Are You Under House Arrest?

Real estate is in the news yet again. We have the FBI’s report of almost 500 arrests for mortgage fraud in Operation Stolen Dreams (press release). Each month we have the list of foreclosure rankings released with Michigan holding on to the top spot and Nevada close on its heels. Then we have all of the people who are just walking away from their obligations due to hardship or simply choosing not to pay anymore. But there is another category that is greatly affecting the real estate market – people under “house arrest.”

We’re not talking about those who have received an alternative sentence from a court and are wearing electronic ankle bracelets to monitor their every move. We’re talking about people who are trapped in their current home because they owe more on the mortgage than the current market value of the house. According to a report from Core Logic, 24% of mortgages are upside down in the US. Some states are considerably worse than others; Arizona comes in at 50% and Las Vegas, Nevada at 70% (article).

Those who have the ability to pay and have chosen to honor their obligations are truly under house arrest.

Why It Matters

One of the most important components of a healthy housing market is the trade-up buyer. These are people who have a need or desire to purchase a more expensive home. Frequently new buyers would opt for a starter-home with the intent of trading up after they build up some equity. If there is no equity or negative equity how is this person supposed to move on to the next house?

The options available for these homeowners are rather limited. They can walk away and have a foreclosure on their record – not much chance of obtaining a new mortgage in that case. They can pursue a short sale where the bank agrees to accept less than the amount owed on the mortgage. That gets them out of the old house but that dings their credit as well. The third option is to make up the difference in cash. That may work when the deficit is small but how often is that the case?

Market Impact

While it’s hard to pin down a real number, in normal times a very high percentage of home sales are to trade-up buyers. These buyers would be expected to gravitate to higher priced homes than the first-time buyer. So if demand for these higher end homes is held down, so are prices. Low demand is not good for the long-term housing picture. So it may be some time before the real estate market makes a true recovery.

So what do we do as investors? We should expect that in the near-term the best part of the market will be the homes geared to first-time buyers. It also bodes well for the rental market. People have to live somewhere and if they can’t buy they need to look for rentals. Until things sort themselves out, the trade-up house may not be one where much appreciation can be expected.

Only when the tide goes out do you discover who’s been swimming naked. – Warren Buffett

Photo: mark coggins

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.