by guest contributor, Peter Fugiel, Ph.D.
The real estate bubble has not only disrupted the U.S. lending system. Five years into the great shakeout, and there appears to be second fundamental kind of damage threatening the U.S. housing market.
The loan servicing industry is at risk of breaking down. Anticipating three to five more years of record foreclosures and lender workouts, the question has to be raised. How can communities maintain their tax bases in the face of a growing number of distressed properties, which are not being disposed of in a timely fashion? Unless the housing system can find a way to pay mortgage companies to keep distressed properties well-maintained, many of these distressed assets will begin to waste. Those losses will spread from the lenders to neighborhoods, and eventually, to astonished U.S. communities facing huge property tax losses.
The distressed property crisis has spread to the suburbs: Three years ago, this column talked about three important Chicago metro communities and how well their moderately priced housing markets had fared. Located thirty miles out from the center city, with plenty of open land, Aurora, Joliet, and Elgin are typical ’hub suburbs.’ All three are now among the top ten largest Illinois cities. They have grown rapidly for over twenty years, and have seen their demographic profiles change in the process. Unquestionably, they have great potential – and until the real estate bubble burst, they had very positive housing profiles. Home values had risen steadily, and there was a good supply of very affordable condo units all well, especially in Joliet and Aurora.
Record foreclosure filings and late loans threaten the loan servicing industry: In the past five years, these three communities, combined, have experienced over 15,000 foreclosure filings from lenders. Among the more than 300 Chicago metro communities for which numbers have been reported, these growth center towns now rank first, second, and third for having the highest number of distressed home loans.* As a result, home and condo prices have fallen far below market levels that were expected at this point in the economic cycle. Distressed home sales constitute more than half of all local market sales, with no relief in sight. Overall, the distressed loan inventory in the Chicago metro area, as in many other higher priced markets, may stretch for three years or longer. Many suburbs will be impacted all over the country.
… the shadow inventory overhanging many big U.S. home markets is posing a tax crisis for many local communities.
Key question: who pays to maintain a distressed property? If a lender can’t dispose of a property for a sales price close to the amount of the mortgage, the temptation will be to let the owner stay in the property, with or without their paying ’rent.’ After a year, however, it is not clear that the residents/owners are still motivated to maintain the property in marketable condition. And even though the local community may be aware that the property is distressed, the community has no way of knowing what the future will bring. If the unit’s current market value is way under water, the loan servicer takes a risk that its costs in servicing the loan will not be recovered. In a worse-case scenario, the servicer will simply hand the keys back to the residents and let them cope with ongoing maintenance, back taxes, and any municipal violations. The foreclosure process would have stalled out, and the community will then face a devalued property that it does not want to have boarded up. The state government’s attempt to assist the owner can easily turn into a tax crisis for those 40% of metro communities that have high numbers of foreclosures. No one is tending to the property and its declining value.
A look at some stats: Nationwide, 2% of all home loans are in foreclosure and another 2% are seriously late and could go into foreclosure. Before the bubble, both of these numbers combined would be less than one half of one percent. Depending upon the market, the distressed property overhang is at least eight times the usual level. The nationwide overhang of distressed loans is equal to a 30-month supply of distressed property sales. Local prices will not recover enough for many lenders to get their loan money back. This has become a market crisis, beyond the lending debacle. And the towns are in the crosshairs of a big problem.
A new wave of foreclosures: With local markets dominated by the sale of distressed properties, prices can’t return to the levels that the industry expected as the economy improves. In fact, more homeowners are thinking about ’strategic defaults,’ where loan payments are no longer made in order to save cash and in anticipation or either walking away from the property or filing personal bankruptcy. This second wave of distressed properties was not anticipated, and it may well indicate that our traditionally scrupulous mortgage servicing industry is being overwhelmed with this kind of very late loan volume, some of which is being caused by serious price declines. We cannot expect the servicers to take a loss waiting around for better days.
More than eighteen months is too long to wait: The common sense of this distressed property scenario is plain: Home units are as difficult to manage as rentals. Residents who are living in a property where they are in legal and financial limbo are likely not to maintain the property. Even though laws have been passed to protect homeowners from hasty or unfair legal actions, communities now have to think of what kind of properties they are going to be left with after even one year of delinquencies. Obviously, those neighborhoods and communities with a pattern of distressed units stand to bear the greatest risk to community health and safety standards.
New collaboration between the states and lenders: This second wave of distressed properties needs to be handled according this new “all-hands” mantra: “By all means, help the distressed household, but don’t lose sight of the value of the unit.” With this unanticipated new wave of distressed properties, the interests of homeowners and the communities have to be balanced. The time lines of distressed property resolutions have to be shortened. State governments have to listen to the lenders about what they may need to keep properties viable.
Reducing loan amounts to reflect market values: The easiest compromise is to allow the current owners to stay, or to rent until they could own. Adjustments to lender principal may be necessary for the sake of keeping the unit habitable and community integrity intact. Some opinion might have it that loan balances should never be adjusted. However, the shadow inventory overhanging many big U.S. home markets is posing a tax crisis for many local communities. And local community viability is a whole a separate issue which has nothing to do with bad lending or poorly conceived mortgage products. Towns should not have to bear the brunt of lender profligacy and local markets should not have to suffer waiting around for lenders to get a better price.
Lenders are under financial stress now; towns will be in the future: If a lender cannot afford to keep the mortgage servicer interested in doing a good job, almost by definition, the lender should liquidate the asset as quickly as possible. No lender has the right to allow an asset to waste, while waiting on a private capital market to return to pre-bubble levels. Investors who purchased real estate that is being held in exotic investment pools have to recognize what the rest of the economy has already learned. This real estate shakeout is bigger than anyone could have expected – eight to sixteen times bigger, depending on the market. That is principal loss territory, especially for sub-grade and second-loan investors. Waiting for the local market to recover jeopardizes the community’s safety and well-being.
Timeliness matters: U.S. local governments are in no position to allow real estate assets to waste. These distressed properties, and the properties that are nearby, currently have some real economic value. These homes need to be paying taxes to support the services that lenders rely upon. Hopefully over time, as the markets witness the lenders write down loan principal amounts – loan reductions that unit owners need, and price reductions that many buyers are waiting for – overall market prices will stop falling. Local markets will begin to reflect a healthier balance between normal supply and regular demand.
And that would be for the best, both for local real estate markets and for the communities they serve.
About the Author
Peter Fugiel is a 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.