There are really 5 groups of participants or “players” to recognize in today’s foreclosure market if we are to understand where you as an investor might profitably fit in. We will consider each in turn–
Part 2 – Who Are The Players?
The first group that must be taken into account is of course those who fell victim to the real estate “bubble” of the early aughts. Second are the lenders–particularly the so-called sub-prime lenders–that may be considered villains of the piece; ultimately to be joined by prominent investment bankers who “merchandized” mortgages to investors in new and dangerous ways.
Third are the well-funded Speculators who were among the first to seize the opportunity to buy new foreclosures in quantity at deep discounts for resale to Investors and Rehabbers. Finally, for most of us, the opportunities are to be found as investors and rehabbers. For savvy, entrepreneurial investors and rehabbers, today’s market has proven to be the opportunity of their lifetimes.
THE VICTIMS: Small Investors & Homeowners
The most conspicuous victims in this situation (self styled or not) have been the small scale investors and home owners who lost their homes through foreclosure. To one extent or another all fell prey to the media hype of the Bubble, manipulative lenders, and their own lack of sophistication and prudence. I mention investors first not out of compassion but, rather, I find them easiest to dismiss. I have little sympathy for those who leapt into the market ill prepared for their investor aspirations. As a class they fell for the representations that rehab is easy and being a landlord is merely a matter of collecting the rent. Counseled that no-money-down and inordinate leverage was the savvy way to make Easy Money in real estate, these neophyte investors were ill prepared for the responsibilities of investment property ownership and among the first to abandon their properties to. Today’s investors feast on the leavings of failed landlords.
Homeowners confronted with foreclosure as the Bubble collapsed–and today–are more problematic. First of all, unlike the quick-to-abandon-ship investors, these are folks who struggle to keep their homes. They may have bought at the top of the market, or responded to persistent (some would say predatory) urging to refinance the home they may have owned for years. They jumped at loans that were a time bomb ticking away. We’re talking about “adjustable rate” loans where everybody, or so it seemed, saw continually rising property values.
These homeowners were encouraged by whoever was counseling them – the brokers involved in particular – that, with property values going up so fast, and with the assurance that there was no reason for interest rates to increase, that if one could afford a $150,000 house, take the opportunity to buy today; or (even better) consider a $200,000 house because, it was claimed, ‘a rising market will take you out’ with rapidly increasing equity’.
Adjustable rate loans and so-called “special loan products” were offered which started out at a low interest rate and would adjust “later on”. This meant that if by any chance rates increased, there would be an adjustment to the loan. But it was a positive, dynamic economy, and there was confidence on all sides that buyers would be earning more by the time those increases came and all the while they would have the home of their dreams. For a period of a few years, everybody was seeing that happen.
So you had all of these market factors in play. You had artificially low interest rates fostered by “innovative” loan products which were, in the end, marketing products designed to fuel the market. Lenders competed for the business and essentially pushed the envelope, if you will, as to who might qualify for financing. Credit standards were progressively eased as new products came out. With such permissive financing terms available, more people bought–often more house than they needed.
The argument, supported by (bi-partison) Federal government policy, was that housing could be made available for everybody, including the blind and the halt. And the result was folks not in a position to own their own home, their income not as stable as one might wish and generally dependent on two wage earners rather than one, found themselves house proud and fundamentally vulnerable. If there were the least disruption, if one of these persons was laid off or disabled, the household would have little possibility of sustaining and continuing to meet their new obligations. A very vulnerable demographic, and it was that demographic that was particularly targeted by mortgage lenders, the so-called “subprime” lenders in particular, who so aggressively pursued this business.
Mortgages “Packaged” As Securities
Why were these lenders seeking the business? Because new financial instruments were being coincidentally developed in financial markets far removed from real estate that effectively transformed traditional mortgages bundled into financial “instruments” sold world wide as investment grade securities. This was not a novelty of the modern era. For a generation or more, mortgage loans have not necessarily been held “in house” by the lenders who originated them. They would make the loans and, in turn, “sell” them to Fanny Mae or its upstart competitor Freddie Mac. These Government chartered quasi-public corporate entities then, in their turn, sold them in packages to institutional investors. It was a remarkable, innovative system that for decades provided banks the liquidity they needed to continue making mortgage loans.
