Buying and Selling During a Decline

During the bubble price rally, sellers and realtors, the agents of sellers, had everything going their way. It was easy to price and sell a house. A realtor would look at recent comparable sales, and set an asking price 5% to 10% higher and wait for multiple bids on the property–some of which would come in over asking. The quality of the property did not matter, and the techniques used to market and sell the property did not matter either. As far as buyers and sellers were concerned house prices always went up, so the sellers were thought to be giving away free money; obviously, the product was in high demand. As the financial mania ran its course, buyers became scarcer; all the ones who could buy did buy. The buyer pool was seriously depleted leaving prices at artificially high levels. When the abundance of sellers became greater than the number of available buyers qualifying for financing, prices began to fall.

Residential real estate markets generally move very slowly and trend in a single direction for long periods of time. Once these markets reach an inflection point, the direction of price movement changes, and the balance of negotiating power shifts from an advantage to one side to an advantage for the other. However, most market participants do not recognize this change for some time. Sellers continue to price and attempt to sell using tactics that worked during the rally, and they find they are unable to sell their properties. It often takes two years or more before sellers accept the reality of the new market and adjust their attitudes and behaviors to the new dynamics of a buyer’s market.

In a buyer’s market, buyers have the upper hand, and sellers need to adjust their pricing tactics to reflect this fact. During a rally, many buyers must compete with each other for the property of a few sellers. In a price decline, many sellers must compete with each other for the money of a few available buyers. It is common for sellers to ask their realtor to find a buyer who will appreciate the “unique qualities” of their property. Every seller thinks their property is the finest in the neighborhood and certainly commands a premium 5% to 10% more than their neighbors. These fantasies are reinforced by the behavior of buyers during the rally. At the risk of losing the listing, the realtor must find a diplomatic way to convince a would-be seller their property is average at best and needs to be priced accordingly. It is a difficult challenge for an experienced realtor to persuade an owner her castle is a cottage. Failure to educate the sellers to the reality of the market wastes the seller’s time and the realtor’s resources. Experienced realtors who thrive in bear markets earn their commissions.

Selling for Less

Sellers in declining markets must compete on price. Only the best properties can command prices equal to recent comps. In a buyer’s market, there are no premiums: getting the price of recent comps reflects a premium because prices are declining. Properties with negatives must price 10% or more below recent comps to attract the attention of buyers. There are many books and articles written about staging a property and various techniques a seller should employ to sell their home. Most of these writings pander to the ego and false hopes of sellers who refuse to compete on price. No amount of sales and marketing is going to convince a buyer to overpay in a buyer’s market. Price is the ultimate amenity.

Paying off a Mortgage

Once a price decline gets underway many buyers who were late to the price rally find they are in a property worth less than they paid for it. As prices continue to fall, many find themselves “underwater” owing more on their mortgage than their property is worth. When these late buyers want to become sellers, they cannot sell and pay off the mortgage balance with the proceeds from the sale. Then they have a real problem. It is a problem with only 4 plausible solutions:

1. The borrower can keep making the mortgage payments until prices go back up. This is the “hold and hope” strategy. If the borrower uses exotic financing–which most buyers did in the later stages of the Great Housing Bubble–it may be difficult to continue making mortgage payments because these payments are likely to increase substantially. If the property is not owner-occupied, the borrower may try to rent it out to cover expenses; however, this is generally not feasible. Buyers who purchased during the mania paid too much money relative to prevailing rents and available income. If this were not the case, it would not have been a financial mania. Since the payments are too high, renting the property does not cover the expenses. Renting out the property lessens the pain, but it does not make it go away. Also, since housing market corrections often last 5 years or more, it may be a very long time before prices recover to peak bubble levels. Keeping the property is a “death by a thousand cuts,” or perhaps a death by a thousand payments.
2. The borrower can write a check at the closing to pay off the portion of the mortgage not covered by the proceeds from the sale. Many people do not have the amount necessary in savings, as few thought such a loss was even possible, and even fewer are willing to go through with the sale knowing they will have to pay for the loss. The undesirability of this option usually forces the borrower to keep the property and try to endure the pain, or let it go up for auction at a foreclosure.
3. The borrower can try to convince the lender to agree to a short sale. A short sale is a closing where the lender accepts less than the full mortgage amount at the closing.
4. The borrower can simply stop making payments and allow the property to go to public auction in foreclosure. Both short sales and foreclosures have strongly negative impacts on credit scores and the availability of credit in the future.

