Tuesday’s measure of June home prices from the S&P/Case-Shiller 20-city index is likely to turn positive when compared with one year ago for the first time in two years, according to a forecast by Zillow Inc.

Prices have risen this summer for a simple reason: more buyers have chased fewer properties. But the drop in supply and the boost in demand isn’t the only reason that Case-Shiller is now turning positive. Another related factor is that the share of non-distressed home sales is rising and the share of distressed sales—foreclosures and short sales, mostly—is falling.

(Case-Shiller reports prices using a three-month moving average with a two month lag. Several other home price indices have also shown bigger-than-usual price gains for the second quarter.)

The decline in the distressed share is important for the housing market, and especially for home-price indexes like Case-Shiller. Because banks are faster to cut prices to unload inventory than are mom-and-pop sellers, home values can fall further as the share of distressed sales rises. This was the case throughout 2008, as home price declines were in virtual free fall amid a cycle of rising foreclosures.

A report last week from economists at Goldman Sachs tries to quantify the share of the decline in home prices that can be attributed to the rise of distressed versus non-distressed homes. They conclude that this “mix shift” is responsible for around one third of the 34% decline in home prices since 2006.

While distressed homes normally account for around 5% of all home sales, the distressed share reached a peak of nearly 50% in early 2009, as the housing market unraveled. The share normally falls during the stronger spring and summer months, when there are more mom-and-pop home sellers, while it rises during the seasonally weaker autumn and winter—though it hasn’t gone as high as 50% since 2009.

The share of distressed sales is still high by any historical comparison. But importantly, it is falling when compared with one year ago, which is a big reason why home prices, as measured by the Case-Shiller index, are rising again. In June, the share of non-distressed sales, meanwhile, was at its highest level since August 2008, according to CoreLogic Inc.

In May 2012, around 25% of all homes were distressed sales, down from 31% one year earlier, according to Goldman. Moreover, Goldman estimates that banks are losing less money on distressed sales than they have in the past, in part because banks are pushing short sales more aggressively. The average distressed home sold at a 20% discount to comparable non-distressed homes, an improvement from discounts of 25% to 30% earlier in the crisis.

With distressed homes yielding smaller discounts and fewer distressed sales coming on the market, home prices have stopped falling. In May, for example, the Case-Shiller index showed that prices were down by 0.7% from one year ago. Without the change in the distressed share, prices would have been down by 2%, Goldman estimates.

Local markets provide even better examples of this. Home prices have risen most sharply in Phoenix, where foreclosures accounted for 27% of home re-sales in May, down from 50% one year ago and 66% three years earlier. Goldman estimates that of the 11% home price increase over the past year in Phoenix, around five percentage points—or 40% of the total—is due to the drop in the distressed share.

Goldman economists Marty Young and Hui Shan note that returning to a normal share of distressed sales “will take several years.” But they add that the market is moving slowly in the right direction, which is “one reason we believe the Case-Shiller house price index has passed its trough and is poised for modest growth going forward.”

So will prices soften later this year? Usually they do because there are normally fewer traditional sellers competing with the banks and other distressed sellers after the summer ends. In each of the last three years, rising prices in the spring has given way to falling prices heading into the fall.

But right now, low levels of homes for sale, particularly foreclosed properties, mean that prices “will not fall in this year’s off-season, or at least not as dramatically as in recent years,” writes Mark Fleming, chief economist at CoreLogic.

The lesson here: to figure out where home prices are headed, watch the share of distressed sales in your market. The pace at which banks move to repossess properties and the strategies they use to work out troubled mortgages will have great weight on home prices going forward. Even more important will be whether housing demand weakens, stabilizes, or grows stronger in the coming year.

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Source: http://blogs.wsj.com/developments/2012/08/27/why-home-prices-are-rising-the-distressed-share/