Part I of this article reviews an agent’s counseling of a negative equity homeowner by analyzing the owner’s net worth in a balance sheet, and the agent’s advice on asset management for the residence. For Part II, click here.
Underwater property: the family’s black-hole asset
The Great Recession wiped out trillions of dollars of home asset wealth across the nation. However, few states experienced the severe rise and fall of prices in the real estate market as acutely as California. This financial carnage was avoidable, but only by way of anticipatory intervention by federal agencies leaning against the boom tide. [For more information concerning the Federal Reserve’s pre-emptive use of monetary policy to avoid the next real estate boom, see the October 2009 first tuesday article, Preventing the next real estate bubble.]
Following the events of 9/11, the Federal Reserve (the Fed) prematurely aborted the nascent recessionary cycle they commenced mid-1999. Without completion of the routine recessionary cycle, which was just beginning to correct real estate sales volume but had not yet brought asset price increases under control, real estate prices continued to balloon.
As a result of the Fed abandoning this corrective, recessionary action, home prices rose at an unsustainable pace, finally peaking in California by mid-2006 after a run-up in prices which began in 1997. In the wake of this price blow-off, California homebuyers who took out purchase-assist loans or refinanced during the boomlicious years following 2002 were individually left with hundreds of thousands of dollars of negative equity.
To compound the difficulties of clearing the market of toxic loans and insolvent homeowners, the federal government’s 2009 Home Affordable Modification Program (HAMP) has given lenders absolutely no impetus to clear out their toxic loan portfolios or provide any type of long-term relief to California’s negative equity homeowners. Thus, lenders give negative equity homeowners with a loan-to-value (LTV) ratio of more than 125% the extend-and-pretend cold shoulder, refusing to discuss a modification of any terms, much less a cramdown of the principal balance of the loan. To stop foreclosure, principal on the homeowner’s loan must be reduced to 94% of the current value of the underwater property – the homeowner’s only honest shot at becoming solvent and remaining a homeowner.
Thus, nearly 2,500,000 California negative equity homeowners are imprisoned in houses that are black-hole assets. Each month of continued ownership sucks up sums of money in multiples of what the home would rent for – the home’s dollar value to the homeowner. Without a principal cramdown, foreclosures will continue as homeowners have no short-term or long-term relief, and little hope that before 2020 (and probably well beyond) the excessive mortgage payments will in any part be returned as net proceeds when they sell their home.
Two breeds of negative equity homeowners exist: those that are fully aware of their financial plight and have tried to get relief but can’t, and those that aren’t conscious or are in deliberate disbelief of their precarious financial footing. Either way they view their financial condition, they represent a large portion of California homeowners who bought or refinanced after 2002 and are now paying on dead-end loans. These loans, while amortized, contribute nothing to the equity in the owner’s home (but perform quite well for their lender’s portfolios).
This is reckless behavior and financially damaging; not only to the individual homeowner, but to the broader California economic recovery and the eventual return of the largest banks to solvency. Massive sums of household funds are needlessly being diverted into retaining upside-down homes. For homeowners, this zero-sum personal income expenditures game siphons money from what would be savings and prudent family investments into keeping the mortgage lender temporarily solvent. This negative equity home, the family’s black-hole asset, smothers their ability to save, reduces their standard of living and diverts earnings from the consumption of goods and services produced by the broader economy to lenders.
But what metaphorical yardstick can a financially upside-down homeowner use to gauge his property’s relation to the waterline?
A balance sheet is a worksheet used to list in dollar amounts all the homeowner’s assets and liabilities. It is an ideal tool to decipher a homeowner’s, and by extension the family’s, financial health. The use of the balance sheet, also called a statement of financial position, is a simple exercise in financial planning which should be conducted by every household (and investor and businessman) every year. Preparation of a balance sheet is especially instructive to families who purchased or refinanced after 2002 since they are likely underwater. [See first tuesday Form 207-1]
In contrast, a profit and loss worksheet is a separate financial statement for reviewing the homeowner’s monthly income and expenditures. It deals not with the value of the home or the mortgage amount, but lists the homeowner’s personal income, monthly payments and ongoing obligations including mortgage payments.
With a firm mental grasp on the family finances through the aggregation of all assets of value and all debts on a balance sheet, comprised principally of the home as the family’s primary asset and all debts encumbering it, forward-looking and prudent financial decisions can be made.
A perceptive agent will use his understanding and expertise in evaluating the real estate market to help friends and clients determine the LTV ratio of their homes, also called a debt-over-value ratio. The LTV ratio reveals the depths of a homeowner’s negative equity beyond an LTV of 94%, the “break even ratio.”
