Apr032015

Lamentations of a long-term floplord

Many underwater homeowners face recasting and resetting second mortgages and HELOCs. Their options limited, most will be stuck paying off these debts.

One of the most obvious signs of the housing bubble was the willingness of buyers to purchase properties where rents only covered a small portion of the total cost of ownership. Speculators ignore the costs because they plan to make a fortune on appreciation; investors focus on carrying costs and consider appreciation a bonus. Speculators bought houses from 2004-2006; investors did not.rainbow

One of the primary goals of the property analysis system on this site was to prevent a recurrence of the foolish behavior witnessed during the housing bubble. Everyone who buys a property should know the consequences of “plan B,” renting the property. Even owner-occupants face unplanned events, both good and bad, that prompt them to move: promotions or transfers, job loss, or other life-changing events. The property search system on this site analyzes each property for sale on the MLS and displays the cost of ownership and comparable rentals. Everyone who researches properties here knows the ramifications of executing “plan B.”

From Speculators to Floplords

During the Great Housing Bubble, many speculators tried to make money through trading houses. Most of these traders were not professionals but amateurs who thought they could be professionals, and most lost money because they did not understand what it takes to be successful in a speculative market.

Most amateur speculators emulate Warren Buffet and adopt a “buy and hold” mentality where assets are accumulated with a supposed eye to the long term. In reality this is often a “buy and hope” strategy — a greed-induced, emotional purchase without proper analysis or any exit plan. Since amateur speculators have no exit strategy, and since they are ruled by their emotions, they will end up selling only when the pain of loss compels them to. In short, it is an investment method guaranteed to be a disaster.

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When house prices stopped their dizzying ascent, many speculators found themselves with large monthly debt service costs and no income to offset expenses (see today’s featured story). Many speculators chose to quit paying their mortgage obligations and allowed the property to be auctioned at foreclosure. Many other speculators chose to rent the properties to reduce their monthly cashflow drain, and they became accidental landlords. In the vernacular of the time, they became floplords — flippers turned landlords.bring_back_the_bubble

Becoming a floplord was fraught with problems. First, they were not covering their monthly expenses, so the losses on the “investment” continued to mount. For houses purchased near the peak in 2006, rent only covered half the cost of ownership unless the speculator used an Option ARM with a very low teaser rate (which many did).

Becoming a floplord was a convenient form of denial for losing speculators because they believed they were buying themselves time until prices rose again, allowing them to sell later either at breakeven or for a profit. Unfortunately, as floplords like the family in today’s featured article demonstrate, even eight years later, the problem persists.

Another problem floplords faced was their own inexperience at managing rental properties. Most had never owned or managed a rental property, and none of them purchased the property with this contingency in mind. They often found poor tenants who did not reliably pay the rent or properly care for the property. This created even more financial distress and greater loss of property value as the property deteriorated through misuse.

So what happens to floplords that hung on for eight years? They face recasting second mortgages that may finally wipe them out.

What effect are second mortgages and home equity lines of credit having on housing recovery?

by Daren Blomquist, Mar 30debt_wouldnt_die

Plans for second homes don’t always work out

Joe Schwarz is sick and tired of being a landlord.

“The property has pretty much been a nightmare since day one,” he said of a home he bought while a student at Arizona State University in 2007 near the height of the housing market in the Phoenix area. “I’ve wanted to be done with it for years but I couldn’t because of the second (mortgage) to be honest … A lot of people shy away from me because of the second.”

Schwarz said he purchased the property for $165,000, thinking he was getting instant equity given that other similar properties nearby were selling for as much as $199,000 at the time. The plan was to rent the property to cover the mortgage while watching the equity increase over time.

When he made this “plan” did he actually analyze rental rates and compare that to a cost of ownership? Realistically, there is no way he made these calculations (or at least not accurately) because if he had, he never would have purchased the property in 2007. The reality is he thought he was buying something under-market,real_estate_only_goes_up and since real estate only goes up, the idea of renting the property was merely a convenience to reduce the cashflow drain while the value continued to climb. Unfortunately, it didn’t work out as he envisioned.

He purchased using some money he inherited along with a stated-income loan and a second mortgage to avoid paying private mortgage insurance (PMI).

I had to go stated because I couldn’t qualify otherwise because I had a part-time job working at a bar while I was in college,” said Schwarz, who has since married and purchased another property where he and his wife live. “I was told if I do a second you don’t have to pay PMI.”

A part-time bartender was given a loan? I imagine he overstated his income on that stated-income (liar) loan. Do you feel much sympathy for someone who lied to obtain the property?

But about a year after Schwarz purchased the investment property, the housing market tanked and he saw the value of the property drop precipitously, falling as low as $65,000. Meanwhile the original plan for renting to a friend fell through, and although he ended up renting the property eventually, the rental income was barely enough to cover his mortgage payments, not to mention maintenance, vacancies and other costs that come with being a landlord.

American_dream_the_money_pitSo was this friend going to dramatically overpay rent to cover the full cost of ownership? Doesn’t that part of the story seem like a convenient lie designed to cover the fact he didn’t do his homework?

“I’ve never really made any money on the property. In fact, it’s been a huge money pit for me,” he said, estimating he’s invested about $30,000 in the property that he never expects to see again. …

If he waits another 10 years, he might get that money back through appreciation. Of course, if he really added up how much he paid in over what he received in rent, his real losses are much, much higher, and he will never recover the full amount.

“I’m never going to see that money … so why would I want to be any farther in the hole?” he asked. “I have kind of been under the assumption over the past few years that this property was going to be a foreclosure or short sale.

“My wife and I are just tired of it,” he continued. “Just tired of dealing with the property … Being a landlord is not the right thing for me.”

As I mentioned in the opening, many floplords weren’t prepared to be long-term landlords, and since the property is a cash drain rather than a positive source of funds, the owner isn’t getting any positive reinforcement for being a landlord.

Hope fades as home prices plateau

… That slowing appreciation is deflating the hopes of underwater homeowners like Schwarz who have held on for years waiting to regain their equity but who are now ready to walk away, according to full-time Phoenix real estate investor Maria Giordano.

“The majority are in situations where they have a second that is going to adjust,” said Giordano, …

Giordano said the combination of slowing appreciation and a second mortgage — or first mortgage in the case of Schwarz — that is going to adjust in the near future is pushing more of the distressed homeowner holdouts over the edge into selling or even foreclosure.

In the post The dangerous tipping point in favor of foreclosure, I mentioned tepid appreciation as a condition that favors foreclosure. Buyers are more likely to strategically default, and lenders earn less through appreciation than they lose through servicing costs, so slowing appreciation may precipitate more foreclosures.yardwork

Many of these homeowners also have the additional hurdle of deferred maintenance that makes it even tougher to sell or refinance their property.

The two I looked at this week had green pools, just nasty,” she said, noting that these distressed homeowners have been willing to keep paying a second mortgage at a lower introductory rate, but now many are realizing that their payments will soon be going higher. “If you’re only paying $200 to $300 on a second … why not ride that out until you decide, ‘Oh shoot, I have to do something.’”

At this point, he doesn’t have many good options. He should have strategically defaulted six or seven years ago, but he didn’t. Now that he’s gone on with his life and acquired assets, strategic default is more costly. His only reasonable course of action is to see this through. He will have to sacrifice and pay off the second mortgage and sell the property at his earliest convenience. For his sake, real estate prices better keep going up.

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