When the 'foreclosure price' becomes the market price

This lengthy update on the housing price collapse in Merced, written by the New York Times' David Streitfeld, is worthwhile weekend reading.  As with all good writing about the housing bubble and bust, the story, in the end, is pretty simple: In Merced, planners, developers, lenders and buyers were blinded by the bubble -- they approved, built and bought thousands of relatively expensive houses that the area's economy ultimately could not absorb:

Hardly anyone in Merced planned very far ahead.  Not the city, which enthusiastically approved the creation of dozens of new neighborhoods without pausing to wonder if it could absorb the growth. Certainly not the developers. They built 4,397 new homes in those neighborhoods, some costing half a million dollars, without asking who in a city of only 80,000 could afford to buy them all.... And, sadly, not the local folk who moved up and took on more debt than they could afford. They believed — because who was telling them differently? — that the good times would be endless.

You know the rest of the story: a tidal wave of foreclosures, driving median sales prices down 50%. The "foreclosure price" -- set by banks eager to unload distressed inventory -- has become the market price; other sellers must compete by dropping their prices. A downward spiral in prices.

A typical foreclosure price progression: "In November 2005, the house sold for $126,000. The bank, which took it back last spring, is asking $59,000. The Seattle man (a prospective buyer) offers $40,000."

Another foreclosure scenario: "The owners, who owe $350,000, can no longer make their mortgage payments. Mr. Seivert is negotiating to buy the house for $170,000 and then rent it back to the couple, who have jobs in the area. They will pay $1,100 instead of their current $2,600 a month."

--Peter Viles
Your thoughts? Comments? E-mail story tips to Peter Viles

Comments

[anon1137]

Good story. Try this: look at a Zillow market value chart for zip code 95340 for the last 10 years in terms of % change. From 1999 to 2006 it goesfrom 0 to 250% and from 2006 to today it falls from 250% to 75%. Wow. And the banks looked at this and thought, yea, this makes sense.

[Laker]

"...The owners, who owe $350,000, can no longer make their mortgage payments. Mr. Seivert is negotiating to buy the house for $170,000 and then rent it back to the couple, who have jobs in the area. They will pay $1,100 instead of their current $2,600 a month...."

So this investor will buy for $170,000, using a mortgage at 6.5%. Assuming all the money is financed his payment will be about $1074.52. Now property taxes are about $180 per month. Add insurance $100, and maintenance of 1% to be $200. So, The monthly cost is about $1550.
It is said that "they" (previous owner , now tenants) will pay $1100 per month instead of $2600....
So Peter, please explain that to me. The SMART investor is going to subsidize his renters by $450 per month! and that is assuming everything is good, never breaks,etc.

Peter, can you give me this investor's phone number please. I'm currently looking at a property that will cost about $3500 overall. I would love him to buy it, and rent it to me for $2200 a month!
I'm waiting for his phone number! I'm running to tell this to my wife.

[mike]

laker:

why would you think the investor is putting 0 down??
there are no loans like that now, the investor likely has money to invest and does not need to borrow much and certainly not all. besides i have a rental which i subsidize for $1000 per month after all is said and done. i still think it is a good long term investment .
but my real ? to you is why do you assume no money down and a 6.5% loan on 100% of the property. if you know a banker or lender who is doing that please do tell. he can lend me 100% and i will start making offers on every desperate situation that i can lay my eyes on...

[Cal]

The person with the investment property could easily be break even with tax deductions and depreciation. If the person who owns the house also makes "active" income (has a job for example) they can get some tax breaks against that income as well instead of just the passive income of the property.

I think realistically the investor would put 20% down and would be cash flow positive, with writeoffs and depreciation the income would produce tax free (sorta, some of the taxes are just deferred which is fine if you just hold forever) returns at higher than market rates he would have got on his downpayment money. The biggest risk is if rents go down locally, It sounds like the whole area is deflating so that is really the major risk. But if he can keep this rental rate or even raise rents later it will be a real cash cow. I don't see that as a bad investment at all.

