Conceptual Framework

Foreclosure is the legal procedure that a mortgage lender must follow to take possession of a home whose owner has not satisfied the requirements of a mortgage contract. In most states, foreclosure is generally a four-phase process that begins when a homeowner misses three consecutive scheduled loan payments. In the first phase of foreclosure, the lender may file a legal intent (“Notice of Trustee’s Sale” in non-judicial approach and “Notice of Lis Pendens” in non-judicial approach) to foreclose upon the mortgage after such default (Cutts and Merrill, 2008; Pennington-Cross, 2006). In the second phase of foreclosure, the mortgage lender can negotiate the possibility of either a restructured loan or a short sale by which the property is sold for less than the amount owed on the mortgage. If these negotiations fail, the property goes to the third phase of

foreclosure, which is an auction requiring a minimum bid set to cover the distressed mortgage’s loan balance and fees. If the minimum is not met, in the fourth phase of the foreclosure process the property reverts to the lender and it is considered real estate (or lender) owned (REO) property. Capozza and Thomson (2006) found that 79% of defaulted loans (90 days or more delinquent) became REO properties and the remaining 21% cured or prepaid.

There is a range of possible outcomes for any given foreclosure, pre-foreclosure sale (or short sale), foreclosure sales at auction, bank owned sales, and vacant or abandoned properties because time to reach those outcomes would likely vary across properties. Thus, it is difficult to forecast exactly how long it would take the process after foreclosure to affect surrounding property values (see Figure 3.1).

Figure 3.1. Foreclosure Timeline. Source: Cutts and Merrill, 2008.

As discussed in section 2, empirical evidence shows that mortgage foreclosure has not only a direct influence on the sale price of a home under foreclosure status but also an indirect influence on nearby home prices. Based on the previous contributions, the following description will illustrate a mechanism to clarify the relationship between foreclosure and housing values for the study focus.

As summarized by Lee (2008), foreclosures could negatively impact nearby housing values through three channels: increased supply, discounting, and the neighborhood spillover effect. In the first channel, additional inventory comes on the market when homes are foreclosed, exacerbating the mismatch between demand and supply. Foreclosure is usually a forced act and thus unnaturally raises the supply of homes in a neighborhood.

Since prospective homebuyers usually shop around neighborhoods before making a transaction, the increase in distressed homes lowers the prospective selling price of all homes in a neighborhood due to the expansion of available choices. Thus, a large number of short sales or foreclosed properties in a neighborhood, by raising the supply of properties for sale, would likely reduce nearby home prices.

Once the downturn begins, both short sales and a rising tide of foreclosed and REOs add to the downward pressure on prices, exacerbating the problem. In addition, a high concentration of foreclosed properties and REOs can create an additional supply in the inventory of unsold homes, thereby lowering the values of nearby homes.

In the second channel, short sales or properties which have a foreclosure notice may sell at a lower price than the average sale price for the area. Typically, distressed

sellers who have defaulted on loans will be more open to any offers and willing to sell the property below its appraised value since the home owner wants to pay off the mortgage in order to avoid the foreclosure sale, and to prevent damage to their personal credit rating. There will often be time pressures to complete the transaction before the foreclosure sale takes place, and homeowners then realize that they must lower their prices to sell their homes. Thus, the housing price in a neighborhood will affect or be affected by the housing prices in adjacent neighborhoods. Properties with distressed loans are likely to sell at a discount, affecting the price of comparable homes used to estimate neighboring property values.

However, when foreclosures are thought to negatively impact the values of nearby properties, timing on selling may influence nearby housing prices based on the concept of comparable property valuation. In general, foreclosure sales and distressed REOs occur at steep discounts, further undercutting market prices. Moreover, the distressed properties occupied by tenants would depreciate faster than owner occupied units since renter occupied units might lead to lower levels of maintenance after the bank pursued foreclosure (Galster, 1983, 1987; Gatzlaff, Green, and Ling, 1998; Shilling, Sirmans, and Dombrow, 1991).