In the price declines of the early 90s, most people opted for option number one. Downpayment requirements were high, and the use of exotic loan programs was less common in the preceding rally, so many homeowners had equity in their properties and were able to make their payments. They accepted debt servitude as part of the price of home ownership. When faced with the four options presented to them, most chose to stay in their homes and keep making payments. As the slowdown in the housing market helped facilitate a recession in the early 90s, a recession compounded in California with defense industry layoffs, many people lost their jobs and as a result, lost their ability to make high mortgage payments. This created a problem with foreclosures that pushed prices lower. The decline in prices in the early 90s, though extreme in certain fringe markets, was not so deep to cause many people to voluntarily walk away from their mortgages. Most buyers during this period were required to put 20% down. This represented years of savings and sacrifice for many, so they were not willing to lose it. Since the total peak to trough correction was a bit less than 20% statewide in California and even less in other states, many homeowners still had some equity in their homes. The combination of high equity requirements and a relatively shallow correction made staying in the home the best choice for many. This kept foreclosures to high but manageable levels. In contrast, the Great Housing Bubble was characterized by low or non-existent equity requirements, and very steep initial drop in house prices. These conditions made foreclosures, both voluntary and involuntary, a tremendous problem.

Much of the purchase money in the bubble rally was debt. As 100% financing became common, the average combined loan-to-value on purchase money mortgages climbed to more than 90% (Credit Suisse, 2007). With so many people with so little in the transaction, it did not take much of a price decline to cause people to give up. By late 2007 prices had already fallen 10% or more in many markets, and there was no sign this would change in the immediate future. It was becoming obvious that those with little at risk were well underwater and they were going to be that way for the foreseeable future. This inevitably lead to one of the unique phenomena of the Great Housing Bubble–Predatory Borrowing. Many simply stopped making payments they could afford because the value of their property had declined significantly. Nowhere in the terms of the mortgage did it state the payments would be made if, and only if, resale values increased, but many borrowers acted as if it did. When borrowers quit making payments they were capable of making simply because they were not going to make money on the deal, their behavior was predatory to the lender who ultimately had to absorb the loss. These borrowers often had so little of their own money invested in the form of a downpayment they felt little actual damage from just walking away from the property and mailing the lender the keys. Many borrowers simply stopped making payments, did not respond to letters or phone calls from the lender, and moved out. Short sales and foreclosures were not the end of the nightmare for sellers. It is the last contact they had with the property, but in many circumstances the debt–and debt collectors–followed them until the debt was repaid or discharged in bankruptcy.

Short Sale

A short sale is a property closing where the proceeds from the closing do not satisfy the outstanding debt on the property. The lender must agree to accept less money at the closing table for the closing to occur. From a credit perspective, there is little or no difference between a short sale and a foreclosure. Both a short sale and a foreclosure will show a series of missed payments and a secured credit line (or multiple credit lines) with a permanent delinquency and discharge for what is generally a very large sum of money. Both will have a strong, negative impact on the borrower’s FICO credit score that will persist for many years.

Because of the potential for fraud and the bureaucratic tangle of various parties involved, it is very difficult to get a short sale approved. If a lender is going to lose money, they are going to want to be sure the borrower is not selling the property to a friend or relative or engaging in some other kind of fraudulent conveyance. Also, the lender will want to be sure the borrower cannot pay back the money. They often require additional financial information like updated W-2s, 1040 tax returns, and a statement of assets certified by an accountant. In most cases, the borrower will have to stop making payments as evidence of their inability to do so in the future. Further, the property will also need to be listed for some period of time at a sales price which would result in sufficient funds to pay off the loan. Once it is demonstrated to the lender that the borrower has stopped making payments, cannot reasonably make future payments, and the property cannot be sold for a breakeven amount, then the lender may grant a short sale request. None of this happens quickly. If a buyer is found who is willing to purchase the property, the process of approving a short sale is so long and cumbersome, most buyers will move on to one of several other available properties on the market.

