Forced Sales and House Prices

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Each foreclosure that takes place 0.05 miles away lowers the price of a house by about 1 percent.

The expansion of mortgage credit earlier this decade and the recent decline in house prices have led to an unprecedented increase in foreclosures since 2006. Foreclosures transfer houses to financial institutions that must maintain and protect them until they can be sold. Foreclosed houses are likely to sell at low prices, both because they may have been physically damaged during the foreclosure process and because financial institutions have an incentive to sell them quickly. In a liquid market an asset can be sold rapidly with a minimal impact on its price, but the market for residential real estate is a classic example of an illiquid market, in which urgent sales lower prices.

Furthermore, foreclosures may lower the prices of nearby houses, either through direct physical effects on neighborhoods or by creating an imbalance of demand and supply in an illiquid neighborhood housing market. If such spillover effects on prices are significant, they might stimulate further foreclosures, because homeowners are more likely to default when their houses are worth less than the face value of their mortgages.

In Forced Sales and House Prices (NBER Working Paper No. 14866), authors John Campbell, Stefano Giglio, and Parag Pathak investigate these issues. They use a comprehensive dataset on 1.8 million individual house transactions in Massachusetts over the period from 1987 through the first quarter of 2008. Importantly, Massachusetts experienced a significant decline in house prices and wave of foreclosures during the early 1990s. That provides a historical precedent that can be used to shed light on the current condition of the housing market.

The authors show that houses sold after foreclosure, or close in time to the death or bankruptcy of at least one seller, sell at lower prices than other houses. The discount is particularly large for foreclosures, amounting to 28 percent of a house's value on average. For death-related sales, the discount is 5 to 7 percent of value, and for bankruptcy-related sales it is 3 percent of value. The pricing pattern for death-related sales suggests that the discount may be attributable to poor maintenance by older homeowners, because it does not depend on the timing of the sale relative to the timing of a seller's death, it is larger for deaths of older sellers, and is larger still for houses where the structure accounts for a greater fraction of the value of the property.

The pricing pattern for foreclosures is quite different. Foreclosure discounts are larger for low-priced properties in low-priced zip codes. This suggests that foreclosing mortgage lenders face fixed costs of homeownership, probably related to vandalism, that induce them to accept absolute discounts that are proportionally larger for low-priced houses.

After aggregating to the zip code-year level and controlling for movements in the overall level of Massachusetts house prices, the authors find that changes in the prices of unforced transactions are close to unpredictable, while forced sales take place at a substantial and time-varying discount. This discount is larger and more persistent when the share of forced sales is higher. These patterns suggest that most unforced transactions in residential real estate take place at efficient prices, at least relative to the general level of house prices in Massachusetts. Forced sales take place at lower prices. When many homeowners are selling urgently, the implied bid-ask spread widens for housing.

The authors also look for evidence that forced sales have spillover effects on the prices of local unforced sales. This question is of particular interest given the increase in the foreclosure rate in the current housing downturn. They find that foreclosures predict lower prices for houses located less than 0.25 mile, and particularly less than 0.1 mile, away. Although foreclosures and prices are jointly determined in the housing market, and both respond to local economic conditions, the fact that foreclosures lead prices at such short distances does reinforce the concern that foreclosures have negative external effects in the housing market. The authors' preferred estimate of the spillover effect suggests that each foreclosure that takes place 0.05 miles away lowers the price of a house by about 1 percent.

-- Lester Picker