Completed September foreclosures were flat, good for homebuilders

Foreclosures are a leading indicator of future housing supply and pricing

Foreclosure activity is closely watched by investors, realtors, and homebuilders alike because it forecasts future housing supply. Foreclosure timelines can vary widely by state, depending on whether a foreclosure needs to be approved by a judge. The large foreclosure pipeline in the judicial states is one reason why prices are still languishing in the Northeast. Homebuyers don’t focus just on existing supply. They also focus on projected supply.

Foreclosure CompletionsEnlarge Graph

Increases in foreclosure activity correlate with lower home prices because distressed properties tend to trade at a discount to non-distressed properties. Foreclosure sale prices are typically 15% to 20% lower than non-distressed prices. Short sales tend to trade at smaller discounts (closer to 15%). These factors lower comparable sales prices (or comps), which, in turn, lowers appraisals and the value of neighboring properties. Low appraisal values are an issue right now for a lot of borrowers, especially those that are using low down payment FHA and VA loans. If the appraisal comes in lower than the sales price, the borrower must put up a down payment or forgo the sale. So there are many ripple effects from foreclosures.

Foreclosure activity is falling as the government encourages servicers to pursue other options

The federal government has taken numerous steps to reduce foreclosures, starting with loan modification programs and also encouraging servicers to pursue other means of dealing with a delinquent borrower. The loan servicer handles the day-to-day management of the loan pool for the ultimate investor. They’re responsible for collecting mortgage payments, forwarding the interest and principal to MBS (mortgage-backed securities) holders, and handling delinquent borrowers.

The most common alternative is the short sale, where the homeowner sells the property for less than the outstanding mortgage and the remaining debt is forgiven. The other type of disposition is called deed in lieu, where the lender offers the borrower money in exchange for the keys. Foreclosures are not cheap, and the lender would like to skip the foreclosure process if at all possible.

Foreclosure completions have been steadily declining for a year now, and finished September at 51,000. This is a 39% decline from a year ago and roughly flat with August. It’s less than half the peak in 2010. The states with the highest foreclosure percentages are judicial states, like Florida, New Jersey, and New York. Non-judicial states, like California and Arizona, have largely worked through their foreclosure pipelines. This explains the disparity in home price appreciation by geographic area. The inventory of foreclosed properties fell by 33% from a year ago to 902,000 homes. You can see from the above “heat map” where most of the inventory remains.

Impact on homebuilders

Increased foreclosure activity affects homebuilders, like KB Home (KBH), Toll Brothers (TOL), and Lennar (LEN), by depressing real estate prices and competing with new homes. Lower home prices mean lower average selling prices for builders and appraisal difficulties, and a glut of foreclosures means lower sales. This effect has been apparent in the quarterly earnings reports of homebuilders so far. NVR, which is East Coast–based, reported an increase in sales, but nowhere near West Coast–focused builders, like Meritage (MTH) or Ryland (RYL).