In the end, a short sale is only in the best interest of the borrower if they believe the bank will try to collect on the shortfall from the property sale. If a borrower is in a position where he will have to pay back any losses, a short sale may result in a smaller loss than a foreclosure and subsequent auction. If the borrower is not in a position where the lender either can or will go after the deficiency, there is little incentive for the borrower to even attempt a short sale. In these instances, the borrower generally lets the property go into foreclosure.

Foreclosure

Foreclosure is the forced sale of a property owned by the borrower in order to satisfy the debt(s) secured by the property. Foreclosure laws are complex, and they vary from state to state. There are no federal laws governing foreclosures. The borrower is the legal owner of the property who has entered into a mortgage agreement with a lender to pay back all borrowed money, fees and interest due. The Mortgage is a security instrument that pledges the property as the security for the loan. This document provides the lender the ability to force the sale of property to satisfy the debt if the borrower fails to pay in accordance with the terms of the agreement. The lender does not own the property; they merely own a lien on the property which can be exercised to force a sale to satisfy the debt. At the time of a sale, all proceeds first go to settling this indebtedness before any residual “equity” goes to the seller. Foreclosures are always public auctions where the lender must notify the general public in advance, and the general public must be allowed to bid on the property. This public auction is necessary to prevent the lender from forcing the borrower to sell the property at a below market price to the lender who could then resell it for a profit on the open market.

Lenders do not want to own real estate. Lenders are in the business of loaning money and collecting fees and interest. At a foreclosure auction the lender will generally bid on the property up to the value of the loan. [1] This ensures auction bids will be high enough to satisfy the outstanding loan amount. The lenders do not want to be the highest bidder. They would rather someone else bid over the loan amount and make them whole. If they end up being the highest bidder, then they must manage the property and ultimately arrange for its sale in the non-auction real estate market. There are costs and fees associated with this endeavor which eats in to the final disposition amount garnered from the final sale of the property. These fees generally increase the loss for the lender.

Recourse vs. Non-Recourse Loans

Loans used to purchase real estate assets can be either recourse loans or non-recourse loans. A recourse loan is one where the lender can sue the borrower for any amount owed in the terms of the loan contract. As with foreclosure laws, whether a loan is recourse or non-recourse varies from state to state. In California, all purchase money mortgages are non-recourse loans. In most states, including California, all refinances, home equity lines of credit or other loans not used to purchase the property will be recourse loans. This distinction becomes very important in a foreclosure or short sale. If a loan is non-recourse, the lender cannot collect from the borrower for deficiency under any circumstances. The sale and closing of the property is the end of the matter: the debt does not survive. If the loan is a recourse loan the lender may have the right under certain circumstances to go after the borrowers assets after a foreclosure. This depends on whether the foreclosure was judicial or non-judicial.

Judicial vs. Non-Judicial Foreclosure

Foreclosure proceedings in most states can be either judicial or non-judicial at the lenders discretion. The lender has the right to sue the borrower in a court of law for repayment of the debt on the property. This legal action is a judicial foreclosure. A judicial foreclosure is slower and costlier than a non-judicial foreclosure. The mortgage agreement has a provision where the borrower authorizes the lender to sell the property at a public auction if the borrower fails to pay the debt. A lender can exercise this right without a court order, and therefore it is considered a non-judicial foreclosure. It is faster and less expensive to perform a non-judicial foreclosure because no attorneys are involved and there is no waiting for a case to come up on a court’s schedule; however, there is a problem with non-judicial foreclosure, in most states the lender waives their rights to obtain money in a deficiency situation because no deficiency judgment is entered in the court record. When faced with deciding between a judicial or non-judicial foreclosure, the lender must weigh the cost and time of a judicial foreclosure against the probability of actually collecting any money with a deficiency judgment. If a borrower is insolvent, which they often are if they are going through a foreclosure, they may not have enough money or other assets for the lender to collect on the deficiency judgment. In these circumstances, the lender will foreclose with a non-judicial procedure to minimize their losses. In these circumstances the borrower is not liable for repayment on the deficiency.

