Via a post on the Bogleheads forum, I read this piece of news from the WSJ Developments blog:
From that WSJ blog post, I read this research paper:
LaCour-Little, Michael, Eric Rosenblatt, and Vincent Yao, 2009. Follow the Money: A Close Look at Recent Southern California Foreclosures
A professor from California State University and two researchers from Fannie Mae studied about 3,600 residential foreclosures in five counties in Southern California in 2006 and 2007. They found the vast majority of homeowners in these foreclosures had negative equity (not a surprise). They then tried to trace the source of the negative equity.
How did they become upside down? Was it because the value of the homes dropped below the original purchase price or was it because of something else? The researchers found that the primary driver for the negative equity was the homeowners’ post-purchase equity extraction through home equity loans, HELOCs, and cash-out refi’s, not the home price declines.
That rings a bell. I posted a story I heard on the radio last year in Refinanced to Foreclosure. A lady called a talk show program saying WaMu foreclosed the family home she owned for 35 years. She loved the home. She raised her kids in it. How did she lose a home she owned for 35 years? The only explanation would be she took her equity out through subsequent borrowing.
If the lady took her equity out already, was the foreclosure a financial loss to her? We don’t know about her specifically, but we can look at the homeowners in the study. The authors of the study wrote:
“Even after these foreclosure events, the unleveraged return on investment for these property owners is very high: roughly 40% over their holding period. If borrowers financed these purchases with 100% financing, of course, the returns on investment are infinite. Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear.”
Now, that’s an inconvenient truth. The foreclosed homeowners made money. Who knew? On average they held their homes for 5-1/2 years. Making 40%, tax free, over 5-1/2 years is quite good, isn’t it?
I have to say these homeowners are smarter than I am. I did several refi’s but I never took any cash out. My home’s value is back to the same as my original purchase price. My rate of return is zero.
Learn this trick from the foreclosed homeowners: when your home goes up in value, follow the high watermark and get your equity out. When your home’s value goes down, demand a loan modification. If that doesn’t work, exercise your put option. That’s how you make money in real estate.
I e-mailed Professor LaCour-Little and asked him if he calculated the average rate of return grouped by the year of the purchase. He said he’d look into it in the next iteration of the paper.