Unfortunately it was a system that we know today lacked oversight. Beginning in the late 1990s Wall Street investment houses carried the sale of “bundled” mortgages to the next level and beyond. Larger and larger packages of loans were bundled, what they call “securitized,” and sold as investment paper, not only to traditional buyers such as American pension funds, but to institutional investors world wide. All of that is to say responsibility and accountability ended up being truly elusive. The person across the desk from the borrower was working with the immediate objective of collecting a commission. The lenders–subprime and conventional lenders alike–had a very uncomplicated mission: To write as many of these loans as possible, understanding that in the end they would not have responsibility for that borrower either, because the loan would be packaged with others and sold to investors who had very little interest in real estate.
Investors essentially look at income spreads and yields. They found the investments attractive, and neither sought nor received appropriate or qualified advice as to whether the underlying loans were soundly made to borrowers who could sustain the consequences of the obligation, whose jobs were stable, who had a history of thrift or home ownership. Such analytical tools, this “due diligence”, were essentially finessed–not so much overlooked as put aside given the prospect of high yields and attractive discounts offered to cash rich institutional investors. It was a complex system run without supervision or governmental protections, and a prescription for near disaster. The system survived, though some of the chief players did not, and goes forward today chastened and still struggling with reform.
So, again, who were the players? First of all, the newbie investors who thought and were told “it is easy…” and jumped in unprepared for any adverse turn of events. Then, more painfully, there are those who were and are still simply struggling to keep their homes. They bought or refinanced homes using adjustable rate loans that were time bombs awaiting ignition. As homebuyers, they were tempted to buy too much house and, quite frankly, there’s not much we can do for them.
In the first half of 2009, an estimated one and a half million homes across the United States slipped into the foreclosure process. That is not to say that all will be lost to their present owners in the end, but a significant number will be. Lenders and the federal government work to restructure the loans that are in the hands of individuals with sufficient means to keep their homes if given some relief. But there are limited resources committed to this “loan modification” process, and the lenders concerned appear reluctant to put great energy into these mitigation efforts in spite of governmental financial support. By and large, there will continue to be a great number of individuals and families who simply lose their homes, or give up and hand the keys back to their nominal lenders, moving on with their lives.
Lenders Play A Pivotal Role
The second group who were players in this–and they are players–are the lenders and independent brokers who sought to represent them. Now, the brokers, by and large, are gone or have moved on to other employment. Among the lenders on the other hand, not necessarily banks, some are gone. Banks became the easy scapegoat blamed for this process. In fact we’re really talking about mortgage lenders, including giants of the industry–Countrywide comes to mind, together with Washington Mutual, both now gone. Among banks, some are merged with other, more solvent companies, while yet others are simply stuck with nonperforming loans and a continuing inventory of REOs.
REOs are the real estate industry’s term for “real estate owned”. That’s a piece of property that has been taken back entirely by the lender and is now in an inventory of unsold, foreclosed properties. Historically, a lender – any lender, particularly banks – is simply not permitted to sit on such homes. They are mandated to get those loans off their books using whatever mechanism might be available to them. Typically, and historically, that was a discounted sale to someone else; perhaps another bank, perhaps a speculator or investor, or conceivably to a new homeowner who sought out or found the opportunity to buy a house at a discount. That has always been the case. What we have been struggling with might be termed Critical Mass. The continuing numbers of REOs have an adverse effect on any lender’s, any bank’s financial statement, and puts that lender under pressure to dispose of property.
Speculators Are Feasting
The third important group of players in this business are the Speculators. They tend to be cash-rich. They are dealers and, as the IRS understands dealers, that means they “buy and sell for profit”. There is nothing long-term about what a dealer does. Like a car dealer, speculators buy, often in lots of multiple units, and sell primarily to investors or to virtually anyone who has access to that market. In many cases, these real estate dealers bring extraordinary amounts of money to this market, and thus are able to buy in bulk quantities. By “bulk” we mean, rather than just one or two or three properties, they will negotiate a purchase of fifty or a hundred or more.
The speculator tends to be cash-rich, or has sufficient credit resources for very favorable bank borrowing at very low interest rates. There is at least anecdotal evidence of venture capital fund managers that commit their considerable financial resources to this activity as they await more favorable conditions in their traditional markets. When the bulk buyer offers to buy, (or relieve the problem of the lender) to the tune of one or two hundred properties as a group, they are effectively assuming the lender’s risk and for that they demand and receive a substantial discount.