Equipped with a determination of the home’s fair market value (FMV) and amount of trust deed debt, the agent can have a dialog with the homeowner about his financial options and his family’s future needs – housing and otherwise. Confidential discussions build long-term good will with real estate owners which the agent reaps the next time the homeowner considers or hears about a real estate transaction.
Family asset planning using a balance sheet
The balance sheet approach to setting a homeowner’s net worth is a meaningful exercise for a knowledgeable and experienced real estate broker or agent since it assists individuals in their estate building through the ownership of real estate. All investors and families that count the dollar amount of the annual increase in the value of their assets usually do so just after the end of each year. The analysis reveals whether the family is on track to meet long-term financial goals, or whether the family is insolvent and in need of a change in behavior – or assets. The balance sheet also helps the family determine which assets they best spend their earnings on and should keep and which assets they should discard.
A balance sheet distinguishes the relation between two basic things, assets and liabilities. Assets are tangible and intangible things of value held by the homeowner. Among them are liquid assets which take the form of cash or something easily converted to cash and include money held in a savings account or tradeable stocks and bonds. [See first tuesday Form 207-1 §1 and 2]
Generally, the largest dollar-valued asset a homeowner will ever own is his home. It is historically considered an illiquid asset as its equity, if positive, cannot quickly be converted to cash. With a positive equity stake in the home, the owner treats it as a valued asset and thus maintains and improves it. Over time, the property’s equity buildup can be cashed-out by either further financing or sale.
Other items make up a homeowner’s assets, such as funds held in a retirement accounts, ownership interests in businesses and trust deed notes owned. Vehicles and equipment owned are also assets, as well as furniture, electronic equipment and any other item of recognized value, such as collectibles. [See first tuesday Form 207-1 §5 through 9]
Liabilities are the flipside of the financial coin. Together, liabilities and net (or negative) worth are equal to the value of the assets (formula: assets minus liabilities equals net worth). Liabilities included in a balance sheet are financial obligations – debts – owed to others, including real estate mortgages and auto loans, charge accounts, credit card balances, one year’s amount of alimony/child support/lease payments and loans collateralized by stocks, bonds or notes. [See first tuesday Form 207-1 §11 through 15]
A homeowner’s net worth is revealed when his total liabilities are subtracted from the current fair market value of his assets. The net worth is a primary determinant of financial wealth and should be known by all individuals, homeowners and otherwise. When net worth is positive, the homeowner is “worth” more than he owes to creditors – he is solvent.
However, this balancing act is immediately upended when a high-value asset, such as the homeowner’s residence, has a negative equity (the mortgage debt exceeds the home’s FMV). If the negative equity is large enough, the homeowner’s value of other assets is overwhelmed; his net worth appears as a negative figure. Instead of a positive measure of wealth, the negative net worth is a measure of insolvency. When insolvent, the homeowner is a candidate for bankruptcy protection. It is in this context that the agent reviews the pros and cons of continuing to own and occupy the property.
Consider a homeowner who purchases a home for $500,000 in 2004 with a 3.5% down payment. In the six years since the homeowner’s purchase, the real estate market saw the home’s value steadily rise then suddenly collapse as asset values plunge. In 2010, the home is worth $300,000 (based on the sale prices of comparable properties sold in the prior six months). Though the property is currently worth $300,000, the homeowner still owes $437,600 to the lender ($45,000 less than the original loan amount due to debt amortization). Thus, instead of functioning as an asset of value to be retained, the homeowner’s residence becomes a “liability” with a $137,600 negative equity, a property to be shed unless the mortgage can be discounted, bringing the LTV to 94%.
Editor’s note – This corrosive net worth phenomena driven by negative equity property is particularly rampant and damaging for those in the Baby Boomer generation. Boomers experienced close to 50% losses in the stock market on two separate occasions in recent years (likely because they were told by their commissioned 401K investment counselors to put their money into stocks, not bonds, as they grew older). They were hit a second time with the devastating loss of over 50% of the value of their homes which too many refinanced and are now trying to sell so they can relocate to a condo near their grandchildren.
The agent needs to instruct the owner to keep long-term estate building in mind when considering the data provided in the balance sheet. The purpose of the review is to show how effectively the property is performing as an asset, be it poorly or well. Similar to a lender reviewing its portfolio, the agent must prompt the owner to consider whether the home is a positive asset with a FMV enabling it to amass equity, or whether it is a nonperforming toxic asset corroding the owner’s net worth – and solvency.
