Why REO Discounts Vary So Greatly: FHFA

Calculations for REO discounts can differ on extreme levels. In a mortgage market note from FHFA, the agency explained the common reasons behind the variations.

The note stated that REO discounts heard in media reports “are typically found by comparing sales prices of REOproperties to prior valuations of the same houses or sales prices of non-foreclosed houses and are generally larger than the discount caused solely by REO status.”

RealtyTrac, which is cited in news reports often, foundREO discounts from 2010 to 2012 ranged from 33 percent to 41 percent, according to the note.

The estimates found in the news media are in accord with consumer expectations as well. FHFA pointed to a Harris Interactive survey conducted in April 2011 for an ongoing RealtyTrac and Trulia study, which found American adults expected to pay 38 percent less for a foreclosed house than a similar non-foreclosure.

The academic world, which tends to depend on location, time and controls for estimates, has a discount range that can be anywhere between zero to 50, but most estimates on REO discounts in academic literature fall in the 10 to 25 percent range when looking at nationwide averages, according to the note.

When observing estimates for just one metropolitan statistical area, the variability is even greater since the academic studies adjust for characteristics and property condition.

FHFA stated there are at least six reasons to explain whyREO discounts vary so greatly. The first three are the condition effect, characteristics effect, and market effect. Those explanations are directly related to the property value of houses. The last three explanations are: buyer-related effect such as risk aversion, seller motivation effect such as loss aversion, and stigma effect. These are whatFHFA called indirect mechanisms.

The condition effect can affect an REO discount since REOs, unlike non-foreclosures, are more likely to remain unrepaired if damaged, such as from inclement weather. Also, some REOs would find a loss in value because of intentional damage left from a previous owner.

The note also stated that REO discounts reported in the news typically don’t account for differences in property characteristics such as age and size when comparing REOproperties to non-foreclosures. According to the note, REOs actually tend to be older and have smaller lots than non-foreclosed houses.

The note explained that REO discounts found in media reports also usually compare REOs to prior sales prices or previous assessment values of REO properties or values of non-forecloses from other neighborhoods.

This can have a significant impact on REO discounts, especially during market downturns. For example, during a downturn, a home that sold in 2006 for $100,000 may sell for $80,000 in 2011, even if it’s not an REO. This type of market downturn can inflate the REO discount estimate, the note explained.

The buyer-related effect deals with concerns over risks such as hidden costs, unforeseen delays, and potential loss of property value due to unexpected issues.

Seller motivation can also affect the REO discount. Since servicers have to pay fees such as taxes, insurance fees, and maintenance costs, they have an incentive to maximize the sales price.

In addition, the stigma of REO properties has an impact on the discount.

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