The Dead Zone: Lowest and Worst Use

The bizarro world of real estate finance is producing some very interesting results in the marketplace.  Since government intervention has turned everything up on its head, several undeniable trends have surfaced:

1.  FHA has become the new subprime lender and monopoly player for most home financing
2.  Underwriting guidelines have eliminated financing options for most full-time realtors...people who know real estate best and likely represent the least risky of all self-employed individuals seeking mortgages.
3.  Conventional financing for multi-unit property is too painful to acquire for almost all investors.

Its #3 that I want to talk about today.  In business, when somebody goes bankrupt, the creditors seize the assets of the bankrupt company and then sell them to recover their investment.  In  many cases, the creditors take a "haircut" and end up with 40 to 50 cents on the dollar.  Nevertheless, tts a way for the market to lick its wounds and move on to something productive again. 

With real estate, when an investor purchases a multi-unit property, the process is somewhat similar.  Let's say the investor is a terrible property manager and runs the property, his real estate business, into the ground.  He runs out of money to fix up the property and nobody wants to live there because it's a dump.  He gets behind on his payments.  Eventually, the creditor, the bank, files a notice of default and then siezes the property at a trustee sale.  When reselling the property, the bank will normally take a haircut on the value of the loan it issued.  Thus, sale prices for REO property are much less than what was lent on the property previously. 

The magic of this process is that a resale normally does occur.  The bank presses the reset button on the property price, gives another entrepreneurial  investor the chance at making a profit, and the property gets put back to its highest and best use...a viable livable residence with rent-paying tenants. 

Well, today we have this strange scenario where investors are folding up left and right. From my front porch I can see three bank owned multi-units buildings.  These properties are now on the market and priced very attractively.  But they keep sitting there.  Why aren't people buying them?

The answer is credit...or the lack thereof. 

Lets look at an example on my block:  2220 Jefferson Ave. is a 3000 SQFT triplex for sale for $98,000.  Thats right...only $30,000 per unit.  What a steal right?  Well to buy this property the same bank that foreclosed is now going to want 30%, or in this case $29,400, as a downpayment to give you a loan to buy the property it owns.  Add an additional $20,000 in capital improvements into the property for good measure.  Your out of pocket expense is almost $50,000 just to get into this one property.  The property would be worth $165,000 fixed up but if you wanted to flip it, the next guy is going to need to cough up $50,000 as well.

Hence, what we see are most of the bank owned multi-unit properties sitting dormant and vacant while the market marches on.  The only multi-unit transactions that are happening out there are cash (at outrageously low prices), FHA (for owner occupants wanting to live in already fixed up buildings), and seller finance (which is being done with around 10% down instead of 30%).  Traditional financing for these properties is less than a third of the market right now.

So what are the remedies? Bank owned properties are typically beat up and won't qualify for FHA.  Banks don't do seller financing so nothing helps there.  Prices are often good but only good enough for cash purchases about one-third of the time.  What you end up with is the bank hoping for that 1-in-3 chance that a well funded buyer will plop down the 30% downpayment.  Nevermind, the rehab expense heaped on after that...the odds of a sale go way down if that is needed.  Thus, these properties sit in hibernation and in a state of lowest and worse use.

These fixer-upper REO multi-units live in a dark and gloomy niche in the market...The Dead Zone.  A place whose salvation is fire-sale pricing or mortgage credit...credit that will be elusive for some time to come.