by guest contributor, Peter Fugiel, Ph.D.
As the record number of foreclosures continues to put pressure on U.S. housing prices, it is clear that any residual property value to be found in the local markets rests with the viability of local communities and the neighborhoods that comprise them. At this juncture in the real estate cycle, towns are going to have to insist that bare minimum property standards be maintained by every lender. Consequently, towns are beginning to develop an interesting array of property maintenance techniques, both to protect neighboring property integrity and to preserve community-wide home values.
The real estate shakeout continues
Recently, all three national rating services have predicted that U.S. home prices will continue to be under pressure from the accumulated backlog of distressed home loans. As the various segments of the U.S. lending industry finally begin to dispose of their backlog of distressed properties, towns and state governments alike are responding to the continuing demands placed on their services. The big question among local policy makers is whether some lenders are even up the task of caring for the many distressed assets for which they are legally responsible.
The consensus forming among localities is that, by definition, a distressed property that is not rented and remains empty, and then is not maintained – is prima facie evidence that the particular lending institution is incapable of observing bare minimum community standards. In such cases of lender incapacity, it will be up to the impacted community to enforce code, safety, and notification requirements.
Under the new rules of direct community involvement with under-managed properties, the community will perform services for which they will need to be compensated. When a distressed property is finally disposed of, the policy consensus is forming that the community should have a first claim (after taxes) to any sale proceeds to pay for its maintenance and related costs, as well as all owner/lender distressed property notifications.
“Shadow inventory” will dominate the next two years of home sales
Last month, Standard & Poor’s announced that there was an accumulated backlog of distressed properties that would need to be liquidated. Specifically, the agency was talking about one specific set of lenders, the so-called “private-label” mortgage pool securitizations that were sponsored by the leading Wall Street firms, among others. The agency has estimated that approximately one-third of this entire lending inventory is currently non-performing. It would be necessary to dispose of these properties, either through short sales or court proceedings. In either event, the agency estimated it would take on average, another three years to liquidate that volume of properties. In some markets, it could take longer. In New York it might be ten years; in Chicago, four years.
Prices on lower-end home units will need to be adjusted downward
One of the common misperceptions about Standard & Poor’s bellwether Case-Schiller Home Price Index is that it is necessarily an accurate indicator of the value of all types of U.S. home units. In fact, the index in recent years has been a better indicator of those units that were financed by this very kind of private label and national bank securitizations that flourished during the real estate bubble. As a result, the properties in the S & P index in recent years tend to represent certain highly leveraged sub-markets, including those in the nation’s very largest urban areas.
In fact, the Case-Schiller Index includes only twenty U.S. markets. And in some of those markets, like Las Vegas, Phoenix, and Miami, the worst aspects of real estate speculation occurred. If anything, the best U.S. homes are not being sold in this depressed market cycle, since few of the best homes were highly leveraged in the first place.
For example, in the affluent Chicago suburbs, the higher the household income, the fewer is the number of the local foreclosures. The type of properties that are sold in a real estate depression are, by definition, self-selecting.
Which markets could continue to be affected?
The rating agency has been talking about the very largest of its sample markets being affected by the shadow inventory. These include New York, Los Angeles, Chicago, San Francisco, Boston and Seattle. With unusually high home prices, and local concentrations of highly-leveraged properties, it is understandable that lenders in these top markets have hesitated about foreclosing on their very largest home loans, and in markets with unusual concentrations of distressed properties.
Failed federal attempts to induce loan refinancing, rather controversial back-office servicing glitches and conflicting first and second legal claims to properties, have each compounded the settlement problem for lenders. Interestingly enough, those U.S. markets that adjusted the fastest currently have much smaller unsold inventories. In markets like Cleveland and Detroit, lenders were not waiting for prices to stabilize. And in some states like Arizona and Texas, a seriously late loan is an automatic foreclosure.
Not all lenders and not all housing units are affected by this shakeout
The U.S. home loan industry is a complicated mix of players and sponsors, federal agencies and gigantic national banks. It turns out that the private label securitizations that the rating agency is talking about represents only one-fifth of the national mortgage market. The U.S. banks represent another fifth, and the two government-sponsored enterprises (GSE) – Fannie and Freddie – represent another 40%. The remainder of the market is comprised of investment companies and savings banks. Currently, the average U.S. loan-to-value ratio is 70%.
While each of the lender types is important, the quality of the loans they hold varies. Private label and large bank loans tended to be riskier, have higher leverage, and are still resulting in substantial losses. The GSE loans are generally considered to be “better made” loans. Unfortunately, the GSE’s have to rely on the banks to service their loans.
And in many instances, GSE loans where there is also a bank equity loan are difficult to settle. This is due to the conflicts that exist between first- and second-lien holders. Obviously, some banks are reluctant to foreclose on a property when their second lien will be extinguished.
Finally, many U.S. homes have low leverage, and would not likely be sold in a bad market. These homes often represent the best properties in an established community. Needless to say, if the best, and least distressed properties are not sold in a difficult market, “market” prices will be skewed by the predominance of only certain kinds of units, condos for example.
Five kinds of properties: Which ones are in your town?
