to see a study done on the deep discounts of short sales which I see many sell for below REO sales. Interesting, thank you.
I agree with the conclusion you come up with. Those are definitely the causes of lowering prices, especially the tighter lending guidelines. The tighter the guidelines, the less people that can buy, and the the less that can buy, the lower the demand, and in turn, prices will fall.
In the end, the price declines are a made of a combination of all of these causes, including foreclosures. Some REO sales are much more damaging on prices than others and that has an affect.
The main cause of foreclosures is that people lose their jobs. The secondary cause is when values decline below the loan amount and people can afford it no longer want to pay. Jobs right now are at an all time low, loans are harder to get as well making things hard to purchase. The lending guidelines keep changing almost every day it seems. I have seen in my own area that the demand for homes is not like it used to be. Many investors are also out of the picture now because they cannot “flip” homes because the demand is not there either. So, homes are now sitting on the market longer and longer.
The prices are a combination of many factors as Tyler said, it is not just foreclosures or short sales, or jobs, but those and more.
Great post Sean. I agree with you that the MIT study may have focused on the “effect” rather than the “cause” of home price declines. To that extent I agree that declines of value cause foreclosures.
I also believe you’re right on the mark suggesting that bank lending policies ultimately cause price declines which later lead to foreclosures. As you mentioned in your article, “Bottom line, the typical homebuyer can only afford as much home as their banker tells them they can afford.” A positive outlook on the immediate economic future and an abundance of equity in secondary markets fuel loose credit policies at banks. These factors lead to rampant speculation and inflated prices.
As underwriting policies change, equity markets dry up, and lenders disappear, every day consumers can no longer participate in the housing market. By removing the retail buyer from marketplace sellers are left with fewer buyers who can qualify for financing, ultimately increasing the supply of homes and limiting the qualified demand (buyers needing loans).
This is also true for the already discounted investor market. Many investors earn the discounted prices they pay for foreclosures by assuming risk (buying dilapidated homes) and delivering banks a vehicle to dispose of bad assets (cash purchases with quick closings for multiple assets). For those intending to deliver these houses back to market as renovated and “financible” homes, what they can sell them for drives what price they pay at trustee sales or to the bank.
When banks tighten lending standards, thus limiting resale values they ultimately cap the market. Profit spreads typically remain the same on flips. Construction costs remain flat or drop slightly. One could even argue the cost of investment capital for these investments also go down in depressed markets. Ultimately it’s the back end financing and the counter productive lending policies that limits home values.
In reviewing the post and the comments to date, I have concluded that extracts can be lifted from each entry to produce a more rounded dissertation.
Foreclosures drive down prices in neighborhoods and communities. This is a result of economic changes both regionally and widespread. Foreclosure create a domino affect causing neighboring homes to evaluate their circumstances in a different light. For those that are struggling to make ends meet… their decision to pursue an exit strategy becomes easier; for those that are only facing property devaluation (that can continue to maintain their mortgage payments), begin to lean towards strategic defaulting.
This is a downward cycle that requires improvement in multiple categories to occur. One of my beefs is that our media and politicians are not able or capable of multitasking these very large and broad issues to resolution.
In a nutshell, for the economy to improve – and housing market to recover, we need the following to occur:
* We need a different strategy for Iraq and Afghanistan that will plug the gaping hole leaking endless cost at an enormous price;
* We need to create commerce again here in the US… not just temp positions under TARP… but career driven employment where we actually wake up and go to jobs we love each and every day.
* We need to get our hands around the real estate mess and make every effort to minimize what ends up in the foreclosure bind. The media needs to step up and expose areas that I consider to be ‘lender hindrance’ and causing homeowners the inability to be approved for loan modification and/or short sale w/in a timely manner.
And yes, we need to curtail the price of gas, milk, education, taxes, insurance, transportation, etc.
There’s a lot of work to be done… We have to make a decision… Do we chose to be a part of the problem? Or, do we chose to be part of the solution?
Foreclosures actually help identify the real value of a property after all a home is only worth what a buyer is willing to pay for it. In a declining market without foreclosures homes tend to sit on the market at higher prices but few or no buyers. homeowners in area feel good because they see the asking prices in area are higher even if their are no buyers. Banks tend to not sit on properties but reduce every month until the home attracts a buyer thus establishing a value that may otherwise be unknown. Just a thought
Well said Scott. The “value” has already dropped, but it is first seen in foreclosure sales as unlike local homeowners who are still clinging to the past banks will sell at currrent >fair market< values.
I disagree with one point, the Banks price a foreclosed property below market value in our area, this home sales, then the prices all drop because of the sale, this keeps going on and on. We live in a resort area with few people, every foreclosed sale under the current market price drives our market down.
Steve – this is a common misperception, but sellers don’t determine prices, buyers do. If these homes were really selling below market it would attract more buyers and push prices up to market. Instead I’d suggest the market has been driven down by the reality that the people that want to live in your area simply can’t afford to spend more. Buyers always have, and always will, buy as much home as their lender tells them they can afford. As a Realtor you know this. The first thing we, as Realtors, are trained to do with new buyers is to find out what they can qualify to buy. The difference between banks and other sellers is that banks are not emotionally attached and will sell at whatever is now the actual market value. Thus the perception that they drive prices lower, when in fact they are simply accepting the reality before them.