[BrantW]

Laker,

The new owner, of course, is banking on a 'V' bottom , and the return of dramatic appreciation in a few years. Never underestimate the stupidity of people. In this game, the tenant is looking like the smart one, and the bank and the new owner are looking pretty dumb.

[shockg]

Laker, How convenient to assume the investor would get 100% financing. You never had any credibility to begin with or else I would say you just lost it.

[amir]

mike, I think that if you're losing $1000 a month, you have a tremendous amount of opportunity cost lost forever for a future return that is not assured. You're speculating.

As for the owner, I can't make his calculation, but it seems to me that RE returns are still too low. That means prices need to come down more to make it worthwhile to invest.

Personally, I would require a 10% return. It covers both inflation, major fixes, and the risk that rent goes down, or the asset remains empty for long periods. Below 10% you're not investing but speculating. Read value investing master Benjamin Graham for the difference.

Currently RE prices in LA trade at about 15 times rentroll or more (unless you're looking at depressed areas). They need to drop to 10 times rent roll and below to reach investment grade. With rents weakening, that means a 50% drop from here, before true vultures start buying en mass and the market reaches a bottom.

[amir]

To shockg,

Even with money down this investment is mediocre at best. Also, the money down has opportunity cost attached. What would that 20% do elsewhere?

So a 100% financing is actually a good way to theoretically examine this transaction, regardless what the actual investor did. After all, if it's a good investment in your opinion at 80% financing, why isn't it good at 100%?

[syscom3]

I think some communities are going to have to accept the inevitable and begin the demolition of the vacant properties ASAP. Burn them down if they have too.

Nothing good is going to happen when section 8'ers and vagrants move in.

[Buying Now!]

The investor is probably buying all cash.

[RichW]

Laker has a valid point. The present foreclosure wave gives ample evidence that most investors/speculators usually will have the least possible amount of skin in the game.

Whether or not people can get zero down now is a good question. Given the lending stupidity of the past 5 years its within reason to assume there may be a handful of fools still operating.

Last but not least is remembering that cash has value too. Even without mortgage interest the cash tied up in the home may had been generating a return in a prior investment, so its reasonable to calculate that against the MRC of the house in lieu of mortgage interest. Then again why tie up your own cash in such a risky/foolish investment ?

[latesummer2009]

"Foreclosure Pricing is coming to the Westside. Everyday buyers are becoming more educated about the fundamental prices of property in Southern California. As the Mortgage Meltdown migrates inward from the Exurbs to Suburbs to the City, it will become clear that "Foreclosure Buying" will be the majority of the market.

Also, what happens when underwater property owners begin buying second properties at reduced prices, close escrow and then let the first property go back to the bank.

More foreclosures, and more price declines, EVEN on the Westside.

http:/www.westsideremeltdown.blogspot.com

[anon1137]

If anyone doubts that investors and speculators aren't still heavily involved in the Calif housing market, just look at the comments on this topic.

[Laker]

shock,
I put 100% financing as a way to calculate the cost to hold the property. In reality, the investor will need to put 10-20% down.
I always thought that you are some sort of investor (specuvestor) but here you proved to be dumb investor with no understanding in simply ECON 101. From your point of view if the investor bought with all cash and no mortgage, he will make clean $1100 from the renters and be happy ever after. You completely ignore the $170,000 that will be buried in the house. Even if you are crazy safe with no knowledge in stocks or bond, you could get yourself a 5.5% CD today. So, all the money that you put down is losing that rate. That is why i refer to the whole $170,000 as financed to get a true (but gross) value of cost.
So, mike you too, i just put it it for sake of calculations. He did put something like 20% down.
For Buying Now! ,
I'm not an investor, but I have some common sense and knowledge. A smart investor will never hold a property that is fully bought with cash. You see, the whole idea of investing in RE is leverage. While it is true that investor X will go and buy a property with cash because it might be fixer that can't get financing, or because it will give him an advantage over mortgage buyer. But as soon as he gets it and fixes it, he will get a mortgage and pull as much cash as he can so that he could leverage it, and use the cash to buy another property.
Funny but this investor is an accountant in his day profession and he looks like zero in accounting...like shock.

