The Morning Report
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Monday, Sept. 25, 2006 | From the meager showing of hands in the air, you’d think someone had just asked a class of fourth-graders to explain the repercussions of gravity on the moons of Saturn.
The class of 185 commercial real estate investors and brokers was gathered over fruit salad, bacon, eggs and potatoes at the Mission Valley Marriott on Thursday morning to discuss the future of apartment investing in San Diego’s shaky housing market. And the meeting’s moderator, commercial real estate broker Robert Vallera, had just opened the breakfast with this question: How many of you think the past 12 months have presented you with good money-making opportunities?
A couple of hands crept up in response, but the majority of people kept their hands down and just swallowed another gulp of coffee. And the response was just as hesitant when he asked how many expected the market to rise in 2007. Most thought it would fall or, at least, move sideways.
Vallera said morale at the breakfast, which has run annually for more than a dozen years, hasn’t always been so low.
“Over the past decade, the mood has typically been more upbeat,” Vallera said. “We’ve had a tremendous up-cycle in terms of the length of the up-cycle and the amount that property values have risen. Now, there seems to be a consensus that the market will go through or is going through some kind of correction.”
Soon, renters may get tangled up in that market correction – if landlords start going into foreclosure on their investment properties and have to kick out the tenants without much warning. And while most analysts agree that’s a long-shot scenario for most real estate investors, the heated market inspired a lot of novices to jump onto the landlord scene. And those people often had little, if any, understanding of what might happen if the market stopped appreciating so dramatically.
When investors buy a piece of property to rent out, one of their biggest considerations is cash flow – they weigh their mortgage and other expenses for the property against how much they expect to charge in rent. When the market practically guaranteed sizable appreciation each year, the landlords could operate with negative cash flow with the knowledge that if it got really tough, they could refinance with the increased equity and float the mortgage again.
So landlords who bought properties last year could find themselves in trouble – the impact of the countywide 2.2 percent drop in median resale price means they may not have the option of refinancing if their cash flow dips too far negative to hold on. And if a landlord starts defaulting on mortgage payments and the property goes into foreclosure, some tenants of the property could become caught in the gears of the very housing market machine they tried to stay out of by renting.
Most analysts agree – there are a lot of “what ifs” right now. But notices of default in the county – notices sent to property owners who’ve missed at least one mortgage payment – have increased 250 percent since last August, according to the County Records Service. And, for some, that statistic is enough to convince them that the rental market will be impacted dramatically in the short term.
Landlords are not required to notify their tenants of their financial difficulty, but sometimes it’s pretty easy to figure out – like if a landlord doesn’t pay the water bill, for instance.
John Woodall rents a nearly 1,800-square-foot home on a half-acre property in Vista and said he’s fairly certain he pays less per month in rent than his landlord owes monthly on her mortgage. He’s watching for signs to gauge whether the home will be foreclosed on.
“She’s still paying for a gardener, so I figure if that stops, I’ll know it’s crunch time,” he said.
Steve Kellman, executive director of the Tenants Legal Center of San Diego, said he thinks the owners of multi-unit dwellings, who aren’t usually concerned with “blips” in the market, will not likely end up in foreclosure.
“But we may see a trend toward more foreclosures among those who bought houses on speculation,” he said. “The novice investor may find troubled times.”
“There’s a lot of people in negative cash flow, who reached pretty far in trying to take advantage of this market,” said Dan Holbrook, president of AtVantage mortgage brokerage and real estate investment firm in Carlsbad. “If we’re cruising along at 110 miles an hour and we hit a bump in the road, we’ll go careening off to the side.”
Holbrook said negative cash flow for landlords is nothing new. But, in the rising market of a few years ago, if an owner ever got to a point where foreclosure was imminent, the property had almost always appreciated in value to the point where that owner could use the increased equity to refinance the mortgage and hold on to the property. Now that the properties, especially apartments that were converted for sale as individual condominium units, have started dropping in value, owners could be stuck with a mortgage that is worth more than the home itself.
So what would happen to the tenants caught in one of these scenarios?
Kellman said a lender foreclosing on an owner’s property could cut off or wipe out the renter’s lease. If the property owner sells the property voluntarily, the remaining time on the lease is transferred to the next owner.
Howard Boehm, broker-owner of San Diego Professional Property Managers, imagines some banks will want to keep the tenants in the property to absorb some of the expenses of holding the property.
Bob Pinnegar, executive director of the San Diego County Apartment Association, said those investors who “stuck to fundamentals” – in other words, who planned around the event of depreciation – would likely be able to hold on to their properties.
It’s those who bought condo conversions in the last few years, he said, who will have the most potential for trouble.
“The last ones to the party are the ones who’ll get hurt,” he said.
Boehm agreed with Pinnegar.
“The people who purchased in the last year, that were not very sophisticated and were just jumping on the bandwagon, a lot of them have extended themselves far beyond what they should have,” he said.
Boehm’s firm runs a middle-man service between landlords and tenants. Novice landlords usually skip that service, said Kathy Belville, a lawyer with Kimball, Tirey & St. John in San Diego, and they’re probably the ones who need the professional and legal help the most.
From the banking perspective, Holbrook said the landlords shouldn’t get too worried about the threat of foreclosure – it is a real danger, but there are a lot of options they can take, like selling percentages of the properties to other investors, or offering to sell the home property to the tenant, like a lease-to-own situation.
“This is an environment where creative structure really comes into play,” Holbrook said. “People need to not just drive right off the cliff. They get in financial distress, have a meltdown, put their heads in the sand, and then get buried even deeper.”
In the meantime, Woodall, the renter, said he’d consider paying more each month in rent, if it meant he could avoid the high costs of moving. Tenants and landlords can work together, he said, as long as they keep each other informed. And if his grass stops getting mowed, he’ll know it’s time to make an offer.