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November 22, 2011

Foreclosure Price Discount: a Lemons Discount, a Liquidity Discount, or Both?

by Yanling Mayer, FNC Sr. Research Economist

The collapse of the U.S. housing market in 2006 has unleashed an unprecedented wave of residential mortgage defaults and foreclosures. It is no coincident that the mortgage crisis is more concentrated in areas where home prices have experienced steep declines, and in subprime neighborhoods where borrowers tend to have minimum equity in their highly-leveraged homes. Despite that the subprime mortgage crisis is now stretching into its sixth year, sales of distressed properties continue to make up a hefty portion of home sales nationwide.

Foreclosed homes are frequently sold at prices significantly below those of non-foreclosed homes. In 2011 Q3, median sales price on non-distressed single-family homes is about $180,000, nearly 29% above the median price of $129,000 in foreclosure sales. While median price difference is useful as a general indicator of market distress, it remains inadequate since average property characteristics among foreclosed and non-foreclosed homes can be quite different.

An alternative measure is to calculate property-specific foreclosure price discount – the difference between a foreclosed property’s actual sale price and its expected market price had it not gone through the events of mortgage default and foreclosure (i.e., assuming the quality of the property has remained constant). The deviation of foreclosure price from the expected market price underscores the impact of market distress and foreclosure events on property value.

The expected market price can be estimated using a repeat sales approach. As a gauge of underlying property value, the FNC Residential Price Index (a hedonic price index) excludes sales of foreclosed homes, making it an ideal index for estimating a property’s underlying market value.

With data through September, median foreclosure price discount during 2011 Q3 is estimated at 19.1%, up slightly from the previous quarter of 18.2%, or 18.6% from a year ago. One in every four foreclosed homes is sold at more than a 30% discount to estimated property value. Another quarter of the foreclosures are sold at prices close to their estimated market price, incurring less than 2% price discount.

Economists often attribute foreclosure price discounts to primarily two factors: (1) quality discounts, and (2) liquidity discounts. Foreclosed homes are generally in poor conditions; many are left abandoned, vandalized, and require large repair costs to restore the conditions. Thus, a portion of the foreclosure price discounts can be explained by a quality discount, or lemons discount. Second, lenders incur high carrying costs (e.g., legal expenses, maintenance costs, insurance costs, property taxes) and opportunity costs (e.g., foregone investment returns). Therefore, they are often willing to accept lower prices in exchange for liquidity. Empirically, it remains a significant challenge to pinpoint how each factor affects property value due to difficulties in obtaining measures on property quality and loan characteristics.

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