With these market conditions, how does a lender decide whether to sell or hold a property
Prestigious sources like the Wall Street Journal and Realtor Magazine have devoted a considerable number of column inches to the growth in residential real estate inventories. Some of that inventory growth has been due to foreclosures, especially in the last 24 months. RealtyTrac.com, an on ine foreclosure marketing company, and the Mortgage Bankers Association are both citing year-to-year growth in foreclosures of 40-50% for 2006 over 2005 and forecast similar results in 2007 over 2006. What this really means is a lot of homes are lender owned today. Because the market is still weak, these homes are not selling.
With these market conditions, how does a lender decide whether to sell or hold a property? By collecting some basic financial data on each property and knowing the cost of capital, a lender can pragmatically decide whether to accept an offer on a foreclosure property or not.
Since most foreclosures will be disposed of within a year or two...
With these market conditions, how does a lender decide whether to sell or hold a property? By collecting some basic financial data on each property and knowing the cost of capital, a lender can pragmatically decide whether to accept an offer on a foreclosure property or not.
Since most foreclosures will be disposed of within a year or two...
The first figure to know is the lender’s cost of capital. This is the weighted average of the cost of borrowing and equity, expressed as an interest rate. Since most foreclosures will be disposed of within a year or two, it may be best to use the cost of incremental, or additional, capital. Most companies will find their current incremental cost of capital to be in the range of 10-12% assuming a mix of preferred stock or bonds, debt, and common stock and that the company that is only moderately risky form the investor’s viewpoint.
The next numbers are the holding costs: taxes, insurance, lawn service, utilities, and depreciation. Yes, depreciation must be considered. Any inventory is subject to deterioration, and empty houses are particularly prone to vandalism, storm damage, and general neglect from being unoccupied. This “inventory carrying cost” may be somewhat subjective and vary widely from property to property, but a lender should be able to determine the ratio of such expenses to the loan value outstanding on foreclosed properties by market area.
Finally, the selling costs are needed: real estate commissions, transfer taxes, fixing up expenses, and other cost borne by the seller. Other than fixing up expenses, selling cost are not particularly relevant since they will be incurred at any time the property sells. The only variable there is selling price so once could argue the difference in the selling costs between a full value sale and a discounted sale should be considered. I chose to ignore them because I focus on the monthly costs of ownership.
Assume the lender has a home appraised at $240,000 with a defaulted balance of $200,000
The next numbers are the holding costs: taxes, insurance, lawn service, utilities, and depreciation. Yes, depreciation must be considered. Any inventory is subject to deterioration, and empty houses are particularly prone to vandalism, storm damage, and general neglect from being unoccupied. This “inventory carrying cost” may be somewhat subjective and vary widely from property to property, but a lender should be able to determine the ratio of such expenses to the loan value outstanding on foreclosed properties by market area.
Finally, the selling costs are needed: real estate commissions, transfer taxes, fixing up expenses, and other cost borne by the seller. Other than fixing up expenses, selling cost are not particularly relevant since they will be incurred at any time the property sells. The only variable there is selling price so once could argue the difference in the selling costs between a full value sale and a discounted sale should be considered. I chose to ignore them because I focus on the monthly costs of ownership.
Assume the lender has a home appraised at $240,000 with a defaulted balance of $200,000
Now let’s look at an example. Assume the lender has a home appraised at $240,000 with a defaulted balance of $200,000. Also assume there is no chance of recovery from the borrower, the houses in the market are taking an average of 14 months to sell (longer for foreclosures), and the house needs some work to sell at the appraised value.
The numbers:
Cost of capital: 12% or $2000 monthly
Taxes $4800 or $200 per month
Insurance $800 or $67 per month
Utilities $120 per month
Lawn service average $100 per month (use summer/winter costs to be precise)
Lender’s inventory loss carrying cost expenses in this market 2% annually or $333 per month
The scenario:
This house has been on the market 3 months
The lender has an offer of $148,000 from a qualified buyer who can close in 30 days
Fixing up expenses will be $1800 to meet FHA lending standards
However, the message is it is better to not to have and hold...
The numbers:
Cost of capital: 12% or $2000 monthly
Taxes $4800 or $200 per month
Insurance $800 or $67 per month
Utilities $120 per month
Lawn service average $100 per month (use summer/winter costs to be precise)
Lender’s inventory loss carrying cost expenses in this market 2% annually or $333 per month
The scenario:
This house has been on the market 3 months
The lender has an offer of $148,000 from a qualified buyer who can close in 30 days
Fixing up expenses will be $1800 to meet FHA lending standards
However, the message is it is better to not to have and hold...
The monthly holding cost for this property is $2820. It could be on the market another 11 or more months. That is $31,020 or more in holding costs. The loan balance, less this potential cost, is $168,980. When you add the fixing up expenses of $1800, the offer of $148,000 is too far from this benchmark discounted value of $168,980. However, an offer of about $170,800 would be a break even offer after discounting for potential holding costs and offers approaching this figure should be seriously considered.
One can argue that the time on the market before a sale is the big unknown. I certainly agree. If the lender feels this house will sell faster or slower than average, that should factor into the decision. However, the message is it is better to not to have and hold if the lender gets an offer that reflects something as good or better than the averages after considering the potential holding costs.
One can argue that the time on the market before a sale is the big unknown. I certainly agree. If the lender feels this house will sell faster or slower than average, that should factor into the decision. However, the message is it is better to not to have and hold if the lender gets an offer that reflects something as good or better than the averages after considering the potential holding costs.
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