What’s the Real Discount on a Foreclosure?

Posted by: Stan Humphries    Tags:      Posted date:  November 9, 2012  

We’ve noticed several recent analyses that report the discount associated with foreclosure sales. For example, see here, here and here. What’s common in these analyses is the computation of the foreclosure discount using the median (or average) sale price of foreclosures compared to the median sale price of non-foreclosures. A significant pitfall with this approach is that it is comparing apples and oranges: the typical foreclosure property is likely quite different than the typical non-foreclosure property. The homes may be different in size, location or a variety of other attributes that affect property value beyond simply their status as either foreclosure or non-foreclosure homes.

For example, in June 2012, the median foreclosure resale in the Detroit metro was a 3-bedroom, 1-bathroom, 1200 square feet home valued at $47,000, whereas the median non-foreclosure resale was a 3-bedroom, 2-bathroom, 1,700 square feet home valued at $113,000. The 59% difference in the median values of foreclosures and non-foreclosures ($47K/$113K – 1) is really an indication that cheaper homes are more likely to be in foreclosure than more expensive homes, whereas many buyers likely interpret this figure as the discount they might expect on a foreclosure relative to the fair market value of the home (which it distinctly is not).

In order to try to provide some clarity here, we’ve computed an apples-to-apples foreclosure discount by comparing the sale price of foreclosure resales to the estimated full fair market value of the home (here, we use the Zestimate which is computed from models that do not include foreclosure resales). For this analysis, we define a foreclosure resale as essentially an REO (real estate owned) sale, that is, a sale to a private party by a lender or equivalent institution that is immediately subsequent to a foreclosure liquidation (i.e., a trustee’s deed upon notice or equivalent depending on the jurisdiction).

Figure 1 shows the foreclosure discount in September 2012 both nationally and for the top metropolitan areas in the United States. Nationally, the median discount is only -7.7% even though the median sale price of foreclosures is 41% less than the median sale price of non-foreclosures (again, simply because foreclosures are more likely to be cheaper homes than non-foreclosures, not because the discount is this high). The greatest discount is found in Pittsburgh (-27%) and the least discount is found in Las Vegas and Phoenix, both of which have no discernible discount between foreclosure and non-foreclosure sales.

Figure 2 below looks historically at the foreclosure discount since 2004. The blue line in Figure 2 is computed using the approach outlined above (the true foreclosure discount) and, for comparison purposes, the orange line shows the difference between the median sale price of foreclosures and non-foreclosures (the method used in the other analyses identified at the top of this research brief). We can see that, nationally, the true foreclosure discount reached its greatest level, -24%, in mid-2009 after REOs reached their highest share of overall sales earlier that same year. Thereafter, the discount became increasingly less, possibly because buyers became more familiar with buying foreclosures (leading to higher demand for the product) or because the quality of foreclosures improved (a higher volume of relatively new homes entering into foreclosure simply because of negative equity) or both.

Why does any of this matter? First, it distinctly matters to home buyers who may form unrealistic expectations about the discounts they will find when shopping for foreclosures. Using the simple approach of comparing median sale prices of foreclosures and non-foreclosures, the most recent press release from the National Association of Realtors noted that “foreclosures sold for an average discount of 17 percent below market value in July.” The very phrasing “below market value” implies that a buyer could expect to realize this discount on any foreclosed home relative to a non-foreclosed price on the same home. In practice, the actual discount will be considerably less as shown here.

The fact that the true discount is less than commonly reported also matters for the implications analysts draw from the continued flow of foreclosures into the market over the next few years. It makes a big difference if you think that inventory priced 30% below market value is going to be hitting the market when actually the inventory is priced only 7% below market value. With for-sale inventory tight in most markets right now (likely because of high negative equity) and demand slowly increasing, it wouldn’t be surprising to see the foreclosure discount decrease even more. This exact confluence of factors is the most probable explanation for the zero discount currently prevailing in both Las Vegas and Phoenix.

Photo image courtesy of Gerard Van der Leun.

About the author
Stan Humphries
Stan is Zillow's Chief Economist. To learn more about Stan, click here