Many parts of the country are starting to climb out of the worst real estate market since the 1930s. Are we finally creeping to a recovery or is there another disaster lurking around the corner that could force the residential real estate market into another dive?
An old friend recently contacted me about one of his commercial real estate investments. A property across the street from his had recently sold. Due to the recent sale, his lender decided to order an appraisal on his property.
Based upon the appraisal, the lender decided that the property was now worth less than what was currently owed on the property, even though the property had a positive cash flow. As a result, the lender decided to enforce a provision in the loan documents that allowed the lender to ask the investors to place additional cash into the deal to maintain the loan-to-value ratios required on the original note.
In this case, the lender wanted $350,000 from each investor. If the investors refused to pay, the lender was going to foreclose.
The two general partners were real estate attorneys who turned the tables on the lender. Their argument was simple: "If the property is not worth the loan amount, then why should we put any additional funds into the deal? You can take the property back."
A large foreclosure may have been devastating to the lender, and the lender relented.
While this was an interesting case, what does this have to do with the residential real estate market?
This particular scenario represents a snapshot of what may be a "tsunami of trouble" that can wash across not only the real estate market, but the entire economy as well.
At our recent AFIRE (Awesome Females in Real Estate) conference, Immobel.com President and CEO Janet Choynowski warned that such a tsunami, triggered by losses in the commercial market, could hit the luxury real estate market.
According to Trepp LLC, the percentage of commercial mortgage-backed securities has been increasing. In April 2010, the overall delinquency rate hit a record high. While multifamily deals showed declining delinquencies, all other sectors showed increases.
What’s particularly disturbing is the number of large loans that are defaulting. Some estimates place this number as high as $8 billion during the first quarter alone.
According to Choynowski, here’s how this scenario could play out: Commercial loans are usually short term. This means that many owners of commercial real estate will have to refinance their loans in the very near future. Because property values are upside down and rent rolls have declined, many owners will be unable to refinance.
As in the scenario above, the lender will either refuse to make the loan entirely or will require an additional injection of cash into the deal to prevent foreclosure.
If the lender forecloses, the general partners are generally wiped out, along with any contributions made by the limited partners to the deal. The real challenge for the residential market, especially the luxury market, will occur after the foreclosure is completed.
Assume that a member of an investment group didn’t put up the money and the lender foreclosed. At the time of sale, the lender takes a $1 million loss on the sale. Because the investor has a 25 percent interest in the investment, he receives $250,000 in debt relief.
When homeowners receive debt relief on their primary residence, the current laws exempt them from having to pay taxes on "imputed income." This is not the case on investments.
As Choynowski explained it, the current laws require taxpayers to treat imputed income from investment properties as regular income. This means that some investors could be receiving an unexpected income-tax bill from Uncle Sam for 2010. Since these investors will no longer own the property, many will be forced to liquidate other assets to pay the IRS.
The net result could be a further reduction in luxury property values as owners sell their homes to pay tax bills on imputed income from their commercial and retail investment properties. This decline could trigger another round of foreclosures as owners decide it’s smarter to do a "strategic foreclosure" (walk away from a property where you are upside down) rather than continuing to make payments.
This "tsunami of trouble" could ripple through both the luxury as well as the commercial real estate market. Making matters even worse, if owners have to liquidate assets they will have less money to put in their businesses.
The aftermath of this tidal wave could mean even more jobs lost, fewer buyers and, as a result, another serious dip in our weak real estate recovery.