Buying and Selling: October 2008 Archives

I keep reading stuff on the internet advising people who are upside down to just walk away if they are a upside down on their mortgage. This has got to be right up there with the worst financial advice I have ever heard.

Here's the thinking: You owe more than the property is worth, and the loan is non-recourse. So the thinking goes that if you just stop making payments and walk away from the property, you're essentially paying yourself the difference.

Not so.

First off, debt forgiveness is taxable income. You borrow $500,000 for a home, that's exactly the same as the lender handing you $500,000. If they only get $400,000 back when the home sells, that's $100,000 of taxable income to you. While it is true that there is currently a temporary amendment to the tax code still on the books at this point in time, it is set to expire at the end of 2008. It is possible that Congress will act to extend or reinstate it, but my guess is that they will not, and if they do, there will be enough exceptions to make it useless for 95% of the people. The lenders really don't like this as it encourages people to lose them money, and contrary to campaign propaganda, it isn't the Republicans who have been dancing to the tune of the lender's lobby. Furthermore, it's already too late to start this process going, as it is the effective date of the final dispository sale which controls the rules in effect. You start right this instant as I'm writing this, and you're looking at something in late February of 2009 if you're exceedingly lucky. Even if you had given the lender a deed in lieu of foreclosure back in June, it still would have been iffy, and most folks force the lender to go through the whole foreclosure process.

Second, your credit is going to take a hit that is going to last up to ten years. Not seven, not two. From Form 1003, the federally required loan application. Every single real estate loan through a regulated lender must use this form. Some of the "Thirteen Deadly Questions" on page four of the form:

a. Are there any outstanding judgments against you?

b. Have you been declared bankrupt within the past 7 years?

c. Have you had property foreclosed upon, or given title or given deed in lieu thereof within the last seven years?

...

e. Have you been obligated on any loan resulted in foreclosure, transfer of title in lieu of foreclosure, or judgment?
f. Are you presently delinquent or in default on any federal debt or any other loan, mortgage, financial obligation bond or loan guarantee?

Look at question e again. There is no time limit. You will be answering that question "Yes" for the rest of your life. If you want your loan approved, even forty years from now, I strongly suggest you have done everything you possibly could to make good on the debt. Judgments typically last ten years, as does the notation, "Settled account." You are going to have a period of two years where lenders can't touch you, even if they want to, it can be ten years before they're willing to take a chance, and you're going to be sweating the fall-out to question e for the rest of your life, because that is cause for extra underwriter scrutiny, and a lender being unwilling to approve even minor variations forever.

Now here's something lots of folks aren't considering: It's true that purchase money loans are non-recourse in California and many other states. That's a good thing, as far as it goes. But there are limitations upon that. One of the limitations is fraud. here's the legal definition of fraud:

All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth. It includes all surprises, tricks, cunning or dissembling, and any unfair way which another is cheated.

Did you "shade the truth" on your loan application? Lots of folks did. Right now, this is a big problem, and one reason why I have always hated stated income loans. Just because the lender doesn't hit it today when the property sells, doesn't mean it goes away. The lender has a minimum of three years to file a suit. They may file a suit even on comparatively small amounts of several tens of thousands of dollars, hoping that you don't show up in court. If you don't show up, the default judgment is entered against you, and that is very hard to overturn. If you lied on your loan application, that turns even a non-recourse loan into a recourse loan. They can go after savings, retirement assets, pension plans, attach your paycheck, you name it. Even if they don't want the rigamarole themselves, they can sell the rights to collect, or even put them out to law firms looking for a bounty on whatever they can get out of you.

Furthermore, if there's some reason to do so, they can pass the paperwork on for criminal investigation. Fraud carries criminal penalties, and it's the government footing all the bills of pressing the case.

Now here is another reason why you shouldn't walk away: If you do so, you are taking all of these consequences and bringing them into the here and now of concrete consequence of actions that have already been taken. But the real estate market is cyclical. Just keep making your payments, and it will come back (it's already starting to rise again here in San Diego, and we're still hip deep in short sales and foreclosures). Maybe there are some exceptions to this, but I'm not aware of any.

Let's look at a personal experience I had with my first property. Bought for $90,000 in 1990, value peaked at $106,000 the next year, then crashed to $63,000. I didn't buy "zero down" like probably the majority in the recent price runup, but the principle is the same. Some people thought they should walk away. Having lived through four previous cycles locally, I just kept on keeping on with the payments. By 1996, the property was worth more than I paid again, and not too long after, people who had just kept on keeping on with their payments were in a position to sell for a huge profit.

Had I sold while the property market was down in the nineties, I would have suffered most if not all of these consequences. By just making the payments, I effectively let time fix the market for me.