In the last channel, if not sold quickly after the foreclosure auction, foreclosed properties stay unoccupied for extended periods of time, which attracts vandalism and crime, increasing the blight, making the neighborhood undesirable for potential homebuyers and pushing down home values in the immediate neighborhood (Kingsley, Smith, and Price, 2009). Bank owned homes are more likely to suffer physical neglect

before and after repossession. Abandoned and vacant properties blighting a neighborhood make difficult for the remaining homeowners in the community to maintain their properties. These problems can lead to increased costs for fire, police, and other services and decreased revenues for local governments. Foreclosures, in turn, can lead to yet more foreclosures by deferred maintenance, disinvestment, and declining neighborhood stability. This negative externality could be attributable to the fact that homeowners facing foreclosure eliminate or reduce maintenance expenditures causing a decline in the value of normally maintained nearby homes. These results in lower property values for homeowners and a reduced tax base for communities. If foreclosures lead to a decline in neighborhood property values, the reverse may also be true. Falling property values may lead to an increase in foreclosures because, if house prices drop dramatically, the borrower may owe more than the house is worth, which could cause more borrowers to default on their mortgages. If both of these inferences are true, this would cause an undesirable feedback loop between property values and foreclosure.

Figure 3.2 illustrates the conceptual diagrams of the impacts of foreclosure on property values discussed above.

Figure 3.2. Conceptual Diagrams of Direct and Spillover Effects of Foreclosures on Existing Home Prices.

Home value depreciation would not arouse much attention in governmental sectors in strong market neighborhoods, even if there are some risks of foreclosure impacts. In neighborhoods where there is a low density foreclosure rate, the low cost of government interventions could be expected regardless of market strength. Thus, trends should be monitored in order to head off problems quickly if foreclosures start to increase. If risks increase substantially, there will be a need to act quickly to prevent actual foreclosures and then minimize vacancy in any properties where foreclosures do occur. Moreover, if the housing market is strong enough, the investors or owner

occupants are more likely to invest the full costs to operate the property in an economically stable manner.

However, the current housing market condition is more likely to be a weak housing market with a high level of foreclosure impacts. Homeowners facing foreclosure are also more likely to defer maintenance leading up to the foreclosure regardless of whether or not the bank pursues foreclosure. From the public perspective, it represents a more difficult challenge in most cities since there is not likely to be sufficient funding for the costs of acquisition or rehabilitation.

Figure 3.3 illustrates the relationship between housing market conditions and foreclosure. The rows present housing market strength that the upper side indicates a good housing condition and the bottom side indicates a poor housing condition. The columns picture the foreclosure impact risk from low foreclosure density on the left to high foreclosure density on the right. This diagram shows how foreclosures destabilize neighborhoods and cause a decline in housing values.

As discussed above, mortgage foreclosure has a direct influence on the selling price of a home under foreclosure as well as an indirect influence on the nearby selling prices, depending on housing market conditions. Thus, searching for empirical evidence that foreclosure has both price-depressing effects on home values for homes in foreclosure and on nearby home values is the main question of this study.

Figure 3.3. The Matrix of Housing Market Dynamics. Source: Goetze, 1979.

To measure foreclosure impact on housing values, this study modified the standard appraisal practice, including (1) the variable for classifying distressed homes related to foreclosure and a typical arm’s length transaction, (2) structural variables describing the physical characteristics of housing, (3) quarter variables representing market price trends, (4) selling characteristics associated with foreclosure status such as renter occupancy and cash transactions, and (5) neighboring residential foreclosures as s proximity externality (see Figure 3.4).

Figure 3.4. The Conceptual Framework for Measuring Existing Home Values and Foreclosure Effects.

In relation to the main question, this study will investigate whether foreclosures cause a significant reduction in neighborhood home values in housing booms and busts. In addition, this study will also investigate how foreclosure impacts on home values vary with housing type and foreclosure type, as well as how the home values vary with the foreclosure proximity and density in neighborhoods. The following section addresses ten hypotheses associated with foreclosure impacts on home prices, which will be examined through descriptive and analytical methods in the next section.