"Can you recommend any exit strategies for my real estate investor friend who has too much inventory now and not enough funds to cover his mortgages?" asks a reader from somewhere in cyberspace.
It's a fair question and one which seems to be raised with increasing frequency in many metro areas. Going on, the reader wonders:
Is it better for him to let all his properties go to foreclosure or short sale them? If he short sales them, he will end up with a 1099-R. Right? If he just lets them all go to foreclosure what are the chances for him to have deficiency judgments against him? How does that process work? Are lots of foreclosures worse than bankruptcy?
The plan right now is to refinance into option ARMs and rent the properties till the market improves. Do you see an end it sight?
Given that demand in many markets -- but not all -- has slowed during the past year it follows that the investment strategies which worked in one set of circumstances may not work in another. Indeed, old investment concepts may be decidedly wrong in the context of new marketplace realities.
Let's look at the reader's letter and see what it says -- and whether help is available.
Can you recommend any exit strategies for my real estate investor friend who has too much inventory now and not enough funds to cover his mortgages?
Notice the terms here: "inventory" and "mortgages." In other words, we likely have an investor with multiple mortgages and multiple properties. Since real estate tends to be a big ticket item we may well be talking about very large numbers, enough to bankrupt most households if something goes wrong.
Is it better for him to let all his properties go to foreclosure or short sale them?
Neither. It's better for him to pay off his lenders in full. But if repayment is impossible, then foreclosures and short sales are not the next options. Instead, contact lenders and see if it's possible to work out some form of indulgence such as a longer loan term, a lower rate (at least for the short term), forbearance (skipping some payments with the lender's permission), or a repayment program to bring loans current if payments have been missed.
With a "short sale" the lender allows the property to be sold for something less than the value of the mortgage. The lender gets all the money from the sale and there's no foreclosure. However, why should a lender accept a loss? It would not get additional profit if the value of the property rose. Some lenders might agree to a short sale but only if the borrower pays for the loss, perhaps in the form of additional personal debt.
A foreclosure is not a good option for a lender because it may get less than the value of the mortgage (the dreaded "foreclosure discount") or it may wind up owning the property -- an ongoing expense it does not want. As an alternative, investors might want to ask about avoiding a foreclosure auction and simply giving the property to the lender with a "deed in lieu of foreclosure." For specifics, consult a local real estate attorney.
If he short sales them he will end up with a 1099-R. Right?
If you borrow $200,000 and pay back $180,000 it's possible that the $20,000 can be regarded as imputed and taxable income which the lender will report to the IRS. However, this is not always the case.
For instance, in California if you have a purchase money mortgage and default on a personal residence, liability is limited to the sale value of the property -- thus there's no taxable shortfall. However, if you refinance you no longer have a "purchase money" mortgage and in any case if you're an investor you don't have a loss on a personal residence.
The rules in other states vary, as do lender policies. Bottom line: Investors with shortfalls may find that they owe big to the IRS. For details, speak with a tax professional.
If he just lets them all go to foreclosure what are the chances for him to have deficiency judgments against him? How does that process work?
I have spoken to brokers around the country about deficiency judgments and while suits against borrowers are surely possible they seem to be rare. However, given the growing number of loan defaults -- foreclosures were up 42 percent in 2006 according to RealtyTrac.com -- past practices may be in flux.
One complication concerns the type of foreclosure. With a judicial foreclosure -- one that involves going through the court system -- there may well be a deficiency judgment. However, in a non-judicial foreclosure there's not a deficiency judgment unless the lender goes back to court. Given the cost of going to court, most lenders will not take this second step unless a lot of money is involved or the borrower has been difficult.
For details, speak with a local real estate attorney.
Are lots of foreclosures worse than bankruptcy?
It's possible to have a foreclosure and a bankruptcy for reasons which are simply beyond the borrower's control -- the loss of a job, a local economic downturn, a natural disaster, divorce, an accident or medical costs. Lenders, for the most part, try to ask what lead to financial problems and in some cases may offer "bad credit" (subprime) loans as a result -- that is, high-cost financing largely intended to be a short-term fix until credit improves and loans can be refinanced. (Without subprime loans borrowers would likely have to wait several years to fully re-establish credit.)
"The plan right now is to refinance into option ARMs and rent the properties till the market improves."
This strategy may make sense -- if it's possible. Option ARM offer absurdly-low initial payments, payments so small they do not even cover interest costs. The result is negative amortization and a rising loan balance. However, while option ARMs are a generally awful mortgage choice, in this particular case they may make sense if they postpone the day of reckoning for our investor and if local property values increase.
But, consider that magic word: refinance. Can our investor refinance anything? For instance, he might not be able to refinance existing debt if local property values have declined, his loan balance has increased or he has late or missed payments. No less important, lenders have begun to tighten qualification standards so our investor may no longer qualify for the amount of financing obtained just a few years ago.
Do you see an end it sight?
In many markets there has been no decline in sale values. In other markets which have now slowed down it's very likely that prices will begin to rebound as supply declines. In other markets, unfortunately, long-term prospects will be difficult, meaning not good.
For a better answer, look at trends in your community. Are jobs up or down? Is the population growing? Is new home construction increasing or decreasing (if you have an existing home you want less new home construction so there's reduced supply).
As always, real estate is a localized commodity so speak with local brokers for a realistic view of community trends.
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