I told you in July that I'd be writing about cash flow vs. capital gains' for
August--and I haven't forgotten about that--but I wanted to share my thoughts
with you on a more timely topic that's been all over the news recently: the
sub-prime mess. What is it? What's happened? How does it affect you and me? And
is it really that big a deal?
What Is It?
Many people I ask think that sub-prime refers to the type of home mortgage
people have. Not so. Sub-prime refers to the borrower on the mortgage, not the
mortgage itself. A sub-prime borrower is just that--less than choice, prime or
grade-A. Prime borrowers have a great credit history, pay on time and are
low-risk in the lenders' minds; sub-prime borrowers don't have a good credit
history, they may not meet the income criteria and are considered high-risk
borrowers.
When the real estate market became hot, lenders and their salespeople lowered
their standards and criteria for qualifying for home loans and as a result made
loans to people who typically wouldn't qualify based on their credit and income
history.
How bad was it? Ken McElroy, one of the largest property managers in the
Southwest, told me, "We turned people away who wanted to rent an apartment from
us because, to us, they didn't meet the income or credit standards for renting.
The next thing you know, they've gotten a home loan and are moving into their
new house." That's how slack the lending standards got.
What Happened?
In my opinion, there was a combination of aggressive and greedy salespeople, who
made their commission on every loan processed, coupled with ignorant borrowers.
Many of these loans had extremely low interest rates attached to them for the
first two years and then the interest rate would increase, in some cases,
considerably.
High-risk borrowers were taking these loans for little or no money down, with
low initial interest rates and very lenient qualifying terms. They had their
dream: They owned their own home. But two years later the interest rate on their
loan increased and they had to come up with an additional $300, $500, even
$1,000 per month to keep their home.
It wouldn't surprise me to find that many people who took one of these loans,
if they were aware of the bump in interest rates down the road, thought, "In two
years, my financial situation will be much better. I'll be making more money.
I'll be able to afford the additional payment." I also wouldn't be surprised if
a lot of people who had such thoughts did nothing in those two years to change
their financial situation.
What happens from here? Here's what we are seeing throughout the U.S. and in
other countries as well: People who can't make the increased mortgage payment
are facing foreclosure and losing their homes to lenders. I think we're just
seeing the tip of this iceberg.
What's the Effect?
So how does this affect those of us who aren't part of the sub-prime drama? It's
interesting that only a small percentage--approximately 10 percent--of all home
loans are in the sub-prime category, yet the ripple effects are being felt far
and wide. For one thing, lenders are quickly tightening their lending criteria
for everyone.
It's now more difficult than before this mess for the prime, highly qualified
borrower to get financing for his or her home. Lenders want more money down,
higher interest rates and tougher penalties. As it becomes harder to get new
loans, the demand for homes, new or used, drops. This affects everyone involved
in the real estate industry, from building suppliers to mutual funds and stocks
with mortgages and property attached.
Mortgage companies, especially those with a high percentage of sub-prime
loans, find themselves sitting on a heap of non-performing loans. Borrowers
aren't paying, and as a result, the mortgage companies can't afford to pay their
bills, including payroll to their employees. We're seeing mortgage companies
laying off entire staffs and closing their doors.
More and more people who thought sub-prime lending had no impact on them are
feeling the effects. For example, I have a friend who is a real estate appraiser
for home loans. Last month she was owed $40,000 by several mortgage companies
for appraisal work she had done. She received nothing because the mortgage
companies who owed her the money couldn't pay her.
In another example, Countrywide, one of the largest home loan companies in
the U.S., was in trouble. You may have heard that Bank of America recently
bailed them out to the tune of $2 billion. What you may not have heard is that
Countrywide is also a bank. So when news got out that Countrywide was in
financial trouble, there was somewhat of a run on the banks by people who
immediately pulled out their savings they had with Countrywide for fear of
losing them, which only added to the company's problems. Although the sub-prime
lending at Countrywide was a small percentage of its loans, it created a massive
ripple effect for the entire company.
In My Own Backyard
When I look at how this has been playing out in my life, it brings to light that
the economy runs in cycles. The years 2003, 2004 and 2005 were tough ones for
many of us who owned apartment buildings. We experienced high vacancies as
people--again, primarily those who wouldn't qualify for home loans before--moved
out of their rental apartments and into their new homes.
In 2006 and 2007 the tides started turning. Due to foreclosures, not being
able to meet the higher payments and stricter qualifying standards, people are
moving out of those same homes and back to more affordable apartments. Where in
the leaner years rents were lowered and many concessions were offered, such as
the first two months free and no move-in costs, rents are now steadily
increasing and the concessions have all but disappeared.
The Good News
The bottom line, once again, is financial education. Is it really a surprise
that a good number of sub-prime borrowers are defaulting on their loans? Many
are labeled “high risk” for a reason. The simple solution for any home loan
borrower is to understand the loan and its terms. Don't rely on the salesperson
to give you all the facts you need. Don't take their word for it. They want
their commission.
Also, if you know your loan is going to increase in the near future, create
the plan today for how you're going to handle that. The first step may be to get
your personal finances in order, and you need to start by taking a brutally
honest look at where exactly you are today.
Tell yourself the truth. It's easy to lie to yourself and pretend that
everything will work itself out. It won't work itself out; you have to work it
out. The sub-prime fiasco can be a lesson to all of us to take a look at where
we are and what we may want to change today for our financial future tomorrow.
The best news of all is that the best time to shop is when there is a sale. I
predict home prices will drop and continue to drop, which is already happening
in many cities. In the world of real estate investing, this is known as a sale.
So today is a great time to begin to look for investment opportunities. As
prices fall, the potential for good cash flow rental properties increases. Do
your homework now so that when those opportunities appear, you're ready to make
your move.
P.S. Two days after writing this article I received a call about a
280-unit apartment building we owned. We were two weeks away from refinancing.
The terms we had previously agreed to--loan amount, interest rate, etc.--would
no longer be honored by the lender. They offered us less money at higher rates.
Because of the ripple effect created by the sub-prime fiasco, they wanted little
to no risk on their end. We declined, so at the moment our refinance is on hold.
Yes, the effects of the sub-prime fiasco are being felt by many.