Of the five kinds of properties represented by the U.S. lending industry, it is difficult to say which loans can be found concentrated in any one community. Still, the broad contour of which institutions made risky loans in what communities is pretty well established by now. In the Chicago metropolitan area for example, approximately seventy communities have experienced more than 700 foreclosures in the past five years. That means the distressed loans are concentrated in perhaps one- third of the local real estate markets, in both City and suburban locations.
Predatory lending/”no doc” loans: These loans were made outside state regulatory rules in many big city communities. This happened because the lender was part of a nationally-supervised U.S. bank, or the lender was part of a non-bank Wall Street firm that that had its own lending and securitization rules. In general, these loans were the first to default, especially in over-priced metro neighborhoods. Because of the huge losses involved with this book of business, however, the remaining inventory of non-performing loans has accumulated. Disposition of the remaining bad loan book will continue to affect over-priced metro sub-markets, including moderate-income suburbs and exurban regional centers.
Standardized GSE loans: These loans were made throughout the country and can be found in those markets characterized by the high leverage that was allowed at the height of the real estate bubble. Because both Fannie and Freddie had continued to receive broad power from the U.S. Congress to “expand their affordable book,” many suburban communities will be affected by the eventual disposition of this inventory – that is, once and if the banks proceed with foreclosure.
Lower leverage loans and properties without mortgages: Many older suburbs and established city neighborhoods are characterized by higher concentrations of stable ownership and older properties. Because the sales cycle in this recession will be characterized by distressed properties being sold, prices will reflect the lower half of property quality in many communities. In effect, with approximately 40% of all U.S. homes affected by high leverage, the ’median’ U.S. home will not have sold in this distressed real estate cycle. As a result, in today’s real estate market, what the appraisers working for lenders are seeing is not what the tax assessors see every day in the rest of the community.
Communities can protect themselves
Most housing market analysts assumed that the real estate bubble would follow its expected capital market cycle, as do all market adjustments. But because there turned out to be ten times as many distressed properties than is usually the case, it will take a decade to clear the markets, especially the big urban ones.
However, there are positives to report. Many banks have learned how to dispose of properties through the short sale, which does not require a foreclosure. Some lenders, including Fannie Mae, now prefer to rent a property to the former owner in exchange for the title. Cash investors help clear the Sunbelt and spec markets once the prices on the distressed units are appropriate for rental income.
Still, all communities need to become proactive about the condition and maintenance of any distressed unit located within their borders. This is especially true if the distressed unit can’t be disposed of easily or if it is going to be rented for a long period of time.
Some of the techniques being developed both by state legislatures and towns include the following:
- liens put on properties for town maintenance and repairs;
- ongoing code enforcement;
- nuisance abatement; and
- notification and registration costs.
Towns increasingly are expecting these costs to be paid ahead of any capital distribution to the lenders.
In general, with this large a number of distressed properties involved, it is important that localities track their distressed home inventory. Inevitably, many towns will have to see what other public finance tools they need to use to respond to the real estate shakeout. This could be everything from property receivership to demolition, from wider neighborhood stabilization efforts to complete area redevelopment.
What is new about this gigantic real estate shakeout?
It is rare that this nation’s capital markets are treated to a simultaneous bout of poor lending and non-regulation. In the case of the U.S. home market of the past decade, there were three separate types of lenders that were “pushing-the-envelope” at the same time. The national banks took advantage of a regulatory loophole and originated loans without following state regulations. The Wall Street loan securitization firms flaunted household credit rules. And the influential federal agencies risked the precious U.S. guarantee system with their private enterprise profit goals cloaked in the mantle of providing more affordable lending.
As a result, a much wider array of U.S. communities will have to cope with the consequences. Just as an example, in the sprawling Chicago metropolis, long-time distressed inner-city neighborhoods have approximately the same number of high-leverage loans as can be found in the newest of communities, located out on the suburban fringe. High concentrations of non-performing condo loans can be found in city high-rise buildings and in suburban downtowns. The real estate bubble period, from 1997 to 2015, will turn out to be the mother of all real estate shakeouts. This particular shakeout has no respect for metro location.
The impact on communities
It might be said that this post-bubble decade will prompt the most important community development changes to happen in U.S. metro areas in the past fifty years. While the temporary loss in modest unit prices poses an enormous threat to the integrity of U.S. communities, it also presents unparalleled opportunities for community planning and for redevelopment. As a result, very few towns will be the same at the end of this decade. Like the freeways of the fabled ’50s, the real estate shakeout will have unintended consequences for planning and metro development that few of us can imagine.
For a detailed examination of municipal government responses to the distressed home inventory, see the excellent three reports released this year by several Chicago metro policy groups at Business and Professional People for the Public Interest.
About the Author:
Peter Fugiel is housing and public finance consultant in Chicago. He holds a Ph.D. in government from Northern Illinois University. Peter’s latest research specialty focuses on sub-market (community-based) real estate research, called Metrometrics. It combines community real estate market analysis with municipal bond credit research. Peter was a long-time municipal bond housing analyst, who helped pioneer the supplement to federal HUD programs with the self-financed state housing agencies.