Tax Implications

Prior to the Great Housing Bubble, if a mortgage debt was forgiven, the amount of forgiven debt was subject to taxation as ordinary income. Since people who lost their house under these circumstances were already financially ruined, this tax provision was seen as unduly burdensome to those it was levied against. The President signed into law the Mortgage Forgiveness Debt Relief Act of 2007 to relieve the federal income tax burden on debt forgiven in a short sale, foreclosure, dead in lieu of foreclosure, or a loan restructuring where the principal amount was reduced. This tax relief is only given to an owner’s principal residence and only for debt used to acquire the property. Speculative properties purchased as second or third homes are not covered, and debt incurred after the purchase through refinancing or opening new credit lines is not covered. This tax change made it easier for some borrowers to make the decision to go through a foreclosure because it removed one of the negative consequences of the decision.

A Buyer’s Market

When the market turned up in the late 1990s the market shifted. During the last decline, the buyers had an advantage. During the bubble the advantage went to the sellers. The seller’s market went on for so long and became so feverish that people have forgotten (or may never have known) what it was like to see buyers in control of the action. Buyers need to be re-educated on how to behave in a buyer’s market. Buyers must remember they are the ones in control. Buyers are the scarce resource in the marketplace. The seller is one of many for the buyer to choose from, and all sellers are desperate. Sellers need buyers. Buyers do not need sellers. No matter which seller the buyer purchases from, the buyer is going to leave all the other sellers disappointed because they are going to continue to be trapped in their homeowner’s prison. [ii] Buyers cannot please everyone, so they should focus on pleasing themselves.

Buyers should not become concerned with the sellers needs, wants and problems. Does it matter if this house is the seller’s entire savings for retirement? Should a buyer care if a sale below a certain price puts the seller into bankruptcy? Buyers need to ask themselves, “Would I give the seller money if I were not buying their home?” Unless the buyer is running a charity, the answer should be no, and she should not care about the consequences of the seller’s financial decisions. The seller created her own problems; it is not the buyer’s responsibility to solve these problems by overpaying for a house.

Pay the Lowest Possible Price

This may sound like common sense, but the behavior of many buyers during the early part of the decline demonstrated a lack of understanding of this principal. Buyers should not ask for or take any incentives, and they should pay their own closing costs. They are paying for all these incentives; it is just buried in the loan. They will be paying interest on this purchase for the next 30 years, and the buyer will be paying property tax on these costs for as long as they own the house. Buyers are far, far better off lowering the price and foregoing the incentives and paying their own closing costs. A buyer’s brokerage typically kicks back 2% at closing. Work out a deal with them in advance where they will agree to take a 1% commission at the closing so the price can lowered by 2%. Again, the buyer is paying taxes on the purchase price, so they should make this as low as possible.

The First Offer is the Best Offer

This is the most counter-intuitive part of buying in a buyer’s market. Ordinarily sellers, or more accurately the seller’s realtor, try to create a sense of urgency to buy the house. They want the buyer to think other people are looking, there is going to be a bidding war, and the buyer needs to get an offer in today. Realtors thrive by creating fear in buyers. They will use lines like:

• It is a good time to buy!
• Hurry. This one won't last.
• Don't throw away your money on rent.
• If you are serious, you had better buy now or you might be priced out of the market.
• They are not making land anymore.
• If you see a property you love, you really need to make an offer.
• The more earnest money you put down, the more seriously your offer is taken.
• Things have been a bit slower than last year, but the last two weeks we have seen a lot more traffic.
• Rates are at all time lows and buyers have more choice than ever!
• Rates are creeping up, so you better get in now.
• If you wait until the bottom, you will miss out on getting a property that you really like.
• This property is priced at below market value.
• Incentives this good won't be available after…
• Don't worry about the asking price: just offer what you're willing to pay.
• Don't worry. You can afford this house.
• I will show my client the offer, but I just want to let you know that we have another offer for more coming in this afternoon.
• Trust me.
• It’s not just the commission. I really care about you.

In a buyer’s market these ploys are all lies (the truthfulness of these statements is questionable in all market conditions). Generally, the buyer is the only prospective buyer, and they can take as long as they want to buy the house. The buyer’s task in negotiating is to create a sense of urgency and panic in the seller. This is why buyers should make their first offer their best offer.

