Epidemic of short sales depresses home values
by RUSS STEWART
Trends in the Chicago-area housing market, throughout the North and Northwest Sides and in the north and west suburbs, can be variously categorized as good, bad and ugly.
The good news is that selling environment is not as bad as it was in 2005 to 2009. The bad news is that residential home values have declined by 40 to 50 percent. The ugly news is that it’s still challenging impossible for home owners to "buy up" — that is, sell their property, make a profit and buy a bigger, flashier home in a more desirable neighborhood.
The good news is that real estate agents are getting busier. Listings during 2013-14 are up by 10 to 15 percent from 2012. "The market is on fire," a broker said, adding that the inventory of homes for sale "is exploding" and there is "enormous pent-up demand," she said. The bad news is that the purchasers are almost entirely first-time buyers or institutional investors. The ugly news is that the bulk of the availabilities are foreclosure-related.
"Prices have bottomed out and have stabilized," another broker said. "They will now increase yearly."
The good news is that the first wave of home foreclosures has crested and is receding. The plethora of adjustable rate mortgages prevalent during the period from 1995 to 2005 epoch have been purged from the lending system, another agent said. A decade ago, when both the Clinton and Bush administrations proclaimed that "home ownership is a right, not a privilege," lenders were giving 80/20 mortgages with no money down. A borrower would get an 80 percent loan-to-purchase price mortgage, plus another 20 percent "equity" loan, meaning that many buyers could buy a home for zero investment with dubious income, get money back at closing, have a below-market interest rate, and then be required to refinance in 3, 5 or 7 years. If they didn’t do so, a much higher interest rate would kick in. The presumption was that housing values would continue to rise 5 to 10 percent annually and that their "equity" would hit 20 percent in a few years, therefore qualifying them for a conventional loan.
Banks and mortgage lenders were under pressure to loan to minorities, and loan officers got a bonus for every transaction. Often, among Hispanic buyers, the income of the husband, the wife, the parents and the siblings was aggregated to qualify for the mortgage. By the mid-2000s, when the recession hit, unemployment surged and housing prices collapsed. So did the ARMs, which constituted the first wave of mortgage foreclosures.
The bad news is that a new wave is cresting, consisting of those who bought an expensive, heavily mortgaged home during the period from 1995 to 2005, when prices were inflating irrationally, have a principal, interest, taxes and insurance obligation of $3,000 to $4,000 monthly, and have seen their property value decline by 40 to 50 percent. They are "under water." They’re making payments based on a value that no longer exists and that cannot soon be recovered, and lenders show no inclination to modify their loans to lower their payments.
The solution is simple: JUST STOP PAYING. The ugly news is that such a tactic is quite prevalent. A foreclosure spans at least 24 to 36 months, and home owners need only pay the property insurance, meaning that $1,800 to $3,000 stays in their pocket. They live virtually free except for utilities for a couple of years, and when they are finally evicted, they have $20,000 to $30,000 for their next rental residence.
The good news is that short sales are driving the housing market and that lenders are eager to unload homes for 50 to 60 percent of the face value of their mortgage. The very good news is that there are a lot of interested buyers who want to acquire distressed — meaning under-water or in-foreclosure — properties. Since homes can be acquired "on the cheap," first-time buyers and institutional investors with cash or mortgage availability can tolerate the 2 to 10 months it takes to consummate a short-sale closing. Those selling their homes need a 60-day sell/buy turnaround. Those under water can’t sell, and if they are in default, they can’t buy, so cash, "pre-qualification" and patience are king.
The bad news is that short sales skew home prices downward. A home owner with a paid-to-date mortgage or no mortgage will list their property at a certain amount, but a short seller will list at 10 to 25 percent less. Naturally, buyers will buy the cheaper property, if it is comparable. The ugly news is that as foreclosure pile up, with only incremental value increases, a decade of under-water- and foreclosure-fed short-sales.
Even if home prices increase 6 to 10 percent annually, "it will take 15 years to recover" 2005 home values, a broker said.
Here’s how a short sale works: The owner lists the property but has no equity, as the mortgage exceeds the property value. The owner requests a short sale package from the lender, which requires a myriad of tax and financial documents and a "hardship" letter, and stops paying the mortgage. Low-ball offers which are contingent on the existing lender’s approval are submitted to the listing agent, a process which can take months and which requires multiple contract renegotiations. Most short sales go through three or more offers and take up to a year to close. Under federal banking regulations, the number of short sales per lending institution per area is limited, so delays are the norm.
However, neither the lender nor the owner cares. The owner is living free, perhaps for years, and the lender, who has an insured loan, is going to be compensated. Here’s an example: A home is purchased in 2005 for $500,000 and has a $400,000 mortgage and a monthly payment of $3,000. The owner refinances a couple of times, nudging the mortgage to $600,000. It’s now worth $275,000, and the mortgage balance is $580,000. It’s short-sold at $175,000.
At closing, the borrower financed more than 75 percent of loan to value, so private mortgage insurance was required. For federal VA and FHA loans, HUD charges the borrower and provides mortgage insurance; for conventional loans, private insurance is needed.
In a short sale, since the lender is not acquiring the property (as in a foreclosure), a private mortgage insurance claim can be filed after closing, and the lender, depending on the policy, can recover all lost interest, taxes, insurance, foreclosure costs and attorney fees, and the difference between the down payment and 20 percent or, in some cases, 80 percent of the loan. Lenders benefit from short sales, not foreclosures. In the example, the lender could recover 80 percent of $580,000, plus the $175,000.
Every listing franchise real estate agency has a short-sale specialist, and they post availabilities on their Web sites, which are scanned by corporate investors nationwide and by buyers’ brokers looking for a cheap purchase. If the listing broker unloads the property, they get the seller’s sales commission, usually become the buyer’s management agent, collecting the rent, and then get a sales commission when the property is sold.
If, in the example, the home is foreclosed, the lender absorbs property taxes and attorney fees, plus the costs of eviction. Angry owners may strip the property bare, even taking the copper plumbing. At the sheriff’s sale, 2 or more years after filing the foreclosure, the lender bids in at the gross amount due. There’s no private mortgage insurance claim and no profit, and the headache of maintaining and selling a cannibalized home. Hence lenders are eager to dump the home in a short sale, and investors are willing to wait, for months or even years, to buy at a bargain price.
For the short seller, there is a consequence. The lender issues a 1099 for the difference between the mortgage balance and the sale price, taxable as ordinary income. All the seller need do is file a "no assets" affidavit with the IRS and the "income" is meaningless.
The good news, especially for short-sale buyers, is that the Chicago-area home rental market also is exploding. Rental homes are available for a tidy price: two-bedrooms for $1,500 to $2,000 and three-bedrooms for $2,500. Buyers of foreclosed homes are making a killing. The foreclosed evictees and their families need to live somewhere, and they prefer to remain in their areas and school districts.
Assume a California company or investment group buys a property for $175,000. They could put that amount in the stock market and maybe make $10,000 in taxable dividends, or they could buy a house for cash, charge rent of $2,500 monthly, and generate $30,000.
actoring out property taxes and management fees, that’s still a yearly net of $20,000 on $175,000, an 11 percent rate of return, and if values increase 6 to 10 percent annually for the next decade, that property could fetch $400,000 by 2025 — a cool $225,000 profit.
The good news is that interest rates will remain low, in the 5 to 6 percent range. The housing market may be "on fire," but for "non-distressed" property owners and those under water, the future remains glum.
Send e-mail to russ@russstewart. com or visit his Web site at www. russstewart.com.