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Study Shows Foreclosure Lowers a Property’s Value by 27%

By: Carrie Bay

Foreclosed homes permeate the American landscape. According to data from the Massachusetts Institute of Technology (MIT), they make up about one in 12 houses with under $1 million left on the mortgage.

These foreclosures drive down home prices, and MIT gives two reasons for their depreciating effect – because foreclosed homes add to the housing supply and because the financial firms that acquire the houses want to unload them promptly.

However, since foreclosures often occur in economically struggling areas, it is hard to determine how much of the drop in a home’s value is due to its foreclosure, and how much can be blamed on the economy in general.

MIT economist Parag Pathak and two Harvard researchers, John Y. Campbell and Stefano Giglio, have conducted a study to put a price tag on foreclosures.

Specifically, they’ve determined how much a foreclosure affects a home’s value, as opposed to a home going on the market because the owner has died or declared bankruptcy.

The three academia colleagues examined 1.8 million home sales in Massachusetts from 1987 to 2009. By looking in granular detail at real estate prices, they concluded that a

foreclosure reduces the value of a house by 27 percent, on average.

“It’s not surprising that there is a discount due to foreclosure,” said Pathak. “But it is surprising that it’s so large.”

By contrast, other types of forced sales lower home prices by smaller amounts. When a house is sold after the death of an owner, the researchers found the price drops 5 to 7 percent on average. When an owner declares bankruptcy, the value sinks 3 percent.

The researchers believe that their discovery of the gaps between these various price reductions is a key to isolating the effects of foreclosures. They suggest that a central cause of the larger foreclosure discount is that the condition of foreclosed houses often deteriorates much more than it does for other kinds of houses whose ownership changes hands.

This tendency of foreclosed homes to fall into disrepair lies behind the other main finding of Pathak and his colleagues – the presence of a foreclosed house in a neighborhood reduces the value of the homes around it.

In their estimation, the value of a home drops by 1 percent, on average, if it is within roughly 250 feet of a foreclosed home, namely because the vacant home may not be properly maintained and because foreclosures are typically resold quickly for a discount, their sale price can affect valuation comparables.

The study is a “very valuable and important paper,” according to Christopher Mayer PhD, a professor and dean at Columbia Business School in New York, who thinks it will open up more research on whether foreclosures cause other foreclosures, a process he calls “contagion.”

Even though Pathak, Campbell, and Giglio found that foreclosures only dent the values of neighboring homes, Mayer questions whether there may be a tipping point “at which a neighborhood starts to fall apart.”