Researchers for the Federal Reserve Bank of Boston have
taken a fresh look at the impact of foreclosures on the price of other homes in
a neighborhood using new data about the location of properties with seriously
delinquent mortgages and their conditions.
Their results are likely to be controversial as they fly in the face of any
efforts to prevent foreclosure that prolong the delinquency period.
The results of the
study “Foreclosure Externalities: Some
New Evidence” was recently published by the authors Kristopher S. Gerardi, Eric
Rosenblatt, Paul S. Willen, and Vincent W. Yao in the Federal Reserve’s Public Policy Discussion Papers.
Researchers base their argument that foreclosures reduce the
sale prices of nearby houses on studies using on a single flow of properties
into the market, all of which have completed the foreclosure process. The Fed study, in contrast, uses multiple
measures of the stock of distressed properties – properties with serious long
term delinquencies, shorter term less serious delinquencies, properties in bank
inventory (REO) and properties recently sold by the lender.
The paper posits that the stock of distressed housing is
more relevant than the flow of foreclosures because, for example borrowers
facing foreclosure have little reason to invest in their properties which could
generate negative externalities in the neighborhood and distress nearby home
values. This is important for policy
reasons if for example one assumes that distressed properties exert downward
pressure on the market but use only foreclosed properties to measure this. One might erroneously assume that delaying or
placing a moratorium on foreclosures would cause prices to rise when it is
instead the transitioning into delinquency which prompts homeowners to stop
investing in their properties. A moratorium
would actually increase the stock of distressed properties and thus the effect
on surrounding homes. The study also looked
at information as to whether a seriously delinquent property is vacant and on
the condition of lender-owned properties.
The paper sets out two empirical facts. 1) Houses that sell very close to all forms
of distressed properties do so at a slightly lower price than otherwise similar
properties in the same Census Block Group (CBG) that sell without nearby
distressed properties and 2) the effect appears when the borrower becomes
seriously delinquent on the mortgage and disappears one year after the lender
sells to a new homeowner in an arms-length transaction.
The research evaluated three possible explanations for
1. Unobserved relative demand shocks that drive down prices
and result in some foreclosures.
This has support both in theory and data. Default makes sense for a borrower only if he
is in a position of negative equity. “All
else being equal, a negative demand shock in location A relative to location B
would lead to a fall in prices in location A and a concomitant increase in
negative equity and foreclosures.”
The fact that demand theory could explain the observations
does not necessarily mean that it does.
One could argue that it is unlikely for significant property depreciation
to occur when borrowers have only missed a few mortgage payments, but he data
indicates that this is the case. An
argument could be made for reverse causality however it could be that the
borrower has been in financial distress for some time and has deferred property
Other facts are inconsistent with the demand
explanation. First the effects diminish
significantly for nearby properties a year after the subject property is sold
out of REO. The second problem is the
variation within CBGs which would negate both a demand and a supply theory
unless one believed there were distinct submarkets within a CBG – which have a
target size of about 1,500 people – and that one part of the submarket suffered
a shock that did not affect the other.
2. Foreclosures generating increased relative supply and driving
The supply theory posits that a foreclosure increases the
supply of property on the market and drives down prices. Normally, when pricing long-lived assets like
houses the supply is defined as all of such assets that exist, whether on the market
or not. Foreclosures do not change the
number of houses or the quantity of land so standard models would not predict
any effect on prices.
The authors engage in a lengthy discussion of the impact of
forward looking buyers skewing the market by anticipating the future availability
of foreclosed homes but concludes that the supply theory, while it could
explain why prices rise after the REO is sold (with the house off the market
its price as well as those of other houses return to pre-delinquency levels) it
doesn’t explain why properties in above average condition don’t have the same
effect as those below average in generating competition with other properties.
3. An externality of reduced investment by distressed
borrowers in the delinquency phase and financial institutions in the
The third explanation is that foreclosures lead to an
investment externality. Neither
delinquent borrowers nor lenders have an incentive to adequately maintain the
property which leads to physical deterioration and reduces the value of nearby
properties as well. This investment
disincentive is arguably present both during serious delinquencies and when the
property is in REO. Borrowers do not
invest in their properties under this scenario either because they have no
funds to do so or because they see no gain as they expect to lose ownership in
the future. Post foreclosure the lender
does not obtain any consumption benefit from investing in the property and the
REO process suffers from an information problem where the property agent has no
ownership stake and the owner/lender cannot be sure if the manager has other
incentives. The optimal mechanism for
investment in single-family residential real estate is to sell the property to
a small-scale investor who internalizes the costs and benefits.
The literature supports the investment externality argument
and the authors find that is also explains why the coefficient estimate
associated with nearby below average REO is far lower than where the REO is in
average condition and why the difference disappears after a new arms-length
owner has had a chance to invest in the property.
The authors sum up their research by saying that perhaps the
most important take-away is that the effects of foreclosure and distressed
property in general on the prices of a neighboring home are fairly small. They estimate that the effect of a property
with a seriously delinquent mortgage and a property in REO on the price of a
home within 0.10 mile to be approximately -0.5 to -1.0 percent, “an amount that
would most likely go unnoticed by the typical seller who does not have many
distressed homeowners living nearby. The
vast majority of properties that sell have no distressed properties nearby
which means that “it is impossible to attribute more than a token amount of the
collapse in prices in the 2006-10 period to foreclosures.”
The authors’ final conclusion is bound to be
controversial. “The policy implications
of even a small investment externality effect are important. Our results suggest that the key to
minimizing the costs of foreclosure is to minimize the time that properties
spend in serious delinquency and in REO.”
This implies a need to pressure banks to get properties out of REO
quickly and to minimize the time a borrower spend in serious delinquency which
means accelerating the foreclosure process, avoiding moratoria, and perhaps
even foregoing extended loss mitigation efforts.