By making those payments, all you're doing is sitting on a temporary loss on paper, as opposed to turning it into a hard loss with real world consequences. The paper loss has precisely zero importance - unless you sell while the market is down. The only times the value of the property is important is when you refinance, and when you sell. It doesn't matter what the value is at other times - unless you make it matter by choosing to sell. If you've got a sustainable loan, keep making the payments, and in two years or five, you'll be in a position for make money again when you sell. What's hurting the real estate markets badly is excess supply and low demand, caused by people who have no choice but to sell, and fewer buyers than usual. What happens when these conditions go back to a more normal market? That's right, the prices go back right where they were - if not higher.

Furthermore, if you get out by selling short or through foreclosure, it's not like you're going to be able to jump back into something else any time soon. Absolute minimum two years, as above, and perhaps much longer than that. You jump out of an upside-down mortgage, and you're going to be sitting out the absolute sweetest time to be in the market - right when it starts to recover. You sell or allow foreclosure, and you turn that theoretical paper loss of $100,000 into a real concrete loss of $100,000. That's permanent, and you're out of the market until lenders are willing to take another chance on you, which could be never. But, if you stay in the property, when it starts gaining value again, you're still in the market. I know lots of people that turned $30,000, $50,000, $100,000 or more of temporary paper losses into profits several times the size, simply by holding on and allowing the market time to recover. Profit or loss on an investment is measured solely by price at acquisition versus price at disposition. If you buy for $500,000 and sell for $300,000, it makes precisely zero difference that it was worth $700,000 at some point in the middle. Similarly, if you buy for $300,000 and sell for $500,000, the fact that the property was worthless at some point between is irrelevant to the fact that you still made a $200,000 profit.

If you have an unsustainable loan, there are options to deal with the problem. Refinance if you can. If you can't, call your lender and see what you can work out, or try a loan modification. For their part, lenders are trying to keep the problem from getting worse than it has to be, and every time someone takes a loss because they couldn't hang on, the lenders take the exact same loss if not worse. There are limits to what they are willing to do, but I am amazed at some of the deals they really have accepted because they believe it is better than what will happen if they don't. Which situation would you rather be in: able to hold on and eagerly awaiting the market comeback that's going to happen, and will benefit those than hang on, or stuck with a bad situation permanently because you couldn't stand the thought of being upside-down on paper?

Caveat Emptor

Article UPDATED here

Okay, I'm excited about this subject, which is why two articles back to back on Mortgage Loan Modification. There's a reason. For the first time ever, I am getting access to a tool that will enable me to keep sixty to ninety percent of the people in trouble from losing their houses. This article will talk about what effect it will have on the overall market, even those who aren't in danger of losing their property.

First off, there's the individual angle. If these folks are forced out of their property while the market is down, it turns a paper loss that doesn't really mean anything into a hard loss which has real financial consequences. If they bought for $500,000 and sell for $300,000, or are foreclosed upon, that's $200,000 in real wealth that has disappeared. Split it between the lender and the borrower however you like; it still doesn't do either one of them any good. If they are able to keep making their payments until the market comes back, they will have an opportunity to at least break even. Lots of folks were upside down on our mortgages in the early nineties. We didn't have idiots on the world wide web telling us to "just walk away" as if there were no consequences to doing so. There are very real, very long term consequences. For one thing, the tax forgiveness for short sales sunsets at the end of 2008, and it's the date of the final dispository sale that controls everything. In other words, with about 75 days left in the year, you're probably not going to make it under the deadline if you start right now. How would you like to get a bill for taxes on $200,000? Congress may still take action before the end of the year, but I wouldn't bet on it with the election coming.

Because they are still in the house, they have not converted an unimportant paper loss which doesn't really mean anything to a hard loss that has long term financial and credit effects. Furthermore, they're not homeless, or further straining an already impacted rental market. Finally, by keeping the folks in ownership of the homes, it is giving them a chance to participate in the recovery of the market. We've seen a tiny bit already in some ZIP codes in San Diego county. Furthermore, inventory is dropping in many areas of the county as well. Back in August, there were 107 homes for sale in La Mesa below $500,000. This morning there were 80. San Carlos, El Cajon, and Santee are all showing similar inventory numbers to August, but those numbers are themselves down from earlier in the year. Furthermore, the number of sales in September were up 56% over a year previously locally. Higher demand, lower supply means higher prices coming. If these folks hold on long enough - and you might be surprised at how short a time that will be - they won't be trying to sell while upside down. They'll be a normal, everyday sale, and they'll walk away from closing with money - maybe enough for the down payment on another property. Possibly even enough for the down payment on a better property. Isn't either one of these better than the consequences of a
short sale or foreclosure, to say nothing of the fact that they don't have the humiliation of having to talk about a negative event for the next seven to ten years, especially with their own kids.

