Friday, August 08, 2008

Why We Have a Foreclosure Crisis in the First Place

by Tanta on 8/08/2008 08:34:00 AM

The Washington Post reports on tenants caught up in the "foreclosure crisis":

Thousands of unsuspecting renters who have been paying their rent on time are getting enmeshed in the foreclosure crisis that is plaguing the housing market.

In many cases, their landlords, often individual real estate investors, bought properties during the boom days, rented them out, then failed to keep up with their mortgages. The homes went into foreclosure, often unbeknownst to the tenants, who face disrupted lives and even homelessness. . . .

The Mortgage Bankers Association, which tracks foreclosures, does not know how many tenants have been uprooted this way. But one in five foreclosures initiated in the third quarter last year were not occupied by the properties' owners, the group said. Some of those nearly 70,000 properties may have been vacation homes. Others may have been vacant. But a large chunk were probably rentals, and as the foreclosure rate has climbed this year, those numbers have probably climbed.
This isn't the first story we've seen, by any means, about the plight of tenants in foreclosure. As far as it goes, there's nothing particularly wrong with the focus of the article--on the effects on the tenants themselves.

But I am as usual struck by the apparent lack of curiosity displayed here about how you can have so many foreclosures of cash-flowing rental properties. It makes perfect sense that vacant "investment" properties get foreclosed a lot: the owner has to carry the mortgage payment without any income from the property. But a foreclosure of a property with a paying tenant is, historically speaking, rather unusual. It means one of several things:

1. The purchase price of the property was simply nonsensical for an investment property, given market rents. Even though the tenants are paying, the rental payment is significantly less than the carrying costs of the property and the owner's other income is in no way adequate to make up the difference. This was a dumb loan for the owner to take and a dumb loan for the lender to make. The odds that it involved appraisal fraud--either an inflated value of the property based on the comparable approach or inflated market rents used to inflate the value on an income approach--are excellent.

2. The property was never intended to be a rental property in the first place. This would be the old "If I can't keep making the payment on this expensive house, I'll just move into mom's basement and rent it out" thing that some people told themselves during the boom. This loan wasn't made with inflated market rents in mind only because no one actually gave a moment's worth of serious thought to what market rents--and normal vacancy rates and so on--actually were likely to be.

3. The tenant is paying rent, but nowhere near what the market would support. This may be a "non-arm's-length" deal between landlord and tenant, or a desperate amateur landlord, or a naive tenant who doesn't recognize "too good to be true" or some combination thereof.

4. The owner is simply skimming rents. That is, the cash flow from tenants could cover all or nearly all of the mortgage payment, but the owner is either a classic fraudster or an idiot trying to juggle a "real estate empire" who simply never intended to apply rental payments to the mortgage.

If there are "thousands" of loans like this, then I posit that it might be more helpful to see these tenants as caught up not in a "foreclosure crisis," but in either a real estate swindle or an insane lending boom that finally had to end. That may not mean much to the tenants involved, but it would help for public policy reasons to stop thinking of foreclosure as the "cause" of these disruptions rather than the inevitable result of such "malinvestment."

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