California home prices continue to rise. So why are there still so many underwater homes?

The share of homes suffering from negative equity — a mortgage balance higher than the home’s current fair market value (FMV) — continues to decline each quarter. In California, just below 7% of mortgaged homes are still underwater as of the fourth quarter (Q4) of 2015. This amounts to 450,000 homes, down from a devastating 2.5+ million back in 2010.

The steady decline is great news for agents and brokers. More homeowners with positive equity directly translates to more buyers and sellers freely active in the market. But the bad news: the decline has started to level off over the past year, signaling that the hundreds of thousands of homeowners still unable to sell may be stuck in their predicament for quite some time to come.

A new report by Zillow claims San Francisco and San Jose have the lowest negative equity shares of any metro area in the nation, at 4.4% and 2.8% respectively. This is not particularly surprising considering the Bay Area’s disproportionally quick rebound from the Great Recession, fueled by strong employment.

However, the situation gets more dire throughout California — particularly inland and in less populated areas in the center of the state. Negative equity in the rest of the Golden State has a larger impact at:

  • 6% in Orange County;
  • 7% in Los Angeles;
  • 8% in San Diego;
  • 10% in Santa Barbara;
  • 13% in Riverside;
  • 14% in San Bernardino;
  • 17% in Fresno; and
  • 20% in Kern County.

Further, many positive equity homeowners are still stuck without enough equity to allow them to pay for transaction costs (approximately 6% of the home’s value) to sell and purchase a new home. Zillow calls this the effective negative equity rate, and estimates 30% of homeowners are in effective negative equity nationwide.

The future of underwater homes

Will negative equity ever disappear from the market?

No, it won’t. Whenever prices decrease locally, recently obtained homes purchased with low down payments dip into underwater territory. Further, the moment a home is purchased it is essentially in an effective negative equity state when taking the transaction costs to immediately sell the home into consideration. Still, the bulk of underwater homes today are vestigial leftovers from the price bust at the conclusion of the Millennium Boom, as the nationwide average underwater home with one lien has a mortgage balance 137% of its home value, according to CoreLogic.

But home values rise on average about 3% each year. Thus, the negative equity epidemic will subside in due time. By these estimates, the last underwater home to be purchased at the height of the Boom will likely regain positive equity and glimpse solid financial shores around 2020.

Before this occurs, many homeowners will give up and choose to strategically default so they can rid themselves of their black hole asset. A rise in personal bankruptcies is typical at the tail end of a recovery, but the increase in strategic defaults won’t surge to the significant levels experienced during the recession.

In the more immediate future, expect the number of underwater homes to actually increase slightly in 2017. Home prices are expected to falter in 2017 in reaction to slower sales volume and rising mortgage rates. Therefore, homes purchased in 2016 may experience a brief dip underwater before recapturing equity later this decade.