By modifying the interest rate, term, or amortization characteristics of the loan, it keeps folks in their houses when the market is glutted with inventory, and buyers are still below expected averages in number. Supply and demand. High supply, low demand. But if we don't add to the problems, the market will work itself out and prices will recover.

Now let's look at the aggregate effect: every time we add a new seller unmatched by a buyer to the marketplace, the price falls. When you're not doing that anymore, the prices stop falling. Maybe they even start recovering. There's only going to be so many buyers over the next year. Every time we avoid adding excess inventory to the market because they absolutely have to sell, we end up ahead of the game. If we can avoid adding more sellers until the excess inventory is gone, prices will start to rise. Supply and demand.

Now let me ask you what happens when prices start recovering? First, a bunch of new buyers that have been holding off for three years now decide it's not going to get any better, and off the sidelines they come. The very fact that these people come off the sidelines, thereby boosting demand, means prices will rise more. And here's the kicker: Once the lenders see prices rising again, they will relax lending conditions a little bit, meaning more people now qualify for a property, and they come off the sidelines also, because the mortgage market controls the real estate market. This is a positive feedback effect - our old friends fear and greed take over as even more people come off the sidelines so they can participate in the resulting orgy of buying. A million people selling for $300,000 when they owe $500,000 is a personal and national tragedy. A million people who used to be upside-down selling for $600,000 when they owe $500,000 is business as usual, and making a profit after the lender and everybody else gets all of the money they are entitled to.

Now to be fair, it also slows the recovery after a certain point, as people who were upside-down can now sell for a profit, and individually, some of them will decide to do just that as soon as it happens. Having been upside-down, particularly upside-down and helpless, is a life changing experience. This will have the effect of a light tap on the brakes upon values just when, if people had not been able to stay in the homes, prices would really be taking off. I think that's all to the good. Anything that helps avoid a repeat a mess like we're working our way out of right now. There is always a substantial portion of the populace driving with their eyes closed, assuming that because a type of investment gained 20% last year, it will do the same thing this year (or because it lost 20% this year, it will do the same thing next year. As anyone over the age of eight should know by now, that conclusion does not follow from the premises.

Caveat Emptor

Every once in a while, a listing agent will get an offer in where the Buyer's Agent did their research, got lucky, or both, and the offer indicates that the buyer is aware of one or more problems that really do exist in a property.

Contrary to most people's immediate reaction, this is a good thing, as I am very happy to explain to my listing clients. It means they know about it and are want to buy the property anyway. Not only can you build a serious case that this means there is no contingency period applying to that particular defect, it means that these buyers are willing to deal with the defect. As opposed to the buyers who discover the problem during escrow, there's a much higher chance of that transaction going through.

Matter of fact, a good listing agent will disclose that problem in the listing itself.

Why in the world would you do something so stupid, you scream? It's really very simple. Pretty much every problem is going to be discovered even if you don't disclose it, and selling a property has a major component of managing buyer expectations. They come to the property expecting a beautiful turn-key property, and when they actually lay eyes upon the thing, it's got this problem. Kind of like picking up what you think is a gold nugget, and finding out it's really donkey droppings. The predictable reaction is revulsion. This is one reason why there may be a lot of showings, but no offers.

You're going to have to price the property for the fault, of course. But if you don't do that, it's not going to sell. Prospective buyers are looking for reasons not to buy your property. Whether they look at it as overpriced or priced correctly but with a fault they don't want, they're not going to put an offer in. No offer, no purchase contract, no sale. It's that simple.

Suppose, as with a property I looked at yesterday, it's not an obvious problem. This thing had been made seductively attractive on the surface, but it was really a cash-sucking vampire property ready to pounce upon an unsuspecting buyer. If you do get an offer where they don't understand and you do get an offer and negotiate a contract, what happens? I'll tell you what happens. Their inspector tells them about the problem. Okay, so they've committed $400 for the inspection, so there's some buy-in, but now they find out about this problem that you should have told them about that's going to cost something in the five figures (possibly six) to deal with. You've just been caught leading them down the primrose path. What's your level of credibility? I think the average buyer is just going to bail out at that point. If they are willing to re-open negotiations, the prognosis is not good for a new agreement. Net result? You've taken the property off the market for a couple days to a couple weeks, and anybody else who may have been interested has crossed it off their list. Furthermore, when it returns to the market, it shows as having been listed that much longer ago, making it less attractive to new buyers coming into the market.

