Through the first quarter of 2008, the real estate market in Tempe, AZ has been somewhat immune to the impact of foreclosures – with average house values hovering at around $300k. But since March of this year, we have seen average property values drop in Tempe by $75k – a 25% drop in just eight months. What is going on with the real estate market?

The rapid appearance of distressed properties at the lower end of the housing market (which I would define as under $200k) is the main cause for this change. These toxic properties are “short sales” (properties that are worth less than the amount owed on them), foreclosures and pre-foreclosures. At some point, these properties will end up on the real estate market in a state of disrepair, having been vacant for months due to the protracted nature of the foreclosure process.

An analysis of these properties reveals where foreclosures have impacted property values on the real estate market the most. In all prices ranges in Tempe, these properties represent only 19% of the current market inventory (well below the average for the metropolitan Phoenix area which is close to 40%). But in the housing market of single family homes selling for less than $200k, the number of distressed properties in Tempe (as well as the Phoenix metropolitan area) is close to 60% of the properties for sale.

A year ago I had a list on my website of Tempe Deals. These were properties under $200k that could represent a potential positive cash flow for investors wanting to turn them into rentals. We updated that list every few weeks as these properties were sold. There were usually 4-6 properties on that list. A recent search on the MLS for the same bargains showed that there are currently 124 properties for sale in that category of which 65 are distressed properties.

At a recent presentation, Valley real estate economist Elliot Pollack indicated that the gap between bank-owned properties and private sales was consistently about $40K at the lower end of the real estate market. So property averages have dropped dramatically due to the huge increase in distressed properties that have been “dumped” on the housing market as they proceed through the foreclosure process. Homeowners who want to sell their properties in the same neighborhoods must drop their sales price to get close to the level of the distressed property inventory.

My own experience working with investors interested in foreclosures shows that these properties often need $20 to $40k in repairs to bring them up to the level of the retail housing market – thus the $40k differential between the retail and wholesale market values. Because of the condition of these abandoned foreclosures, they present a greater challenge for first-time home buyers. It is more difficult to get lenders to approve them, so most are bought as cash transactions by investors which keeps the number of owner-occupied homes down and increases the number of rentals in those neighborhoods. First-time home buyers are limited to the retail end of the market. Because of the distressed properties being sold in the same neighborhoods, appraisals tend to be low. Getting the property to appraise at the level of the loan becomes a concern and can hamper the success of the transaction.