12/18/2007: "The Foreclosure Effect"

The average single family residential sales price is down. In some areas as much as 15% or more off what it was a year ago. But this does not mean that if you place your home on the market for sale, you will receive 15% less than what you would have a year ago. (While 15% is not a universal

The average single family residential sales price is down. In some areas as much as 15% or more off what it was a year ago. But this does not mean that if you place your home on the market for sale, you will receive 15% less than what you would have a year ago. (While 15% is not a universal number, I will use it as such for the purpose of this post.)

The assumed 15% is an average. It is the sum of all sales divided by the number of sales. It includes all sales, including the resale of foreclosed properties.

Foreclosed properties do not typically sale at or even near market value. There are several reasons for this. First, lenders are not in the real estate business. They are in the loan business. They make their money by loaning money, not by holding a wasting asset. When they foreclose on a house, they want to turn it as quickly as possible to free up those funds so that they can make money loaning the money to someone else.

Banks also face regulatory issues. Bank examiners, at least in Georgia, push banks to sell foreclosures quickly. A bank with a lot of REO properties on their books faces tough regulartory evaluations and can even face stiff penalties.

Another significant consideration is the terms under which many lenders sell a foreclosure. Often, the lender will provide the purchaser with a contract addendum of 10 pages or more which essentially puts the purchaser at a significant disadvantage. This alone is sufficient to greatly reduce the sale prices of foreclosed homes well below market prices.

Realizing all of this, what kind of impact does the resell of foreclosed properties have on the real estate market? Let's assume that the typical foreclosure sells for 33% below the market price of comparable homes. Using these assumptions it is very simple to determine the effect foreclosures would have under these conditions.

If you have 10 homes sell for $150,000 each, the total sales price is $1,500,000.

If you have 9 homes sell for $150,000 each, the total is $1,350,000 and the 10th sell for $100,000 (one-third off), the total would be $1,450,000.

If you take the $50,000 difference and divide it by the total of the 10 market price transactions ($1,500,000), you will see where if only one out of ten home sales were foreclosures, the average sales price would drop by 3.33%.

If 20% of the sales were the resell of foreclosures, the reduction would be 6.66%.

If 30% of the sales were the resell of foreclosures, the reduction would be 9.99%, and so on.

So, if 30% of the sales in your market area are the resell of foreclosures, and the average house value has dropped 15%, then you could probably expect your house to sell for 5% less than it would have a year ago, not 15% less. And that 5% is due in part to the competition offered by the foreclosures.

5% is still a significant reduction, but it is not near as bad as the 15% overall average.

You could carry the numbers out further and consider lost appreciation, inflation, mortgage rate change effects, etc...but making the numbers more complicated does not make the bottom line effect any more right or wrong. It just makes getting there more complicated.

This exercise is only an example of how foreclosures affect residential sales prices. It does not reflect actual conditions and transactions, but it does reflect the impact foreclosures can have on average sale prices.

How does all of this affect how you price your home if you are placing it on the market today? In a declining market it will probably be worth less in 90 days than today. You have to price your home with this in mind, but do not fall prey to those who quote you the average sales price in your market. When pricing your home, rely only on arm's-length market price transactions keeping in mind the direction the market is headed at the time.