Everyone knows real estate owned properties (REOs) are bad for prices in local housing markets. But the precise reason proved hard to quantify, until recently. A new study by the American Economic Association seeks to identify why REOs cause price declines. The American Economic Association points to two critical factors:

  1. the eyesore of neglected REOs dragging down neighborhood desirability (called disamenity); and
  2. the added supply of low-priced homes engorging inventory, which increases seller competitiveness in the housing market.

The study examines several real estate markets across the nation from January 2007 through June 2009, the height of the recent foreclosure crisis. In California, REOs peaked at over 50% of all home sales during this period. They have since subsided to a relatively healthy level of 6% as of Q2 2014, which is consistent with historic norms.

The study finds that location is key: the effect an REO has on property values (measured by the list price of non-REO homes for sale) is much more significant if the REO is directly next door versus the other side of the neighborhood.

Competition from REOs drives down list prices

One of the markets studied was San Francisco County. In San Francisco, during the first week an REO appears on the multiple listing service (MLS), sellers within a half-mile radius of the REO were 8% more likely to reduce their list price than the average seller nowhere near any REO listings.

Further, the closer the subject property is located to the REO within that half-mile radius, the more likely the seller is to adjust their list price. This effect diminishes in the second week after the REO is listed.

Sellers close to newly-listed REOs adjust their list prices to meet expectations of a lower sales price, as the final sales price for REOs is significantly lower than the REO’s original list price (averaging anywhere from 5%-20% below list price in the study).

However, the study also found that REOs do not diminish the number of homes traditionally listed on the market. In other words, equity sellers of non-REOs were not discouraged to the point of removing their home from the market.

Not all REOs are eyesores

The effect of disamenity on nearby homes for sale is harder to measure. That’s because nearby eyesores cause the original list price to be lower, as the seller or seller’s agent adjusts the price based on the surrounding neighborhood’s current desirability. That is, the more abandoned, run-down homes near the listing, the lower the realistic seller’s list price. Of course, some sellers refuse to budge on their desired list price due to sticky pricing delusions. But the study found that is less common (at least during the panicked years of the housing crisis).

Disamenity more heavily affects property values in areas where REOs are more likely to be damaged (defined by high-density areas where property values are already low). Specifically, nearby home prices tend to decline slightly in the period leading up to a foreclosure, then rise again once the home has completed foreclosure but has not yet been returned to the market as an REO. This suggests homeowners allow their homes to decay during the foreclosure process. Then, once the bank retakes possession, the bank will fix it up for sale.

The American Economic Association study concludes that the competitiveness of REOs on the increased home supply has the most direct effect on list prices, while the disamenity factor only has an effect in certain situations where REOs are in a poor physical condition.

The authors of the study suggest converting some REOs to rentals rather than placing them on the MLS will reduce the immediate effect of price reductions in times of increased REOs.

Why it matters

While all this is very interesting given past events, does it have any significance in today’s market due to the return to near-normal REO levels experienced in 2014?

Yes! REOs are expected to make a resurgence later in 2015 in reaction to falling home prices. Another problem: REOs are most often snatched up by cash-heavy speculators, who have quickly exited the housing market in 2014. When REOs begin to make their dent on local housing markets in 2015, who is going to buy up these properties?

End user homebuyers are still making a cautious return, but they are likely to return with more gusto once prices bottom sometime in 2016. REOs will continue to chip away at local home prices until around 2019, when the home sales volume recovery will finally take place (followed by a more stable home price recovery) due to:

  • a thriving jobs market; and
  • the convergence of first-time homebuyers and retiring Baby Boomers on the homebuying market.