The bulk buyer is taking ownership of the properties, together with the risk inherent in whether they can resell at a profit in a timely manner. But the risk is greater than mere profitability and timeliness. Consider, as a practical matter, the foreclosed property on a given block in any given neighborhood. There’s every possibility the house will be occupied by squatters, vandalized or intentionally or inadvertently burned down. That risk of absolute loss, and the expense of keeping the property safe and secure, is now borne by the solely by the speculator.
In the end, that risk and liability is the lender’s “bottom line” and primary incentive, and where speculators find their opportunity. Banks are not in the business of owning and maintaining properties. Banks are not investors; they are not rehabbers. Properties that are boarded and awaiting disposition are more than a nuisance, they are a cash draining liability. Meanwhile, they are boarded up and unoccupied, presenting both an economic threat to the lender and what is called an “attractive nuisance” to the community for which the lender may be held liable. In assuming these considerable risks, speculators and dealers take on the banks’ problems in return for extraordinary “bargain” discounts.
Investors & Rehabbers Occupy The High Ground
Investors, and their Rehabber cousins occupy a beneficial middle or even “high” ground in this mix. Investors are neither willing nor able to take on the level of risk assumed by the bulk-buying speculator. But they too are seeking an economic advantage– to acquire property at a discount. They won’t get the discount that the speculator does, but their intention is to buy, fix, and hold that property for rent. In today’s market, to buy such a property and fix it is a socially beneficial role in the marketplace. The speculator’s time horizon is generally measured in months, not years. The investor, on the other hand, is taking the longer view, and it is the investor that I take a particular interest in, together with those who undertake the more ambitious projects as Investor-Rehabbers . That longer view is probably on the order of three to five years or more. Some will hold those properties indefinitely for cash flow and wealth building. We will talk more about that.
Prospective Homeowners Find Opportunity As Well
Finally, there is a small yet growing group of prospective homeowners who see a chance for home ownership at a bargain price. For these individuals, whether they are first-time homeowners or people who have been living in a condominium or apartment and would like a home of their own, it is an extraordinary opportunity. But there are obstacles to overcome. As for investors, there are negotiating elements and financing requirements that are sometimes rigorous and seldom understood. Hopefully there are individuals at hand who understand that marketplace and can guide them appropriately and professionally. There are high quality loan programs available for home buyers, and significant government tax incentives designed to encourage home ownership while stimulating the still recovering housing industry.
Interestingly enough, with the virtual disappearance of subprime lending, the Federal Housing Authority (FHA) has stepped up as the lender of choice. Only a few years ago a very small fraction of such transactions were backed by or directed by FHA financing. Today, we’re finding that sixty to seventy percent of transactions actually consummated are accomplished by way of FHA lending programs. For decades savvy real estate agents, and many borrowers as well, tended to avoid the FHA because of burdensome documentation requirements, red tape and delays.
By happy coincidence, before this crisis got underway, the FHA was already reviewing its underwriting standards and guidelines to make it a much more efficient system and the consensus is that they were largely successful. Today FHA should be considered a true alternative for buyers of every economic level. FHA loan limits have now increased to something on the order of $625,000 in some major markets, so we’re not just talking about distressed or low end housing when it comes to FHA. It’s a viable program that’s available for the new homeowner who can qualify. Credit standards are reasonable, and often significantly lower than traditional lenders are currently demanding. For properties requiring improvement or rehab, the FHA 203k program is in place and readily available. Arguably, until banks and major lenders in fact return to the market, FHA is the program of choice.
Find Your Comfort Level
The very existence of this last group, aspiring homeowners may well drive your decision to get involved. First time homebuyers represent demand for affordable housing. Among the several groups of players, where do you want to be? You have resources both personal and financial. Depending on the extent of these resources, you have opportunity at several levels. You don’t have to buy a hundred units as a high rolling wholesaler to “get in on the action”. Working with a broker, you could initially buy just two or three properties and test the water. It will take a certain amount of cash, carefully wrought business and marketing plans, and backing from a bank, but that may be feasible for you. As a wholesaler (dealer) or investor, the foreclosing lenders are where you look for “inventory” and, for now and over the next two or three years, they must be considered “highly motivated sellers”. It is this mix of Players and their separate motivations that combine to create our opportunities today. #
– Philip Elmes
NEXT TIME: “What & Where Are The Investing Opportunities?”