Even strong markets can have negative equity

An article was published in the Austin Business Journal recently stating that even in Austin’s record strong real estate market, some homeowners still have negative equity – 8.1% in Travis County, 8.6% in Williamson, and 10-11% in Hays and Bastrop counties. How can this be in some of the best markets in the nation? Shouldn’t there be no negative equity in a good market?

When I first got into real estate in the mid 70’s, the average tenure of home ownership was 3 to 5 years, at which point the homeowner moved up. That has changed dramatically during the bubble and recession. Most surveys will show that most homeowners have owned their home 11-13 years before selling. Now that I think about it more, 11-13 years is not a very long time compared to the duration of homeownership by my grandparents. They held one of their properties for over forty years! In that time period, its value went up by 20X and the mortgage was paid off within the first 20 years. Lots of bad things happened in the past 40 years and the property still went up by 2000%. Talk about resiliency and the power of inflation.

The secret to property wealth creation is to just hold on for as long as possible. A 20+ year holding period smoothes out all the volatility. Any thoughts of negative equity are long gone. According to the US Census Bureau, the average time that a person lives in a home they bought is 13.3 years.

In all of our Texas markets we went back to 2000 to look median home values to answer not only the negative equity question, but what average appreciation has been in that same time period.

Yearly Appreciation for Texas Metros

Charting the Texas metros over the last ten years shows a healthy increase long term. More importantly it shows the health of the regional market with no strong negative deviations during the recession. Each metro has had comfortable but not crazy appreciation, which in my eyes is preferable. Texas has been blessed not to have any of the 45+% price swings the bubble states had (CA, FL, NV, AZ, etc). Single digit appreciation keeps speculators and short term investors from dominating sales.

median home price voice

Homeowners who think of their home as shelter may not be much bothered by negative equity. As long as they make their monthly payments, they can continue to live in the house, just as if they were tenants. But homeowners with an investor mentality are looking to a future in which they build equity. For them, negative equity is an emotional burden until they rid themselves of it, and it can turn into a curse.

Less than 10 percent of Travis County homeowners owe more on their homes than they’re worth. Nearly 11 percent of homeowners in Bastrop County are underwater. Ten percent of Hays County homeowners are underwater. Williamson County has about 8.6 percent of homes tied to mortgages that exceed their value. All the Texas metros fall into this percentage of about 10% of any given market. Again based on the data, of those homeowners with negative equity, over 50% are underwater between 1 percent and 20 percent. A small number, but alarming if you take the information at face value.

If we review the suggested cumulative amount of negative equity in Austin is about $2.1 billion. Again this is about 10% of the housing market in Central Texas. To put it in perspective, the negative equity rate across the country is 18.8 percent or 9.7 million homeowners. In Las Vegas nearly 34 percent of homeowners are underwater.’

Let’s go back to the original question – can a strong market have negative equity? The answer is yes, no matter how healthy the market is. Any hard asset historically cannot be sold immediately for a strong profit due to the costs of selling again. When you or I buy a home or investment property the thought process is to hold for a number of years, primarily because we know that home cannot achieve enough positive equity without an acceptable hold period. And as stated above there are always extraneous reasons that can cause mortgage default also. The other issue is financing. Should a borrower have higher leverage, the ability to recover equity in a quick manner is hard due to the higher borrowing costs.

New homeowners in production neighborhoods are underwater for the first few years due to financing. Is this a nick against production neighborhoods? No! Historically the consumer will pursue the easiest path of resistance and leverage. Location and quality of product also are part of the equation, and that is where new homes fulfill a need. This has been happening for years historically so I don’t see it as an issue.

Most of this is occurring in newer suburban outer rim neighborhoods, particularly at entry level, $150K to 250K. Why? The entry level consumer adds on so many things and is historically highly leveraged, so until the builder is out of the neighborhood for 3 to 5 years, most of those homeowners are underwater. The good news for most of these consumers is that they build equity and sell at a profit historically.

This is what Realtytrac (a foreclosure database) shows for Austin, the majority are entry-level. All Texas metros follow the same behavior.

foreclosure voice

What should underwater homeowners do? If you’re only a little bit underwater, maybe by a couple of percent or two, you might do nothing. In fact, most people who are underwater at the moment are basically continuing to pay their mortgage because they feel that this is the house they want to live in, they can afford to pay their mortgage, they have their income coming in, so there’s really no behavioral change, and most importantly they see the light at the end of the tunnel towards positive equity. It’s only when you reach deeper levels of negative equity that people start to think about choices around things like “strategic default,” for example.

What is a strategic default, and what are the conditions that make a homeowner more likely to strategically default? Simply put, strategic default is when someone willingly stops making their mortgage payments and goes into default even though they can afford to continue to make those payments. And there are two primary factors that drive strategic default based upon the research studies that have been done over the last couple of years.

One is, obviously, negative equity, and it’s not just being underwater, but being deeply underwater. And most of the data suggest that deep negative equity is somewhere around 125 to 130 percent—so being more than 30 percent below your mortgage amount—that people start to really consider whether or not it’s worth continuing to make that mortgage payment.

The second is whether or not it’s an owner-occupied or an investor home. Obviously, if you live in the house, and it’s your own home, the decision is much harder than if it is an investment property of yours.

The above scenarios historically and presently in our region are nonexistent. It’s mostly concentrated in the states that had big housing bubbles. So, we’re talking about markets in Florida, Nevada, Arizona, and California. It’s also generally focused on exurban areas of large metropolitan areas, so the farther-flung suburbs are often places where you find lots of negative equity. People who bought new homes in those exurban areas, generally, during the bubble years are much more susceptible than those who bought homes in the ’80s and ’90s, for example.

Presently negative equity is slowly decreasing. It is declining not necessarily because of house price appreciation, which we don’t see at the moment in most major metropolitan areas, but actually due to foreclosures and less foreclosures. Foreclosed properties are often ones who are underwater and so, as foreclosures happen, negative equity is reduced. So, it’s reducing, I guess, is a good thing, but not necessarily for the best reason.

If we look historically, what is the normal for negative equity? Most analysts never really tracked a long-time series of negative equity in large part because it’s never really been a pressing national problem in the real estate industry until the decline in prices during the recession. But, we went back recently to 2006 with the national data, and a little over a million people were underwater in 2006, as compared to 10.7 million now. At the height of the recession nationally it was just under 25% of all mortgages. So, even then, when house prices were running up, there were still a fair number of individuals who were underwater. Of course, at that time in particular, people could leverage themselves highly. So you had folks who were getting 110 or 125 percent financing going into the sale in the first place.

Real estate is local, so adopting a national or regional standard for a ‘normal’ underwater equity is not easy or healthy. But again if you look at historical numbers a healthy market should have somewhere between 5% to 10% negative equity. The good news is that the vast majority of the homeowners are looking long term at their investment where steady equity appreciation is present.

So, the negative equity story locally and regionally is not something to worry about.

Remember that homes and real estate are still undervalued, but appreciating. If you are planning to buy or sell, ask your real estate professional to run numbers for your local neighborhood. To rely on a national or regional number is a disservice to your home investment. Values vary greatly across any metro. The good news is the majority of Texas is positive.

What is the bottom line? Home prices are slowly recovering locally, regionally as well as nationally. Sales of both existing homes as well as new construction homes are improving. More people are moving into apartments and are likely to purchase a house, especially as the job market continues to gain ground. And fewer are losing their homes to foreclosure. The housing market is showing long term improvement, although some metrics (home values) look rosier than others (employment, new construction). The recovery isn’t a neat straight line. Instead, it is a messy picture of many variables that together show the economy and real estate markets are improving.