Written by Bill Waltenbaugh, as originally published in The Reverse Review.

Q: What kind of impact, if any, do short sales and foreclosures in the area have on the value of a home?

A: This is a great question and one that has certainly become more relevant over the past several years. Not too long ago, during the mortgage boom years, the inventory of foreclosures and the availability of short sales were few and far between. As such, under normal circumstances, considering these sales in the market approach was unnecessary. Most of these “distressed” properties were “rough around the edges” and wouldn’t normally be considered a reasonable alternative by the typical residential buyer. Customarily, these homes were purchased by investors with the intent of cleaning them up, making a few renovations and then listing and selling the property at a higher price for entrepreneurial profit.

However, today’s market is much different. Freddie Mac sold roughly 31,000 previously foreclosed and repossessed homes in the first quarter, a new record for the company as both government-sponsored enterprises shed inventory from the end of last year. To make matters worse, it doesn’t look like things will get better anytime soon. Combined, both Fannie Mae and Freddie hold 218,000 REO properties as of the end of the first quarter1 and the Federal Housing Administration held 60,739 properties repossessed through foreclosure on its books as of December 2010, up 47% from the year before.  With so much “distressed” inventory and sales available, the question remains; how do these properties affect the values of neighboring homes?

The Uniform Standards of Professional Appraisal Practice (USPAP) is the standard appraisers must adhere to when completing an appraisal for a federally related mortgage transaction. This standard requires appraisers to consider all relevant transfers and determine which sales they should use in their analysis to arrive at a credible opinion of value for the subject property. To do this, the appraiser needs to investigate the circumstances of each transaction to determine if any atypical motivations or sales concessions were involved in the transaction. If a transfer involves atypical seller motivations, it probably shouldn’t be used as a comparable sale. However, just because a property is bank-owned, doesn’t mean the transfer didn’t involve typical motivations. These days, many bank-owned properties are in similar, if not better, condition than competing properties in the neighborhood. Given adequate market exposure, the typical buyer in the neighborhood would also consider these properties when in the market for a home.

Although USPAP requires appraisers to consider these types of sales, some states are fixing to make it more difficult. Four states – Illinois, Maryland, Missouri and Nevada – are currently considering legislation that would prohibit or greatly restrict the consideration of “distressed” transfers in an appraiser’s analysis and estimation of market value. Legislation like this can very easily put appraisers between a rock and a hard place. On one hand, appraisers are required to adhere to the requirements of USPAP. Yet on the other, doing so and considering “distressed” sales could get them in trouble with the state.

Despite which side you fall on in regards to the legal wrangling, there is no doubt in my mind that “distressed” properties have an affect on neighboring “non-distressed” homes. One of the main tenets of appraisal theory is the principle of substitution that dictates that a buyer will not pay more for a property than the price of an equivalent substitute property. Given this principle, the value of a property, or any other goods or services for that matter, is limited by its competition. In other words, if any given market has enough “distressed” properties, those properties will have an affect on the value of the rest of the competing properties in the neighborhood.

I like to explain it this way: a good comparable property is one the typical buyer of the subject would also consider when in the market for a home. Essentially, these properties are considered “reasonable alternatives”. They are similar with respect to location, condition, utility and appeal. For the most part, the owner of the property doesn’t matter; a similar turnkey conditioned property from a lender is just as appealing to a similar turnkey conditioned property from the average-Joe homeowner. At the end of the day, it comes down to availability and competition. If there are enough “reasonably alternative” similar properties available at a lower price, the price of the competing properties will need to be lower in order to compete.