This piece originally appeared in the November 2022 edition of DS News magazine, online now [1].
As the housing market downshifts, sellers will need to adjust to three emerging distressed disposition trends going into 2023:
- Downward pressure on sales rates at foreclosure auction
- Home price appreciation switching to a headwind for REO
- A shift in buyers toward local investors with a track record of converting distressed properties into quality, affordable housing for owner-occupants
Pressure on Foreclosure Sales Rates
This trend is already emerging in the second half of 2022 as buyers at foreclosure auction bid more conservatively to hedge against slowing home price appreciation and even a possible home price correction in some local markets.
The foreclosure sales rate, which represents the percentage of foreclosure auctions that result in a sale to a third-party buyer, dropped just below 50% in the third quarter of 2022—the lowest level since Q2 2020. That’s according to data from the Auction.com marketplace, which accounts for close to half of all foreclosure sales nationwide.
A 50% sales rate is still high relative to pre-pandemic levels. Between 2015 and 2019, quarterly foreclosure sales rates averaged 38% and stayed within a 10-point range of 34% to 44%, according to the Auction.com data.
As with many trends, the pandemic broke the mold for what was considered normal when it comes to foreclosure sales rate. The supply of properties available to buy at foreclosure auction was severely restricted due to foreclosure moratoria and widespread forbearance early in the pandemic. However, demand for distressed properties barely skipped a beat as buyers quickly experienced a surge in demand for the well-renovated, affordable housing stock they deliver to the market. Additionally, the restricted supply was disproportionately weighted toward vacant properties, which historically attract higher demand from investors.
The supply-demand imbalance in the foreclosure auction marketplace during the pandemic resulted in record-high foreclosure sales rates. Nationwide, the foreclosure sales rate hit as high as 63% in Q2 2021, and it was much higher in some local markets.
However, the retail housing market is now quickly cooling in response to skyrocketing mortgage rates, causing distressed property buyers to recalibrate their calculations for maximum bid at foreclosure auction. A sales rate that continues to be near 50% despite these headwinds is a testament to increased transparency and buyer-inclusivity at foreclosure auction thanks to technology such as Remote Bid and Foreclosure Predict.
“You have to be careful about fixing and flipping that you’re not catching a falling knife,” said Paul Lizell, a Florida-based real estate investor and coach who purchases distressed properties from Auction.com.
Lizell said he’s lowered the starting point for calculating his maximum bid by five points, from 75% of estimated after-repair value to 70%. Additionally, he’s upped his rehab calculations by $10 a square foot, to $35 for resales and $25 for rentals due to the rising costs of materials and labor.
Lizell’s bidding adjustments align with overall bidding behavior on the Auction.com platform. Foreclosure auction buyers purchased at an average discount of 23% below the estimated as-is property value nationwide in the third quarter of 2022, an increase of 12 points from six months earlier, according to Auction.com data.
The recent increase brings average purchase discounts back to pre-pandemic norms. The average purchase discount at foreclosure auction was 22% between 2015 and 2019, and the discount was relatively stable over that five-year period, staying within a six-point range between 20% and 26%. This reversion to the pre-pandemic mean is evidence that investors are not yet anticipating a nationwide home price correction.
“I don’t think we’re going to see that big drop-off (nationwide) unless unemployment rises a lot,” Lizell said, adding that he thinks some select markets will see a correction. “Where you’ll see those prices fall … Southern California, Las Vegas, Arizona, and Florida will be hit.”
More conservative bidding behavior at foreclosure auction is putting downward pressure on the sales rate, but pro-active servicers are already adjusting pricing downward to maintain a sales rate close to 50%. That 50% foreclosure sales rate threshold has proven to produce the best disposition outcomes—not only for servicers in terms of lower loss severity and REO risk, but also for distressed homeowners in terms of equity protection and for surrounding communities in terms of higher homeownership rates, higher property values, and quality, affordable housing.
Price Appreciation a Headwind in REO
Maintaining an elevated foreclosure sales rate—at least compared to pre-pandemic levels—of about 50% will also help servicers pro-actively adjust to the second disposition trend emerging in a cooling retail housing market: home price appreciation switching from a tailwind to a headwind for properties held as real estate-owned (REO) inventory.
An elevated foreclosure sales rate helps mitigate the risk that holding REO inventory will be akin to catching a falling knife in markets where home prices turn negative. Instead, more of that risk can be transferred to the local community developer buyers purchasing properties at foreclosure auction and REO auction. Given their proximity to the frontlines their local markets, these local community developers are well-equipped to manage that risk and most efficiently convert distressed homes into quality, affordable housing for owner/occupants—even in a slowing market.
