A hot conversation topic in today’s real estate community is the potential emergence of the next foreclosure crisis due to COVID-19. Why? Because people are comparing the last housing crash that occurred in 2008-2009 to today’s situation.
While the two periods share some similarities, like a high unemployment rate and an economy on the decline, now is not then, and then is not now!
Besides the Dr. Seuss verbiage, there are certain things that make this correction different. I am going to go over some of these differences in-depth and show you why now is not the time to be rubbing your hands together and waiting for foreclosures to flood the market.
To kick things off, let’s do a comparison between the last recession and today.
The Great Recession of 2008 vs. the Great Lockdown of 2020
In 2008, banks were the problem. There was a debt crisis. A majority of lenders that were offering loans to real estate investors, commercial real estate investors, and residential buyers were being backed by Wall Street securities.
For a lot of different reasons, there were misaligned incentives to write as many loans as possible—even if they were bad loans—with the hopes of bundling them up and later selling off the portfolio. To expedite the underwriting on these loans, some reduced standards to the point where allegations were accepted and documents were not necessary for a loan to be approved. These loans were called no-doc loans.
Eventually, the bad loans became toxic and overwhelmed the entire portfolio of loans. As the crisis deepened, the real estate market crumbled under the weight of the bad loans.
They created bad debt with toxic loans, which froze the bank’s liquidity when the loans couldn’t be resold. The aggressive no-doc underwriting left very little recourse for the banks, except to start the foreclosure process since they needed liquidity. This in turn caused a crash in real estate prices.
It became a vicious circle because as the prices came down, more properties went underwater (negative in equity), incentivizing borrowers to default, which then caused more foreclosures. Eventually, the banks offered loan modifications, but it was too late and the damage was done.
As these bad loans came due, the banks had no option but to foreclose, which overloaded the courts. They eventually worked their way through all their cases and flooded the market with foreclosures and short sales.
Today, we are experiencing an income crisis. There is an enormous disparity of income from so many people losing their jobs all at once. While this could become a recession, it isn’t a foregone conclusion.
As banks were a part of the problem then, banks are part of the solution today. The stress tests that the banks have been subjected to since the last crash have left them in a much stronger financial situation.
In addition, the major banks have suspended share buybacks to maximize their liquidity. The result: the banks have been preemptively working with property owners since early March by providing workouts for existing loans. This includes forbearance, deferments, and other deals that allow an owner to skip a payment until a later time.
This might mean the payments get moved back to the end of the loan, to a short period after everything reopens, or anything in between. This might cause hardships later on, but it alleviates the negative effects of the current income crisis now.
It’s important to note that the banks are able to work with owners because of their own increased liquidity and because the underwriting used for today’s loans is more conservative. There’s more incentive for the bank to pause a temporary bad situation on a good loan than start the foreclosure process.
The signal the banks are sending with the workouts is clear: Now is not then.
Another immediate benefit of the increased liquidity is the increase in refinances that are taking place. Rates are at historic lows, allowing for property owners to save money by refinancing their current loans.
In commercial real estate, the lower rates mean it’s generally easier to refinance out of higher-interest debt. While you may not be able to pull out as much money as you planned due to the stricter lending guidelines, these restrictions will be offset by the gains of the lower rate. The net effect is the borrower lowering his or her risk for foreclosure.
Beyond all this, many foreclosures currently in the system are stuck. Most courts closed for evictions and foreclosures because of the coronavirus pandemic, resulting in no new supply hitting the market and cases that were already started just sitting in the pipeline going nowhere.
However, foreclosures have started again in some places (and more will follow suit), but it may be late 2021 when you start seeing some of these deals hit the market.
Where Does That Leave Us?
The bad news is property values will drop. This is almost inevitable with the current unemployment rate and changes in the economy. That said, the drop is not going to be anything near what we saw 10 years ago, and most owners selling will not be banks or involve short sales.
At the end of the day, people need jobs to pay their rent. To offset the current income crisis, landlords may need to provide concessions to keep a healthy tenant base. That might mean a lost rental payment or a general reduction in rent.
My estimate is that these concessions will result in a decrease in earnings of about 5-10%. Which in turn, will lead to a 5-10% drop on the valuation of commercial real estate since valuations are based on earnings. It’s not 50% like some are anticipating, but there will be a drop nonetheless.
If Not Foreclosures, Where Can I Find a Deal?
You can approach this market with the understanding that there will not be foreclosures on every corner and that the prices will not plummet. You can still get a good deal, though, by approaching tired owners.
These are owners who were thinking of selling prior to all the problems that came along with COVID-19. These are the landlords that have been doing this for 10-15 years, baby boomers looking to retire, or people who tried real estate and realized it’s not for them. These owners are going to be more realistic and motivated to sell.
Don’t expect a 50% reduction from them, but a 10-15% reduction may be worth it in order to get their money out and into something else.
To sum it up, I don’t think that we are looking at a major foreclosure crisis anytime soon in residential housing. The equation just doesn’t add up for it. That said, there are deals to be had out there—and if you know how to find them, you can still do well.
Do you have any predictions for our upcoming economic situation?
Join the discussion in the comments below.