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 depressed prices. 

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 maintenance.

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 down prices.

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 lender-ownership phase.

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.