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Two years ago, to the delight of investors and the anguish of homeowners, foreclosures regularly sold for 30 percent or more below the price of "normal" homes. How times have change! Now the foreclosure discount is less than half that amount and still headed south.

Foreclosure Discounts Fade Away

Two years ago, to the delight of investors and the anguish of homeowners, foreclosures regularly sold for 30 percent or more below the price of “normal” homes. How times have change! Now the foreclosure discount is less than half that amount and still headed south.

The discounts investors receive for buying homes that have languished in default for months, if not years, are what attracted most investors to real estate in the first place. It was hard to pass up a property priced far below the one next door when all that’s needed to flip it is a little elbow grease and a few visits to Home Depot. Mouth-watering discounts right down the street enticed thousands into investing

In fact, rehabbing often proved to be more expensive than anticipated, making a healthy foreclosure discount even more essential. Investors spent an average of average of $15,600 per property fixing up, for a total of $3.9 billion in 2011, according to the Harvard Joint Center for Housing Studies. As rehab costs have risen over time, foreclosure discounts have gone in the other direction.

Foreclosure discounts, however, were also widely blamed-fairly or unfairly–for lowering home values when appraisers mixed them in with other comparable properties when valuing a home. This practice was so controversial that it contributed to a two-year long, highly charged re-do of appraisal guidelines and today appraisers are discouraged from using foreclosures as comps.

As the discount has declined, the problem with appraisals is disappearing but investors are facing some tough decisions. The latest data, from the National Association of Realtors Realtor Confidence Index survey of 3400 plus Realtors suggests that for REOs the discount has fallen to 16 percent average discount to market, while short sales are selling at a 13 percent average discount. For properties in average or better condition, the discount is now only 11 percent.

According to CoreLogic, when foreclosures and short sales are included with normal sales, home prices are now higher than they would be without distress sales. Excluding distressed sales, home prices increased on a year-over-year basis by 11 percent in June 2013 compared to June 2012. Including distressed sales, prices increased more, 11.9 percent.

Two factors are causing shrinking foreclosure discounts: declining numbers of foreclosures and rising demand, largely due to large scale purchases of foreclosures by institutional investors, who probably can afford to pay more for properties. In markets where large institutional investors have been actively buying large numbers of foreclosures, the discount has virtually disappeared. In the second quarter, REOs and normal homes reached the same sales price in Las Vegas and other markets.

The demise of the foreclosure discount may become a major factor in changing the nature of residential real estate investing. Despite the entry of big investors into real estate, small “mom and pops” still account for the vast majority of foreclosure sales. They are the ones who were attracted to residential real estate investing in the first place by discounts and without them, they will have a more difficult time achieving a return on investment better than they can get elsewhere.

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