The likelihood of a home price correction is growing, particularly at a local market level. Home value forecast data from Zillow shows home values decreasing in the three-month period between August and November in 552 out of 896 metropolitan statistical areas nationwide (61%), including New York, Los Angeles, Chicago, Dallas, and Houston. The same forecast data has home values decreasing over the next year in 259 of the 896 markets (29%), including New York, Los Angeles, Chicago, Washington, D.C., and Boston.
In late 2020 and 2021, heady home price appreciation averaging 17% annually—and much more in some local markets—helped cushion the negative impacts of holding and maintenance costs associated REO inventory. As price appreciation reverts to more historically normal levels—or even turns negative in some markets—time in REO inventory joins holding costs and maintenance costs as a headwind against lower loss severity for distressed dispositions.
This again points to foreclosure auction as the ideal disposition channel in a slowing housing market. A property sold at foreclosure auction spends zero days in REO inventory.
But not all properties are good candidates for selling at foreclosure auction given that venue’s limitations—a one-and-done auction with no interior inspection available. For those properties, an immediate post-foreclosure REO auction (known as Day 1 REO) provides the best opportunity to keep days in REO inventory to a minimum and thereby minimize the impact of the home price appreciation headwind.
A Shift to Established Local Buyers
The growing likelihood of a home price correction in more local markets also represents a growing risk for distressed property buyers—especially to the extent that pro-active servicers transfer the risk to these buyers in the form of earlier dispositions at foreclosure auction or REO auction.
A rising risk profile for distressed property deals will likely sideline some newer and less established distressed property buyers who have a lower risk tolerance. Those buyers have less margin to absorb losses. On the other hand, this environment will likely attract more action from well-established local buyers who have weathered previous down cycles in the real estate market.
Early evidence of this trend is showing up in Auction.com buyer data. In the first seven months of 2022, 80% of Auction.com buyers purchased just one property on the platform.
Those buyers represented 53% of purchases in that timeframe. This is down from the first seven months of 2021, when 86% of buyers purchased just one property and those one-property buyers represented 64% of all purchases.
Conversely, buyers purchasing between two and 10 properties in the first seven months of 2022 accounted for 38% of all purchases, up from 30% in the first seven months of 2021.
The slightly higher volume of purchases indicates a more established investor, but these investors are still relatively small-volume local community developers. The median distance between buyers and properties purchased on the ADC platform in the first eight months of 2022 was 20 miles, down from a median of 23 miles in the first eight months of 2021.
Atlanta-area investor Tony Tritt is a good example of a well-established local real estate investor. He started investing in real estate about 25 years ago and has grown that into a small business that employs 11 full-time staff and keeps construction crews of more than 20 people busy renovating the 35 to 50 properties he buys each year. He has averaged five foreclosure auction purchases a year through Auction.com over the past decade.
“It was different the last several years because you’re in a rising market … that makes it a little easier because you’re buying off today’s numbers,” said Tritt, who contends that some bandwagon investors of the last few years have been overpaying for homes purchased at foreclosure auction. “(Now,) I give myself some room in case it goes down.”
Established local community developers like Tritt are not to be confused with the Institutional Investors that scooped up thousands of properties at foreclosure auction. Those investors have largely exited the foreclosure auction marketplace and turned to the retail market and bulk purchases from other institutional investors as their primary acquisition channels.
Public record data from ATTOM Data Solutions shows investors purchasing 10-plus properties a year accounted for 9% of purchases at foreclosure sale in the first nine months of 2022, down from 12% in
2021 to a new record low since 2000, the earliest year data is available. By comparison, 52% of foreclosure auction sales went to these buyers at the peak of the last foreclosure crisis, in 2009.
Many of the institutional buyers purchasing during that last foreclosure crisis were holding properties as rentals. That is not the case for the established local community developers like Tritt, who has renovated and resold 70% of the properties he purchased on Auction.com since 2016, based on an analysis of public record data. Ninety-one percent of his resales went to owner-occupant buyers.
Most other Auction.com buyers are also reselling a high percentage of properties to owner-occupants. An analysis of more than 150,000 properties sold at foreclosure auction on Auction.com between 2016 and 2022 shows that 53% have been renovated and resold, with 73% of those resales going to owner-occupants.