Homeowners' Dilemma: to be or not to be in Foreclosure

According to several experts, the residential real estate market is poisoned to deflate at around 40%-50% in many areas of the country, specially in high speculative areas such as in California, Florida, Arizona, etc. Furthermore, foreclosures will greatly increase in the country according to several statistics and projections. It doesn't take more than to look at the work of the prominent economist H.S. Dent (www.hsdent.com) or doing a quick search in a bookstore for a myriad of recent economic books that talk about the upcoming Greater American Depression.

Many homeowners have a very difficult decision to make in these historical economic times. Their properties are in a position now that it'll be extremely difficult to make them cash flow positive as rentals, and/or to sell them for more than what their underlining mortgages are. It's overwhelming to see the amount of new investors created during the 2001-2005 residential real estate boom. These investors where speculators with little investment education who wanted to jump on the train of quick real estate appreciation; in many occasions renting their properties out and getting negative cash flow in exchange for hopes of future appreciation. They ignored well known facts in the professional investment world: In order to get positive cash flow, most of the time you need to buy in the rare market where high cap rates are the norm (annual net operating income divided by property price. For example, a $1,000,000 property with $60,000 of net operating income per year has a cap rate of $60,000 ÷ $1,000,000 = 6%.). Such markets are usually severely depressed like Anchorage or Oklahoma City in the late 80’s. The reason tenants are willing to pay more to rent than they would have to pay to own in such markets is that they believe property values are falling or level, in which case not owning is a good idea in spite of the high rent.

Even then, the positive-cash-flow situation is typically a brief window that lasts only six months to a year. Positive cash flow is so rare and so desirable that it attracts out-of-area investors. Their coming into Anchorage or Oklahoma City or wherever drives the prices up so that high cap rates are no longer available.

The other way to achieve positive cash flow is to make a bargain purchase like at a foreclosure auction or out of probate. In that case, you have a low loan-to-value ratio, even though your loan-to-purchase-price ratio may not be low. When you achieve a positive cash flow through a bargain purchase, you generally should sell out soon because your extraordinary amount of equity will result in your return on equity being low.

Return on your investment is interesting to look at initially, but after purchase, you should switch to looking at your return on current equity. Dividing current net operating income by past purchase price is a misleading apples-and-oranges comparison. Return on investment (down payment and closing costs) will be high initially and climb higher if you bought right; but return on current equity (current market value of property less current mortgage balances), which is the correct denominator, will show a low and falling rate of return. That tells you to redeploy your money to where it can earn a higher return.

Basic financial education suggests that It doesn't make sense to continue investing in an asset that is rapidly deteriorating in value to the point where a property will perhaps be worth about 40%-50% less than what it was bought for. What perhaps started as an asset with some equity when the homeowners purchased the property, is now a draining financial liability.

The most recommended approach now for property owners trapped with negative cash flow rental properties or trapped in a personal residence they can't sell with or without equity, would be to speak with the mortgage lenders about possible options; banks should be nowadays more willing to negotiate financial loan terms in order to avoid foreclosure (be aware that most banks don't offer much assistance unless a homeowner is already behind in his/her payments and has been sued with a foreclosure complaint).

If the homeowner decides to stop paying the monthly mortgage obligation, after 3-4 months of no mortgage payments, the lenders will start legal foreclosure proceedings, and in about 6 months or so (depending on the state laws where the property is and how busy is for a trustee or the county court house to schedule a sale due to the present high volume of homes in foreclosure), his/her property(ies) will be sold at public auction. At the public auction, is very common nowadays that no private/individual buyer bids and purchases the property(ies), thus forcing the lender to take the property(ies) back and try to sell them in the open market with a real estate agent (which doesn't guarantee that the properties will be sold anytime soon). After the homeowner is sued and before the property(ies) are sold at the foreclosure auction, the homeowner can have a local real estate agent list them for sale in the MLS (Multiple Listing Service), and if the agent is lucky enough to find a buyer before the foreclosure auction takes place, the lender could accept what is called a "short-sale" in which the lender accept a lesser payoff amount than what the homeowner owes as a payoff in his/her mortgage, so that the lender can avoid more loses in the future. Homeowners must contact their lenders directly to request a short-sale package to be sent by fax and/or mail. Roughly, the steps for a short-sale are the following:

- Request a short-sale package from both lien holders.
- Get a buyer for the property; preferably at a price close to the fair market value of the home
- Submit to lien holders short-sale packages with requested information (preliminary HUD-1, hardship letter, W2's, bank statements, income tax returns, purchase and sale agreement with a new buyer, etc)
- Obtain approval by both lien holders individually in the form of a payoff letter. Make sure that in the payoff letter the lenders waive their rights to a mortgage deficiency judgment
- Submit payoff letter(s) to closing agent.
- Close on the purchase.

Many homeowners across the country are faced with this dilemma: They either keep their high credit scores and get stressed and financially drained with a depreciating asset that will probably be worth 40%-50% less than when purchased, or get rid of the assets in foreclosure, get rid of the stress, and keep their hard-earned cash to buy more properties in 2012-2014 or so when the market is perhaps expected to hit bottom and they will be able to create massive wealth in the upturn of the new real estate cycle that will probably peak in 2022-2023 or so.

Bankruptcy is another option, however, an attorney should be sought for it. If you are considering filing for Chapter 13 bankruptcy protection, be aware of something that your attorney will perhaps not tell you: Based on research papers, the overwhelming majority of Chapter 13 filers do not complete their payment plans and are not discharged (see The Realities of U.S. Personal Bankruptcy under Chapter 13, Hülya Eraslan Wenli Li and Pierre-Daniel Sarte, February 14, 2007 and Chapter 13 Bankruptcy: Successful Versus Unsuccessful Debtors, David A. Evans, Utah State University and Jean M. Lown, Utah State University, 2003)

Since, I'm neither a financial advisor, nor a legal advisor, I'm not legally suitable to recommend a course of action and this is a very intimate and personal decision based on the homeowner's personal priorities in life. They have to arrive at their own conclusions based on the facts that I'm providing and other facts that they accumulate in their research.