After the balance sheet is completed by the owner and his agent, it will become clear which assets are being mismanaged. In this context, an upside-down house should be dumped to free up cash for more prudent family expenditures. The financial impact of a homeowner’s current housing situation directly affects his annual increase in net worth and his ability to achieve his long-term goals. In the case of a negative equity owner, his home diverts large sums of cash monthly, now and into the distant future, which will never be returned. Thus, reaching reasonable long-term family goals will be impossible with a black-hole asset on the balance sheet.
Negative equity owners are a gap in homeownership
Consider a homeowner occupying his residence. He is and will experience the same possessory benefits as does a tenant occupying the same residence – shelter for the family. So what makes the homeowner different from a tenant renting the same home? Should both not be paying the same monthly amount to provide themselves and their family with the same shelter? The monthly expenditures to own or rent should be roughly the same, except for the premium paid by the homeowner to reduce his risk of losing the family residence, represented primarily by the monthly principal reduction on the mortgage. However, the benefits are very different – if one holds the economic function of an owner.
As reviewed in The Homeownership Gap staff report written by Andrew Haughwout of the Federal Reserve Bank of New York, the equity a homeowner holds in his residence is integral to his effective ownership of the property. Homeowners who have a positive equity stake in their property behave as effective owners: they receive the entirety of any increase in the property’s value and any principal reduction by amortization or other principal payoff of the loan.
Agents must understand that while a positive equity homeowner receives all the inflation, appreciation or sweat-equity increase in his property’s value, the negative equity homeowner receives none of these ownership benefits for his efforts – the exact financial situation experienced by a tenant. Just as a landlord receives the full benefit of any increase (or decrease) in his property’s value during his tenant’s occupancy, the mortgage lender in a negative equity situation receives the full benefit of any increase in the property’s value during the owner’s possession of the property — plus the payoff of all the principal on the mortgage — until the loan balance is reduced to 94% of the property’s value.
Thus, until the 94% LTV is reached, a negative equity homeowner receives absolutely no benefit from any increase in the property’s value or his monthly mortgage payment – except the present open market rental value of his occupancy – since the property value is less than the loan amount. With no benefit of ownership accruing to a negative equity homeowner beyond the benefit of shelter enjoyed by a tenant in a property, he does not, as an economic function, own the property.
The authors of the report conclude negative equity homeowners should not be tallied in the national homeownership rate since they are not economic homeowners; they do not experience any of the homeownership incentives enjoyed by a homeowner in a positive equity position beyond possession. Additionally, none of the public policy objectives for encouraging homeownership are met. This they refer to as the homeownership gap. The national homeownership rate (presently 67% and dropping fast) would decrease by 25% to 45% if the homeownership gap was considered, revealing the massive population of negative equity homeowners (2,500,000 of which are in California) who are not, in effect, owners.
As the Great Recession is allowed by the government to wear on in the real estate market, causing more properties to fall into foreclosure and exerting greater downward pressure on the prices and values of neighboring properties, the homeownership gap will only widen. Homeowners of upside-down properties are essentially relegated to the economic, if not legal, status of tenants.
Loan-to-value ratio of the negative equity owner
During the years leading into the Millennium Boom when lenders (and collaborating bond market rating agencies) deluded themselves by embracing the enduring myth that home prices would continue to rise on a mathematically unsustainable trajectory, they rationalized that homebuyers need not be required to make a down payment to qualify for mortgages with LTVs of 100% or more. Thus, from the very outset, homeowners with LTV ratios exceeding 94% actually “owned” no economic interest in the property they purchased. Logically, an LTV greater than 70% to 80% (or an adjustable rate mortgage (ARM) loan) leaves owners constantly vulnerable to market fluctuations adversely affecting pricing. As home values began their decline toward the end of 2006, these homeowners were immediately plunged underwater.
Some negative homeowners chose to hold on to their underwater properties and continue paying on their mortgages. They initially hoped the monthly debt amortization and future price increases would soon eliminate their negative equity condition and return them to solvency. However, even when the value of a property rises to equal the declining balance of the loan (an LTV ratio of 100%) the negative equity owner is still in a financially diminished position – he has not yet reached the “break even point” should he need to sell. It must be remembered that costly transaction expenses are incurred when selling a house, generally about 6% of the sale price.
To continue our previous example, if the homeowner who now owes $437,600 on his mortgage is miraculously able to sell his property for that amount, his sales expense will eat up another 6% of that price in cash. It is not an even wash. Instead, the homeowner will suffer a cash expenditure of around $26,000 to close the sale, as 6% of the sale price is lost to transaction expenses. Thus, for an underwater homeowner to regain equilibrium and rise to the water line, instead of aiming for a reduced LTV of 100% as the sales price, the negative equity owner must instead have an LTV no higher than 94% to break even on a sale and fully satisfy the mortgage.
