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   ARTICLE   |   From Scotsman Guide Residential Edition   |   October 2008

Don’t Foreclose on Opportunity

An increase in real estate owned properties brings new possibilities to the housing market

Consumers and venture capitalists alike are looking for signs that the housing market will bottom out. Mortgage brokers who understand varying opinions on this, as well as the effect that foreclosures and real estate owned (REO) properties are having on the market, can better determine this for themselves.

There are many factors that brought the housing industry to its current state -- from overleveraged buyers to nonprime loans -- resulting in foreclosures that likely will continue for several more years. Understanding these factors, as well as the impact of the price to own versus rent, can help brokers better advise clients.

How to Buy

There are three ways to approach distressed properties:

  • Pre-foreclosure sale: When homeowners are in the early stages of default, or pre-foreclosure, investors can buy directly from them. If the homeowners have equity and are motivated to negotiate, they can come out relatively unscathed. 
  • Auction: When the bank forecloses, it can sell a home at auction. This may require a hefty deposit, an as-is conveyance of the property and title, and consummation within short terms. 
  • As real estate owned (REO): Properties that do not sell at auction become REOs. These pose less risk for the average investor because the bank has resolved issues associated with title, other liens and real estate taxes. 

Half-full or half-empty?

Many real estate brokers say now is the best time to enter the market. They point to ample housing inventory and motivated sellers coupled with relatively low mortgage rates as evidence.

One out of every 464 homes nationwide is in the foreclosure process as of this past July, according to RealtyTrac Inc. More than 750,000 homes were in RealtyTrac’s database of REOs, and REOs comprise about 17 percent of the inventory of the market of available homes reported by the National Association of Realtors.

With REOs, as well as short sales, scattered plentifully across many markets, bargain prices are certainly available for discount shoppers.

Conversely, economists point to the Standard & Poor’s/Case-Shiller Price Indices, noting that prices must drop further before it becomes the “best time” to buy. Supporting this premise is the fact that between January 2000 and June 2006, average home prices across 10 major metropolitan markets increased by 226 percent, according to the May 2008 price index.

The run-up

Household incomes did not push home prices up. Between 2001 and 2004, incomes dropped according to a Federal Reserve study, which stated, “The decline in the median [income] for homeowners was only 0.5 percent, but the decline for other families was 6.5 percent.”

As a result, many cash-strapped first-time homebuyers were forced to overleverage. According to the National Association of Realtors, in 2005, 43 percent of U.S. homebuyers put nothing down and borrowed 100 percent. For an average purchase price of $150,000, the average downpayment for a first-time homebuyer was 2 percent.

Typically, 40 percent of the purchase market is driven by first-time homebuyers, according to the National Association of Home Builders. That generally leaves the balance of the purchase market to move-up and move-down buyers, as well as landlords and speculators.

The excessive home-price run-up during the boom was caused by investors, speculators and second-home buyers, however, as they drove 40 percent of the purchase market in that period. Further, the frenzied demand was fueled by loosened underwriting, which permitted lower credit scores, undocumented income and assets, and 90-percent to 95-percent financing.

With the collapse of the market for nonprime loans last year, consumers who need purchase money now are left with agency and government financing. Underwriting standards have tightened. Lenders now require higher credit scores, documented income and assets, and lower loan-to-value financing. Taken together, this shrinks the amount of qualified candidates for home financing.

Defining the bottom

There are several signs to consider when identifying the bottom of the market. These include the impact of homebuyers being limited to agency and government loans, as well as the price-to-rent ratio within a metro market.

First, the bottom in prices likely will come when typical first-time homebuyers can afford to purchase an average-priced home using a fully amortized loan. This can be determined via a calculation that compares the combined household income with the mortgage debt to support home prices. Consumer confidence will not regain traction based on plentiful inventory but rather on affordable prices coupled with sustainable mortgages that retire the debt over time.

Second, the bottom in prices will come when the price-to-rent ratio normalizes. Between 2000 and 2007, the nation’s average price-to-rent ratio increased 60 percent. Rental rates serve as a “gravitational pull” on home prices.

In short, home prices will drop to the historical appreciation rate that can be plotted as its “normal” average. Roll the clock back to 2000 and add the normal annualized real estate appreciation rate for a given community. Moving forward to this year, the number should be less than the 226-percent price run-up. Each metro market will have a different reversion to the mean number and individualized appreciation rates given home type, square footage, age and other factors.

More important, all the credit props have been pulled out from under housing, which means that prices likely will not just revert back to the mean but below the mean.

Finding opportunity

Brokers and their clients who wish to identify, purchase and finance real estate investment opportunities now must conduct greater due diligence. This means retaining the services of a real estate agent who is capable of doing a feasibility study; hiring a contractor to make sure that the property is up to standards and costs are identified before going in; hiring an attorney to make sure there are no title-related issues; and identifying a mortgage lender with the right program.

At the end of the boom, about 69 percent of the U.S. population owned their homes. With the increase in foreclosures and more people moving to rental housing, this rate has already begun to decrease.

The first wave of foreclosures -- at about 8,500 per day -- is taking out the overleveraged and low-credit-score nonprime borrowers, many of whom had short-term ARMs. This trend is expected to continue for a few more years.

By 2010, it is expected that about 21 million homes will have negative equity; this equals about 40 percent of homeowners with mortgages. Some of these white-elephant properties will be among the pool of distressed homes that come on the market as short sales and REOs. Further, those home prices will continue to drop until they reach an equilibrium point where sellers are willing to sell and buyers are willing to buy.

And by 2012, foreclosures are forecast to reach about 6.5 million. Much of that borrower category likely will comprise owners with 5/1 interest-only loans and option ARMs. Both borrower types had similar characteristics: overleveraged income and an inability to sustain the mortgage debt.

Many are seeing opportunities in foreclosures, however. Real estate investment trusts (REITs) will be key players, according to The Wall Street Journal. Some REITs are looking to buy foreclosed-upon houses and bank-owned properties to rent, with plans to later resell.

In fact, Moody’s Economy.com projects that in the next five years, the market demand for rental housing will grow by 12 percent across 54 metropolitan markets. The questions remain, though: Where will these new tenants come from? What objective standards will landlords use to screen new tenants? And what could happen to prospective tenants’ incomes in a recessionary market with an increase in job losses?

Another issue is, with players like REITs in the market, where do private individuals fit in? Private individuals can act on these opportunities if they have solid credit scores and can document their income and assets. It will be more difficult, however, because the bar will be raised.

Those who are resourceful will form partnerships to pool income and savings while also reducing risk. In the latter case, identifying lenders willing to finance purchases by partnerships or corporations may be difficult.

The market is facing new challenges with increased foreclosures and REOs. Brokers who know how to tackle these challenges can best help their clients do the same and be well-positioned when the market bottoms out and makes its way back. 


 


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