The Influence of Foreclosures on Housing Market Prices

When foreclosures are present in material numbers they determine the market for houses and place continuous downward pressure on prices. Much has been made of recent increases in existing home sale volumes. The media and uniformed analysts have interpreted these rising transaction volumes as evidence of stabilization, a market bottom or a recovery. Of course each of these announcements accompanies the news that prices have fallen dramatically. Anyone with a basic understanding of economics realizes that when prices fall, transaction volumes increase. Rising volumes aren’t positive from the perspective of the market stabilizing, although they are a signal that the markets are clearing. It is the presence of a material and growing number of foreclosures in the market which is driving volume increases and price declines in the existing home market.

Banks and lenders are not in the business of owning and administering homes. Lenders incur substantial costs associated with ownership including taxes, insurance and maintenance. Furthermore, lenders are compelled by regulators to divest themselves of such properties quickly. Lenders price foreclosed properties to sell. Unlike owners, banks do not have a reserve price, a mortgage balance to pay off, a misperception of the home’s value or price maximization as their goal. Lenders want to be rid of properties in a timely fashion.

To achieve the goal of divestment, lenders price homes at substantial discounts to current market prices. This discount varies by market but may be 10% to 30% relative to trailing, comparable transactions. In the presence of foreclosures, buyers generally don’t pay the existing market price. Potential buyers have the opportunity to purchase discounted foreclosed properties. Even in the instance where a buyer transacts with a non-distressed seller, the buyer has the ability to set the price at discounted levels due to the presence of foreclosed properties in the market. The seller must make concessions to compete with foreclosures.

The effect of foreclosures is to perpetually force the “market price” of houses lower as long as there is a steady and material supply of distressed, bank-owned properties. There is no reason why prices would stabilize in such an environment until values return to levels supportable by incomes and competitive with rents. If house prices get cheap enough, buyers will return regardless of price trends, future expectations or the presence of foreclosures. Unfortunately, these price levels will not be realized in the near future given the extraordinary appreciation experienced since 1996.