And even with an LTV of 94%, the negative equity homeowner would not receive proceeds from the sale of his home – he just wouldn’t need to add cash to close escrow. However, he would lose the entire down payment he made and all the monthly amortization of principal. Typically more financially damaging is the amount of interest paid monthly in excess of the property’s rental value, the implicit rent the owner receives for his occupancy – his only benefit.
The homeowner obediently pays the agreed monthly mortgage payment to retain possession and sells the property to a buyer when the LTV is at 94%. However, these calculations don’t take into consideration the money he would have saved by renting a comparable property (if not the same property) and retaining the difference between his monthly mortgage payment and the monthly rent a tenant would pay for the same or a comparable home.
The hindered trade-up option
Studies show and lenders know that nearly 90% of homeowners with negative equity will continue to pay and eventually pay off the excessive debt (in lieu of purchasing consumer goods and services to raise their standard of living, or saving for health care and education). Staying with a seriously underwater property (115% LTV or more), referred to by income property brokers as an alligator, is financially short-sighted and cripplingly self-defeating. It is a zero-sum game; what the lender unnecessarily gets is not spent to better the family.
A homeowner in a negative equity situation is logically advised by his agent to consider the future housing needs of his family, in this home or another home, whether owned or rented. Most families buy and sell their primary residencies two or three times over the course of their lifetimes as the result of increased income, changing family size and job or social demands. Thus, nearly every homeowner prior to the age of 60 will trade-up and relocate to a replacement home. However, the negative equity situation dramatically interferes with a homeowner’s ability to accumulate a large enough down payment to purchase a desired replacement property.
Three financial conditions generally contribute to the down payment of a replacement home:
- recovery of the initial down payment on the property sold – based on six or seven years of consumer inflation;
- any increase in the value of the home sold based on the cumulative effect of monthly inflation, demographic appreciation and property improvement; and
- amortization of the mortgage used to purchase the home sold.
The initial down payment poured into any negative equity household is completely eliminated by a property’s decline in value. With the down payment wiped out, these funds cannot be recovered and applied towards the purchase of a replacement home. Thus, a down payment must be re-saved if he is to become a homeowner – again.
Asset values, after their frenzied rise in early- to mid-2000, have returned to 2000 values and are stagnating. Prices will not likely rise sufficiently, much less soon enough to create an equity in any negative equity property with more than a 125% LTV until well into or after the period of the next real estate boom in 2016 to 2018. Any increase in home prices will likely only run parallel to the nation’s annual rate of consumer inflation until that next uncontrolled real estate boom occurs (likely sometime around 2017, the Fed and Congress permitting).
For an owner of property with a positive equity, the realization of equity buildup through debt amortization is immediate and experienced monthly. However, before a negative equity owner can build any equity through debt amortization, the property must first daylight into a positive equity position, the 94% LTV situation. In the national sample of negative equity homeowners reviewed by the authors of the Fed report, 37% will be brought to a positive equity position (above water) within three years and 53% will see sunlight in five years if they continue making their scheduled monthly payments. For those homeowners who see daylight after years of steady mortgage payments, it is only then that they will begin to accumulate equity which can later be converted into a down payment on a replacement residence.
However, in order for the sample group to buy another property in five years, their net savings must increase if they are to save up for the standard 20% down payment and cover the 6% recurring and nonrecurring transaction expenses on the purchase and finance of a replacement home since no net sales proceeds will exist from the property sold. In the Fed’s reported sample group, each household will need to save an additional $1,300 per month for the 20% down payment to purchase a comparable property five years in the future. Nationally, this equals a savings increase of $66 billion annually for five years – less money than the amount homeowners will lose to the lenders in unnecessary excess payments.
Due to the need for a greatly increased savings figure, many negative equity homeowners who stay with their underwater property will be forced to become renters when they eventually sell their property. They will not be able to save for a down payment on a replacement home, which is not good for the MLS resale market or new construction sales. Additionally, households who stay in their underwater homes and at the same time are able to save are immobile, unable to move elsewhere to follow employment opportunities, much less improve on their standards of living or provide funds for educational needs.
Data gathered by the Census Bureau finds the number of households in transition from one home to another is currently at its lowest since 1962. When fewer households are in transition and fewer families are buying and fewer properties are selling, agents earn fewer fees. Solvent homeowners would alleviate all these pains.
Editor’s note –For further study discussing the corrective options of a negative equity homeowner, see the upcoming second part of this series, “The underwater homeowner, his future and his agent: a balance sheet reality check – Part II.”