There are many properties priced over market in a buyer’s market. Sellers resist the realities of the market environment. Asking prices that are much too high do not warrant buyer consideration. Most sellers will not reduce their asking prices more than 15% to consummate a transaction, so “lowballing” a seller with an offer 25% from their asking price is a waste of everyone’s time. If the asking price is not within 15% of the price a buyer is willing to pay, the buyer should not even instigate a negotiation. If the asking price is within range, buyers should start with a bid at least 10% below asking price. This is the best offer. The buyer should lower the opening bid as follows:

• If actively bidding on the property, the buyer should make all offers expire in 3 days, and these offers should be delivered on a Tuesday. The buyer should not allow the seller to think about things over the weekend. If the buyer is still interested in the property after the offer expires, resubmit a fractionally-lower offer (1% is a good rule) on the following Tuesday (make them sweat over the weekend). The new offer should not be so much lower as to lose consideration, but it should be enough lower so that the seller gets the message they need to accept the offer before it drops further.
• If the seller makes a counter offer, the buyer should retract the offer and resubmit a lower one. This works the same as the time decay offer above. After the buyer has lowered an offer a few times, the seller may panic and take the offer before it goes any lower. This is what buyers are after.
• Buyers should lower their offers 1% each time they speak with the seller’s realtor. Every time the seller’s realtor communicates with the buyer, the realtor will pressure the buyer to increase their offer. If the buyer lowers their bid each time the realtor speaks, the buyer sends a message that the realtor pressure is not working, and it is, in fact, hurting the deal. Buyers should lower their offer 2% if the realtor uses one of the standard lies mentioned above.
• If the realtor tells the buyer there is another bidder on the property, the buyer should immediately withdraw their offer and tell the realtor to call if the deal falls out of escrow with the other buyer. Since this statement from the realtor is almost certainly a lie, it will cause them to have to explain to their client why the only buyer around has pulled their offer.

Closing the Deal

When the seller starts to counter-offer, it is very tempting for buyers to agree to their price to close the deal, particularly if the counter offer is below the original offer. Buyers should not do it. In a buyer’s market, the seller will come to meet the buyer’s terms. Buyers have the power. However, if the seller is now asking below the original offer, and if the buyer really, really wants the house, the buyer may raise the offer one time. Even after a price agreement has been reached, the deal can still be made better. The buyer should go through the inspection sheet and establish holdbacks for all repairs. The buyer should do this as an incentive for the owner to get this work done before move-in.

Not everyone has what it takes to implement all of these price-shaving techniques. However, the more of these that buyers put into practice, the lower the price they will pay for the home they want. A buyer will never see the seller or the seller’s realtor ever again. It does not matter if they are offended. In the end, they will be relieved the buyer took the house even if that buyer made their lives hell in the process.

Summary

Many would-be sellers failed to sell their homes at inflated bubble prices. This might not have been a financial burden depending on how they managed their mortgage debt. They may have regretted missing the windfall they could have received by selling at the peak, but they stayed comfortably in their homes and forgot about the excitement of the real estate bubble. The sellers who missed the peak sales prices and fell underwater on their mortgage faced more difficult choices. Many borrowers concluded a foreclosure was the best course of action because they owed more on their loan than their property was worth. Also, due to the exotic loan terms utilized by many borrowers, they were experiencing increasing loan payments and decreasing property values. With the prospect for recovery bleak, many decided to give up paying their mortgages and allowed the lender to foreclose. One can argue the morality of this decision, but financially, it was the best course of action given the conditions.

In a buyer’s market, the buyer has the power in a negotiation. Buyers should take advantage of this power and negotiate the lowest possible price. Since the price determines the loan amount and often the taxes on the property, the buyer benefits through lower interest costs and lower taxes by minimizing the purchase price. Buyers are not responsible for fixing the prior financial decisions of sellers. Overpaying for real estate to cure the financial mistakes of sellers is not in a buyer’s best interest. Financial transactions with real estate are not relationship building exercises. Buyers almost never maintain a relationship with sellers after the transaction is complete, and paying extra money for a house to be a “good neighbor” or nice person is not to a buyer’s financial benefit.

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[1] By mid-2008 lenders were so overwhelmed with foreclosures that many began bidding less than the loan amount in hopes auction bidders would limit their losses and they would not acquire even more residential real estate.

[ii] Homeowners who owe more on their mortgage than their house is worth in the resale market are by definition homedebtors. The fact that they cannot leave the place they live means they are effectively in prison.