How Equity Might Save Homeowners in Foreclosure
What it Means for Investors
By Rick Sharga
The anticipated wave of foreclosure activity due to the COVID-19 pandemic has failed to materialize, due in large part to concerted, and surprisingly well coordinated efforts by the Federal Government and mortgage industry to prevent unnecessary defaults from happening.
The most obvious actions were part of the government’s CARES Act: a moratorium on all foreclosure activity, and a mortgage forbearance program that gave any borrower with a government-backed loan (loans backed by Fannie Mae, Freddie Mac, the FHA, VA and USDA) a six-month reprieve from making mortgage payments, with an option for a second six-month grace period. The Biden Administration extended the foreclosure moratorium through July 31, 2021 and added a third six-month payment holiday to the forbearance program.
As the moratorium expired, the Consumer Finance Protection Bureau (CFPB) stepped in and enacted new enhanced servicing rules that required servicers to engage with distressed borrowers for a period of at least 120 days, which had almost the same effect as the moratorium, making it difficult for servicers to initiate foreclosure proceedings on seriously delinquent borrowers.
There were exceptions to these new rules that allowed servicers to begin foreclosures: loans that had been 120 days delinquent prior to the moratorium; loans on vacant and abandoned properties; cases where the borrower had been unresponsive to servicer outreach; and cases where all possible loan modification options had been exhausted.
After the end of the moratorium, foreclosure starts did increase for three consecutive months before retreating slightly in November, according to reports published by ATTOM, but foreclosure activity was still running between 60-70% below where it had been prior to the pandemic in 2019, and at its current pace seems unlikely to reach those pre-COVID levels until sometime late in 2022.
Why a Foreclosure Wave is Still Unlikely
Expecting a wave of foreclosure activity seemed entirely reasonable back in the spring of 2020, when the COVID-driven recession caused a 31% quarterly drop in the GDP (one of the largest quarterly declines in history) and claimed over 22 million jobs across the country. In most cycles, it is fairly easy to draw a straight line from unemployment rates to mortgage delinquency rates to default and foreclosure rates. But this time was very different.
First, the economic recovery was almost as dramatic as the drop; the GDP rose by 34% in the next quarter, and as of December 2021, over 80% of the jobs lost had been regained.
Second, many of the jobs that had been lost were relatively low-paying jobs in the service industry – retail, restaurants, travel, tourism, hospitality, and entertainment. These industries all have a high percentage of employees who are renters, rather than homeowners, so the fallout in terms of mortgage delinquencies was far less severe than what it might have been in a more “normal” recession, where job losses would have happened across the board.
Third, the forbearance program has been an unqualified success. As of December, over eight million borrowers had entered the program, with just under a million remaining in forbearance. During this period, while seven million borrowers entered and exited, delinquency rates actually went down, suggesting that borrowers by and large were managing to make on-time payments even after leaving the program. In fact, recent reports from the Mortgage Bankers Association note that approximately 85% of the borrowers who have exited the forbearance program continue making their payments as scheduled – a far cry from the performance of distressed borrowers with deferred payments or modified loans during the Great Recession.
Another critical difference between this cycle and the last one is homeowner equity, which currently sits above $23 trillion – an all-time high. During the Great Recession, over one-third of all homeowners were underwater on their loans, owing more than their homes were worth. Today that number is in the low single digits, and according to ATTOM, over 70% of homeowners have more than 20% equity in their homes.
Surprisingly, even homeowners in foreclosure have a significant amount of equity, according to information recently released by RealtyTrac. Over 87% of the approximately 170,000 homeowners currently in foreclosure have positive equity, and only 6% are seriously underwater on their loans (owing at least 25% more than their homes are worth). Almost 45% have between 20-50% equity, and another 28% have more than 50% equity in their properties.
Having equity does not prevent a borrower from defaulting on a loan. Foreclosures usually happen due to something that affects a household’s finances such as a job loss, divorce, or unexpected bills. But positive equity gives those borrowers an opportunity for a better outcome than a foreclosure sale – a chance to minimize damage to their credit score and use the proceeds for a fresh start.
Borrowers who find themselves in financial difficulty, and unable to make their monthly mortgage payments can tap into this equity to either refinance into a more affordable loan or sell the property in order to avoid a foreclosure.
According to the RealtyTrac analysis of homeowners in foreclosure in all 50 states and the District of Columbia, there are 16 states in which at least 90% of homeowners in foreclosure have positive equity. There are only two states – Mississippi and South Dakota – in which less than 70% have positive equity. Mississippi is also the only state with a significant percentage of seriously underwater borrowers who are in foreclosure (41%). Only three other states – Alabama (16%), Louisiana (16%) and Virginia (15%) – had higher percentages of seriously underwater borrowers in foreclosure than the national average of 6%.
Implications for Real Estate Investors
For real estate investors interested in foreclosure properties, this situation requires a completely different purchasing strategy than the one used in the Great Recession. During that period, with home prices plummeting over 35% nationally from peak to trough, and a high percentage of homeowners in foreclosure underwater on their loans the two most prevalent strategies were to wait for lenders to repossess the properties and buy them as REO (real estate owned, also known as bank-owned properties) or try to negotiate a short sale on underwater properties before the foreclosure sale took place at a sheriff sale or auction.
In today’s market, where home prices escalated 18-20% between 2020 and 2021, where supply is woefully inadequate to meet demand, and where the overwhelming majority of homeowners – even those in foreclosure – have ample equity, investors need to use an entirely different approach. Most of these properties are likely to be sold prior to the foreclosure auction, or at least they should be, if the defaulted borrower moves quickly in order to save as much equity as possible. The majority of properties making it to the foreclosure auctions today are selling there – often at prices higher than the amount owed to lender. So, it seems highly unlikely that very many homes will even reach the REO stage, and very few will qualify for a short sale.
So successful investors will move upstream, working directly with distressed homeowners to negotiate a deal that pays off the homeowner’s debt and also lets them move on with some of their equity while still providing the investor with a reasonable purchase price. Or investors may want to become more active at foreclosure auctions, which often deliver higher returns, but at a somewhat higher risk.
The COVID-19 foreclosure wave seems more and more unlikely to happen. But for investors who adapt to the changing default market environment, there will still be hidden gems to uncover.
