How Big Is The Foreclosure Discount?

How Big Is The Foreclosure Discount?
by Peter Miller

Here's a puzzle: If a lender sells a foreclosed home what kind of discount will be available to buyers? Is it possible that there will be no discount, some discount or a huge discount?

These are tough questions because if local markets are strong enough, there's no discount at all according to Christopher Cagan, Ph.D., director of research and analytics at First American Real Estate Solutions.

"In the booming years of 2004 and 2005, foreclosure rates reached historical lows," says Cagan in a new report, A Ripple, Not a Tidal Wave: Foreclosure Prevalence and Foreclosure Discount.

"Homeowners who found themselves in difficulties could almost always sell their residences quickly and at a good price, thus avoiding damage to one's credit rating and receiving the benefit of remaining equity after paying mortgage balances and commissions. In cases where a lender did have to foreclose on a property, it could usually be sold readily at market price, without having to offer a substantial discount to encourage the sale of the foreclosed property."

But the good times of 2004 and 2005 largely disappeared in 2006. Cagan, an economist, looked at 815,000 home sales in the first half of 2006 -- including almost 25,000 foreclosures -- and found evidence of significant foreclosure discounts.

In California, for example, Cagan found that the typical home sold for $494,000 while the median foreclosure price was $435,000 -- that's a difference of $59,000 or 13.5 percent.

There's no doubt that $59,000 is a lot of money but there's a catch: Cagan found that the big price differential between homes sold at market value and those sold through foreclosure was not the result of an apples-to-apples comparison. In practice Cagan found that lower-priced homes were foreclosed more frequently, so foreclosure sale prices appear lower than a comparison of like homes might show.

"On the whole," says Cagan, "the foreclosure properties sold for less than they had been valued for -- less than their value would have been had they been offered on the market as non-foreclosed properties. This is what he calls foreclosure discount. For instance, discounts had been almost absent in California in 2004 and 2005 when properties (foreclosed or not) could be sold almost immediately at excellent prices. In the first half of 2006 -- when homes could take several months to sell and price reductions were often required -- foreclosing lenders had an incentive to offer at least a small discount to move their properties quickly."

In other words, the foreclosure discount in California was not $59,000. It was something lower. How much lower? When Cagan compared foreclosed homes with properties of similar size, location and condition, he found a $25,000 price differential -- a property with a fair market value of $460,000 typically sold for just $435,000 through the foreclosure process -- a difference of 5.4 percent.

Nationwide, because the market was not generally as strong in the first half of 2006 as the California market, Cagan found a much steeper foreclosure discount.

"For the first half of 2006, the foreclosure discount evaluated on a national basis was 14.2 percent. On that very general level, this is the discount that lenders accepted (beyond the background rises and declines of the general market) in order to sell their foreclosure properties."

The national figure, however, may not apply to individual states and communities. Such factors as local economic trends and population growth impact foreclosure rates -- the lower the foreclosure rate the lower the foreclosure discount.

For instance, Cagan found that in the first six months of 2006 the foreclosure discount was 1.9 percent in Arizona but a whopping 27.8 percent in Missouri. In local areas, the foreclosure discount was just .5 percent in Brevard County on the east coast of Florida but 46.6 percent in the city of St. Louis. Sometimes the discounts differed enormously in nearby jurisdictions: The foreclosure discount was 20 percent in the city of Baltimore -- and just 10.7 percent in surrounding Baltimore County.

What does it all mean?

How a home is sold -- whether in the open market or by foreclosure -- can make a substantial difference in terms of the sale price.

A home sold by foreclosure is likely to be sold at a discount, but not always.

The size of the foreclosure discount varies by location. Generally, the better the local economy the smaller the foreclosure discount.

There may not be any foreclosure discount in communities that have a growing population, an expanding job base and strong real estate sales.

Owners facing foreclosure are better served selling homes directly rather than waiting for their properties to be auctioned off.

Lenders have a stake in avoiding foreclosure. Even with private mortgage insurance (MI), they can still face substantial losses, especially in slow markets. For this reason lenders would greatly prefer that owners sell in the open market and fully repay loans rather than having a property go to foreclosure.

The more homes on the marketplace through foreclosure, the greater the foreclosure discount. In particular, Cagan found that "in markets where foreclosures constitute 8 percent or more of total market sales, foreclosure discounts are likely to be particularly large -- often 20 percent or deeper."

"What the First American study demonstrates is that foreclosure discounts are real in many markets," says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the leading online marketplace for foreclosure properties. "At the same time, it's plain that lenders, mortgage insurers and borrowers have a mutual interest in avoiding foreclosures and the losses they typically represent, especially in markets where foreclosures are common and discounts are deep."

~~ from RealtyTrac.com