Why This Time Is Different: The Financial Incentives Have Changed

This deserves a major section in this month’s newsletter because I don’t think enough real estate professionals understand what’s happening behind the scenes.

The financial structure of today’s mortgage market is very different from the last downturn.

And those differences will force many lenders, investors and servicers to become considerably more interested in short sales and other faster resolutions.

The backstops aren’t always there anymore

During the last housing crisis, a substantial portion of the losses was absorbed through government guarantees, mortgage insurance, investor arrangements and extraordinary intervention programs. (bailouts)

Today, we have a different mix of loans and investors.

More loans are held in private portfolios, non-QM structures, or by investors who purchased them after origination.

Some nonperforming loans have been sold with different contractual protections than the original loans. Some have mortgage insurance or guarantees, while others have limited or no protection.

The important thing to understand is that not every investor has someone else to absorb the loss.

For an investor carrying the full exposure, every additional month of delinquency, legal expense, property deterioration, tax advance and insurance expense matters.

More Importantly:

The cost of capital has changed

Here’s something else to consider.

Many loans still outstanding today carry interest rates of 3% or 4%.

Those low rates were perfectly normal when these loans were originated.

But suppose you’re an investor or lender with capital tied up in a nonperforming loan.

That money isn’t producing the return you expected, and meanwhile, there may be opportunities to invest capital at significantly higher yields.

Why would you want to tie up money for another year or two in a foreclosure if you could resolve the loan sooner?

Let’s look at a simple illustration.

Illustration: The Value of Redeploying $250,000

Investment comparison	At 3% annual yield	At 8% annual yield
Annual gross interest	$7,500	$20,000
Difference per year	$0 (baseline)	+$12,500

Illustrative interest income only, assuming fully performing investments. Actual returns, loan values, recovery costs and investment risks will differ.

Now multiply that across hundreds or thousands of loans.

And remember, a nonperforming loan may produce no current interest income at all.

This is why the cost of capital matters.

An investor must be willing to accept an immediate, controlled loss if it produces a better economic outcome than carrying a nonperforming asset through foreclosure.

Short sales are a financial decision

Most agents look at a short sale as a homeowner transaction.

The homeowner owes more than the property is worth, and the lender has to approve accepting less.

That’s true, but institutional investors look at something else.

They’re comparing the probable net recovery from a short sale today against the probable net recovery from foreclosure later, including:

• Legal expenses, servicing advances and holding costs.
• Time required to complete foreclosure and dispose of the REO.
• Property deterioration, maintenance and preservation.
• Changing property values and market exposure.
• The opportunity to recover and redeploy capital sooner.

This is exactly why properly managed short sales are so attractive.

It doesn’t mean every investor will approve every short sale. Some loans are insured or guaranteed, investor guidelines differ, and some properties may have greater recovery potential through foreclosure.

But the economic pressure to evaluate faster alternatives is paramount.

My view is that this financial pressure will become one of the strongest drivers of short-sale and coordinated-sale activity over the next several years.

Don’t overlook this part of the business. Understanding the lender’s economics will make you a much better short-sale negotiator.