What if it actually gets through escrow and the purchase is consummated without the buyer finding out? That's the worst situation of all, because now the courts are going to get involved when the buyer does find out. Bismarck said that people who like treaties and sausage shouldn't see them made, but if he had ever been involved in a twenty-first century US lawsuit, that would have been first on his list. You're probably going to pay your lawyer more than whatever extra profit you made, and you're going to end up paying their lawyer plus damages as well. Plus, you might very well be ordered to buy the property back. No. Thank. You.

Now, suppose you disclose the problem, and price the property accordingly. You might not get Mr. and Ms. Yuppie looking for the perfect little place for them - but you can quite likely get Mr. and Ms. Yuppie looking for an investment opportunity. You've obviously decided that fixing the problem is not something you're willing to deal with, for whatever reason, but perhaps they are. You have decided you want it sold, and here's the opportunity for that. They know about the problem, and they're interested anyway. It's a matter of managing expectations. Remember up above, where I talked about revulsion? But if your prospective buyer is expecting the problem and prepared to deal with it, they're much more likely to make an offer when they visit. No, you're not going to sell for the same price as the showplace up the block. But you wouldn't sell to that buyer anyway, and trying to do so is one of the biggest wastes of time and money that would-be sellers of real estate talk themselves into.

So an offer where the prospective buyers indicate that they are already aware of an existing problem is not an offer to be blown off. It's a serious offer from interested parties. It is a lot more likely to get the property sold, and it pretty well vaccinates you against later lawsuits on the issue. You can waste your time trying to find and sell to the Suckers of the Century, or you can decide to accept that the property is what it is, and sell to someone who understands the situation from the outset. You're a lot more likely to end up better off in the end result from the latter - because even the Suckers of the Century can get themselves a good lawyer and sue you when they do discover the problem. They are on the hook for several hundred thousand dollars. They're not just going to blow it off and say, "Oh, well," and when they do get that lawyer, they're going to get a lot more out of you than the difference between what you got, and what you could have had without the lawsuit.

Caveat Emptor

Article UPDATED here

This really ticks me off.

I just got done going around about this with a clueless Realtor. According to them, it's not available. It's simply pending contract signatures. But it's showing as "Active" in MLS.

This is not a minor issue. Let me illustrate why. I had my friend call and inquire about the property. He was told it was "available." They wanted to set up a time to get together and show it to him, and were there any other properties he wanted to see?

Now I'm fully aware that this may be an instance where that agent wants both halves of the commission, in which case they are violating their fiduciary duty to their listing client by telling me "We accepted another offer." But I'm going to presume that everything is exactly as they told me, in which case they are still violating both MLS and ethics rules, as well as trade law.

If everything they told me is absolutely true, they are still using the property as bait for a "bait and switch" game. If what they told me was true, they do not in fact have the property available for sale. My client and I did come in and make an offer, but they're telling me that the property is not available. But for those people without an agent who call, they're using it - dishonestly - as a means to gain an audience. This is not a small issue. The hardest issue in obtaining clients is getting that first initial face to face meeting. If someone gets a first meeting with you because they claim to be listing a property that is not, in fact, available, exactly how is that morally different from just making it up ex nihilo?

In fact, they claimed that their listing client didn't want it marked as pending yet. I understand the position they're in, but what the client wants is not on the list of available options. if the property is not available, it cannot be in the Active register. That's what we all have to agree to in order to get access to MLS. That's what the ethics we agree to as Realtors says. If you're not going to play by the rules, you shouldn't have access to MLS, and you shouldn't be able to call yourself a Realtor. There's also a section of commercial law that deals with false advertising. Somebody advertises something people want, the FTC and various state regulatory agencies have grounds to get very interested if you do not in fact have it. You might ask Big Bear supermarkets about that. Such an action is what put them out of business around here. I guarantee that six figure real estate is lot more important than 5 cans of peas for $1 in the estimation of the regulators.

The upshot? I told them to get it off the active list by 9:00 tomorrow morning, or face a formal complaint to MLS and the Association of Realtors. I have a client that wants that property. If it's in MLS, they understandably want to know why their offer is not being considered. If I don't take action, my client will be justifiably curious as to whether I am somehow complicit in whatever is going on. This problem could be more severe than the listing agent is representing it. It could be a fiduciary and agency failure on their part, trying to get both halves of that commission, requiring a client to employ Dual Agency in order to get the property, in violation of fiduciary duty, agency law, and RESPA. It could even be an Equal Housing Opportunity issue. But one thing is for certain: as long as it stays active on MLS, there is something major significantly wrong. This isn't a minor bookkeeping issue. This is the bedrock of what we agree to in order to participate in the system, and someone who cannot adhere to this should not be in the business at all.

Caveat Emptor

Article UPDATED here