Why Too Many Foreclosures Can Lead to Devastation

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Recently, I wrote about the path of progress and why one should consider investing in areas that will benefit from, for instance, the building of new rail lines which reduce commuting time and increase the quality of life for those who have access to such facilities compared to those who do not. As most people instinctively understand, real estate appreciation is always driven by the familiar factors of supply and demand. A favorite resource of mine is the book “Equity Happens” (aff.) written by real estate experts Robert Helms and Russel Gray.

In that book, not only do the authors discuss investing in the path of progress, but they simplify the concepts of supply and demand to the most basic level. As they put it, sometimes you have too much milk, other times you have too much cereal. When you add more cereal, the oversupply of milk is counteracted. Thus, as you increase population, the oversupply of housing stock is counteracted, supply becomes in balance with demand, and values begin to rise again.

(While there are a lot of data points that suggest when a market is balanced between supply and demand, even professional real estate appraisers can’t necessarily agree on which factors to use and how to weigh them.  For instance, how many months of supply indicates a balanced market? There’s plenty of room for disagreement and a lack of objective standards.)

Certainly, job growth is known to lead to an increased demand for real estate; as is population growth – both are key factors in making a decision to invest in a particular area. But, what is the opposite of the path of progress? What happens when a tidal wave of foreclosures severely depresses the value of the housing stock in a particular location? What if there is also negative job growth, killing demand? Once the bottom falls out, how will supply and demand ever get back into balance?

One answer may surprise you. When the value of real estate drops below replacement values, economists predict that the real estate itself (improvements, that is) will start to deteriorate. Such was the theory advanced by Edward Olsen in his 1969 article, “A Competitive Theory of the Housing Market.”  (Incidentally, this is the same reason why rent control ordinances usually permit rent increases when landlords improve or repair units – the failure to allow a rent increase under such circumstances amounts to an economic disincentive to maintain the housing stock.)

You don’t need to look much beyond Las Vegas, Michigan, or some markets in California to see the effects of foreclosure on the housing stock. At best, foreclosed properties suffer from deferred maintenance; at worst, defaulting homeowners often completely trash their houses before they leave. Eventually, the existing foreclosure stock becomes so awful, that people looking for a new place to live may consider buying – gasp – a new home, instead of having to face the challenge of cleaning up someone else’s mess. Job losses in Michigan prevent the excess housing inventory from being absorbed (even by investors – there’s no one to rent to) and when the decay becomes too bad, government are forced to bulldoze entire neighborhoods.

The unpleasant (but necessary) final result is that supply becomes closer to equilibrium with demand. Just one more reason for lenders to work with borrowers to avoid foreclosure whenever possible.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.