Why real estate investors want underwater properties

At first “underwater” properties may not sound especially attractive but a home that’s submerged today can be instantly attractive with new ownership.

“Underwater properties are sometimes hidden gems, homes and land with lots of potential for savvy investors,” explained Rick Sharga, Executive Vice President with RealtyTrac, a leading source of real estate deals and foreclosure data for investors. “That’s because the term ‘underwater’ typically refers to the owner’s finances rather than a property flaw of some sort.”

How underwater properties are created

An “underwater” property is generally the result of unsustainable finances, falling values or both. An owner can become underwater when the property’s value is less than the outstanding mortgage debt and the owner must sell. Here are several ways this can happen.

First, underwater homes can be created as a result of changing owner economics. For instance, a home is purchased for $300,000 with 5% down. The mortgage balance is $285,000. Everything is fine until the owner loses his or her job. Unable to keep up with mortgage payments the owner is underwater.

Second, local home values fall at the same time an owner must sell. In this situation the borrower must sell even though the sale price will not be enough to cover the mortgage debt. So far falling prices have not been common during the pandemic but they do happen. The National Association of Realtors reported that in the second quarter, out of 181 major metro markets, home prices rose in 174 metro areas (96%). This also means property values generally declined in 7 metro areas.

Third, with mortgage rates reaching new lows in recent months many owners have decided to refinance. The good news is that refinancing can replace high-cost mortgages with new mortgages and lower monthly expenses. Qualified borrowers can refinance as much as 100% of the property’s value with the VA program and more than the property’s value with financing under the Fannie Mae High LTV Refinance Option (HIRO).

The catch is that properties with high loan-to-value (LTV) ratios can go underwater if local property values decline. If a borrower cannot pay then the property is likely to be underwater if offered for sale.

Fourth, some houses are simply empty. That means the owners are paying for mortgages, taxes, insurance and repairs without the benefit of owner-occupancy or rental income. In the third quarter there were more than 1.5 million vacant homes, so-called “zombie” properties, according to ATTOM Data Solutions. Can zombie properties be good investments? Sometimes yes, especially if the property is available at discount.

How to “cure” underwater properties

An underwater property is not necessarily a property in trouble. As long as the borrower keeps making payments the lender will be happy to continue with the financing. However, if the borrower cannot make payments then being underwater becomes a problem.

How can borrowers get out from an underwater property? There are several approaches.

  • Rent the property for enough to cover the mortgage.
  • Sell the property in the open market and bring cash to closing to make up any mortgage short-fall.
  • Sell the property in the open market and get the lender to take a loss on the loan. This is a so-called “short sale.” Will lenders agree to a short sale? Not if they can help it. 
  • If the home cannot be sold for more than the value of the debt, and if the owner cannot make monthly payments, then the end result is likely to be foreclosure and a home sold at discount.

A discounted property value sounds interesting but is the discount enough to make the home attractive for a quick re-sale? Can the property be used as a rental with a positive cash flow? To answer such questions investors, need to know a lot about both the property and the local market .

Should I invest in an underwater property?

Some underwater properties have investment potential, others do not. Whether a given property makes investment sense depends on such factors as the potential acquisition price, repair costs, local market demand, whether you want to flip or hold, mortgage rates, and your financial capacity in the event of surprise costs and vacancies.

“No less important,” said RealtyTrac’s Sharga, “in the COVID-19 economy we have a number of unknowns that differ substantially from recent markets. For example, widespread eviction and foreclosure moratoriums have been created by federal, state, and local governments. What happens to home values and rental rates when the moratoriums end? In some local markets this will be a great time to buy, in others that won’t be the case. While underwater properties can be attractive, having as much information and data as possible before investing is prudent, especially in the market that’s now unfolding.”

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