[Cal]

Laker,

As I said you haven't addressed the tax benefits at all and that is why you don't understand why it is probably a good deal. The return on the property is most certainly above the opportunity cost of the money somewhere else, the risk is harder to quantify since I don't know the area but the deal sounds as close to a no brainer if the local economy is stable and/or if the landlord can push rents even a small amount in the future.

[Pat]

What exactly are the tax benefits? You can deduct the cost of the property (mortgage, taxes, upkeep) from the rent payments, but only up to the amount of the rent payments. Thus, you don't have to pay income tax on the rent. However, it does not allow you get any deductions on any other income you might have. Also, since it is a rental property, you don't get the capital gains break either. What tax benefits am I missing?

[shockg]

Laker, You have a reading comprehension problem. I never saif the investor likely bought with all cash. I was assuming 20-30% down. That would give him a positive cash flow. And you are right that you are not a real investor. You obviously sold your only real asset, your home. If you don't have the $$ you shouldn't gamble.

[Not_buying_it]

Cal,

I think if the bank accepts 170k for a house that previously sold for 355k then we can say with 90%+ certainty that this is a "distressed area" with an unstable economy!

If they don't accept 170k but demand something north of 200k then the ROI is way less attractive.

Either way this does not sound like a good deal!

BTW if any of you are considering becoming landlords you might want to consider the cost of your time. Managing properties and dealing with tennants is not a "barrel of laughs" and if you employ contractors and agencies to delal with these matters you ROI will plummet.

Now I'm holding my breath for Cal to reply that these services are tax deductable!

[Roger Ramjet]

I'm a flipper! I've made millions off idiots! Have a nice life you idiots. I played on your greed and I won, you lost. Sitt'in on the beach collecting 6%. Bye

[Laker]

Cal,
For the landlord/investor to make money here just because of tax, I believe it needs to be your primary residence or 2nd home. Obviously it is a rental, so not a primary residence. I assume the investor will claim it as a second home.
Correct me if I'm wrong, but i don't think investors can simply deduct the mortgage interest on their 20 homes they own for investment purposes....
Now, assuming he get a mortgage for 80% of the $170,000 that is $136K the monthly is $860. The idea of mortgage interest deduction is that it will reduce his income that is subject to tax by the interest he paid the previous year. So, $8800 in the first year. So depends on his tax bracket, he could save 20-33% of that amount.
You can look at it another way, with the mortgage deduction he essentially will get a cheaper loan than the 6.5%. We can assume that the net apr will be around 5.0% to 6%. If i plug in a "net" 5% interest to this virtual loan of $136K, you get $730 after tax payment. Now, add $177 property tax, add $75-100 insurance. Now add $32,000 in a 5.5% 100% safe CD to get a monthly lose of $146. Add upkeep and maintenance of 1% or $150 monthly to get about $1300. He will get paid $1100.
Cal, and mike. Can you explain to me why is it a good investment.
I look at it this way:
I applied after tax numbers and need to subsidize my tenant by $200 every month.
I assume that nothing serious will break, and just assume standard market maintenance.
I assume a fix rate 30 year and not ARM that will rise as my rents rise.
In a place like merced, don't build on assumption of rent increases...the wages are not increasing any time soon, so as we discover it every day now...rents are connected to wages...
Instead, i would invested the $32,000 that i had and get $146 per month and 0 (zero) headache and/or worries...
I think i would jump on that wagon if and only if i can get that house for $70,000 or lower. Then collecting $1100 monthly is cash flow positive, otherwise it is pure speculation on appreciation...

[LA Land Fan]

Did anyone read the article in whole? Here are some choice quotes:

"But Merced’s per capita income of $23,864 ranks among the lowest for metropolitan areas in the country"

"...city of only 80,000"

"...working-class agricultural city ranked by the American Lung Association as having some of the worst air in the nation"

"Businesses in Merced are struggling. Downtown buildings are festooned with “for lease” signs. Unemployment, consistently high here, rose to 12.1 percent in July."

