If you want to buy a Ford, you don’t expect to pay a Mercedes price, do you? Fords and Mercedes are two different automotive submarkets; about all they have in common are four wheels and a horn.
So if you want to buy an REO, you should expect to pay a significant discount from the price of all non-REO properties in the neighborhood because they also are two different tiers of the housing market. That reality has existed since the first wave of subprime REOs shocked the nation, but for reasons that have escaped me, most people have pretended that only one nice and tidy single family housing market still exists in each locality. Of course, that’s ridiculous.
Realtors have pushed for years to see the market formally bifurcated into distressed sales and non-distressed sales (also called full-value, fair value, non-REO, standard, normal, non-discounted and regular). The related issue of how to use distress sales as comps in appraisals was a central stumbling block in the long and bloody battle over the Home Valuation Code of Conduct (HVCC).
That dispute was resolved by establishing provisions guarding against the indiscriminate use of distressed sales when valuing a full-value property, but the larger question of whether we should recognize that we live in a world of one or two single family residential marketplaces when tracking price trends and setting housing policy has remained unresolved.
At the core of the question is the economic and financial impact of the discount. In my talk at the BP Summit, I shared the finding from recent foreclosure market research that found discounts are greatest when markets are unstable, often in the wake of a wave of foreclosures that send a shockwave through the market. In order to sell their REO inventory, lenders find they have to lower the prices of their REOs, and the gap between REOs and “normal” homes widens. Investors move in and snap up bargains. As markets stabilize, so does demand for REOs and prices rise. Sometimes the discount shrinks to half its initial size.
Of course, to investors this two-tiered structure is the foundation of every flipping strategy. A larger discount of 30 percent or more increases the potential for profit when a property is rehabbed and resold, moving from the distressed sales market to the full-value market. However, larger discount markets also are more unstable, which means full-value prices are low and perhaps headed even lower, increasing risk at resale. Conversely, stable markets with lower markets offer lower discounts and hence, lower profit potential. Yet prices in their full-value markets vacillate less and are more likely to appreciate during the time it takes to rehab and get a distressed sale property ready for resale.
I believe that public recognition of the reality of the two-tiered market helps us to understand that foreclosure and short sales are not inherently toxic to home values. Indeed REO and non-REO markets can exist quite happily side by side, appreciating in value in response to supply and demand, just as markets for Fords and Mercedes can coexist in the same showroom or sales lot.
Over the past two weeks, three announcements by authoritative housing and mortgage data providers suggest that the two-tiered marketplace is achieving acceptance by the people who shape the housing markets. Lender Processing Services announced last week that its authoritative Home Price Index now tracks price changes for non-distressed homes apart from distress sales. In addition, its foreclosure price data now accounts for the impact of short sales on estimates of normal market prices.
Next, CoreLogic has begun to separate its pricing data into “full-value” and distress sales. “In a strong sign that the housing recovery has begun, the national median price of full-value homes that are not foreclosures or short sales rose each of first two months of the year,” the company said in its February price report.
Because of its data on REO saturation of the 50 markets it tracks, Clear Capital has been a leader in analyzing how stabilization helps establish two-tiered markets. Clear Capital’s March data actually shows that both REO sales and home values appreciated simultaneously, just as two distinct markets should in a healthy marketplace. The national REO rate went up 1.2 points since last month and 1.8 points over the past quarter to hit 27 percent, pointing to an acceleration of REO sales. The Midwest contributed the most to the increase, jumping 3.8 points over the quarter to 34.3 percent, with the other regions all seeing softer increases.
“We are continuing to see, overall short term home value strength against the rising REO saturation,” said Dr. Alex Villacorta, Clear Capital’s Director of Research and Analytics. “This is an indication of market stability, and bodes well for the continued growth we’re expecting over the rest of the year.”
If America can shed its visceral fear of foreclosures, perhaps the day will come when we will truly get a full picture of monthly prices with data tracking both distressed sales and full-value sales drilled down to the smallest local markets.