Sound like $170,000 is 2x too much for a house there in my opinion...

[Mary C.]

It should be noted that Merced was being touted as a "bedroom community" for the SF Bay Area, where property values skyrocketed. But since some of this Merced housing was over $500K, I'm not sure it would make it attractive for a three hour commute each way to San Francisco or San Jose. The whole argument of "more house for the money" falls flat if you spend that much time on the road (and there are closer-in cheaper long commutes in Tracy and Modesto, which are nicer towns than Merced). There was also the lure of it becoming a "college town," which so far has not panned out. So, people invested there for the potential instead of the reality, that maybe the lure of relatively cheap housing for Bay Area workers and the new UC campus would cause rural gentrification.

[Cal]

In typical Laker fashion if it is talk of purchasing a house he will only look at the most negative aspects and ignore any of the positive aspects. The next time you actually make a objective fact based argument which is mathematically correct it would be your first time.

On 5.5% CD (I couldn't find that rate on bankrate, but I'll assume it's out there), you only look at it pre-tax and overrate its returns, Gee, why is that? It's is more conservatively around 4% after tax.

The depreciation on the property will be considerable, land cost (which can’t be depreciated) is cheap and the structure is highly improved("It has a pool with a small waterfall, a TV room in the converted garage, a deluxe outdoor barbecue setup and a kitchen with all the latest gadgets. "). The investor is an accountant and I guarantee he will depreciate to the maximum extent and the value assigned to things with the shortest depreciation schedule will be maximized while the building which has the longest depreciation will be minimized to front load the paper losses as much as possible and maximize the sheltering of the investor active income from both State and Federal taxes.

You were forced to look at the deductibility of interest but ignore it on all the other expenses (insurance, maintenance, property tax).

If you look at other investor liabilities on this property it is highly favorable:

Vacancy factor- You just gave a homeowner who was going to lose their highly improved home that they've lived in for 13 years back to them at a 57% discount to what they were just paying. These are pretty desirable tenants, they care about the property and have an interest in its upkeep.

Maintenance- The tenants have been putting money into the property for the last 13 years, I highly doubt this is a deferred maintenance nightmare and most likely in very good shape. The investor will know this in advance and the surprise factor will be small.

Property management- This property won't have a property manager, you have existing tenants who have an interest in the home. Property management will be the investors time in those few instance there is a maintenance problem. That time is not a non-zero expense but it is probably not significant either.

Sure the owners could lose a job but they kept jobs in Merced for 13 years, this sure sounds like a much smaller risk property than a standard property. Heck, if everything went to plan the costs of sale will be much less than a typical property.

I would not be surprised if the investor gets 8%+ (pre-tax) return on his down payment money. A lot depends on the investors personal financial situation but I have no doubt an accountant has all the numbers perfectly calculated before making the leap. His return won't be risk free but considering the markets nowadays it certainly doesn't sound like the horrible investment Laker made it out to be. Lakers initial scenario was that that this investor is paying over $5400 for the privilege of renting to this couple. The issue is much more complex and layered than Laker presented and could easily be seen in a positive light as a good investment even being very conservative with a lot of numbers.

[Maggie Knowles]

According to the article, this summer the Merced County Planning Commission voted to approve a plan for the eventual construction of a city of 16,000 houses called the Villages of Laguna San Luis on the western edge of Merced County.

Even though they don't have enough jobs or water to support the project. What are they thinking?

[kat]

Several months ago when I posted on this board that the whole foreclosure thing was a good thing, people said . . . well, you can guess. When I said that the market would start rebounding in mid summer -2008 - and take off in the fall, I was called worse.

Why it seemed so illogical for me to say that purging the real estate market of laborers who couldn't speak English buying $750,000 , is still lost on me. But I have another prediction, when the market takes off again - and it's just on the verge of becoming a frenzy folks - the same thing will happen all over again except for the predatory lending part. Once people decide to make their move it will be like a room full of mousetaps going off - the first one will go, then all of them at once. Prices will go up, speculators will feed and the greed will flow.

I doubt you people have learned a thing.