I have some questions about underwater mortgages/loans:
1. Can someone explain why they are bad? I get that a loan is underwater when the mortgage/loan is higher than the full value of the property. I get that it's not an issue in the long run if you pay the whole thing off, or if the value of the property rises again. I don't understand why when people/businesses are underwater on property they immediately hand in the keys?
2. Somewhat an ethical questions, how come when loans go underwater the lender has to take the hit, when if the property value goes up the lender does not get a piece of the appreciation. I get the interest paid to the lender is what they get out of the deal, just seems a little heads I win, tails you lose. Has anyone heard or done a deal where the lender participates in both?
1. Usually there is some kind of cash flow impairment that results in the value of the property being below the balance of the mortgage. Theoretically, an updated market value of a stabilized asset could be below the loan balance, but in those cases if the cash flow is sufficient to make the payments, the borrower would just stay current on the mortgage and the keys would not get returned. The situation you outlined would only happen if the loan was in or about to be in default. We have loans right now that have current LTVs of 105% but the borrower hasn't missed a single payment. So, until that one becomes a problem, we would just continue taking our P&I payments every month.
2. The lender has the potential upside of acquiring the collateral for below market value. The borrower has the potential upside of market appreciation for their asset. The trade off for using someone else's money is interest and possibly losing the collateral. Allowing the appreciation to be cut by half would skew the risk profile to the property owner too far in favor of the lender.
Okay, thank you makes sense.
Just a follow up on (1), whats the highest LTV you have seen where loan payments are still being made?
Also, so when most people say "the loan is underwater" they're really implying that the ability of the property is impaired in some ways to make profit/payment? Is that different from a residential perspective, for example, when we had the financial crisis, and people bought homes that became underwater, that was more about adjust rate mortgages (ARMs) and homeowners couldn't refinance and had to give back the keys?
And, to answer the follow up question, it is more complicated than that but yes - the borrowers couldn't make the payments on the higher rates, fell into default and lost their homes. Property values went down across the board but the only people who lost their homes were the ones who couldn't keep up with their payments and couldn't refinance into lower rate fixed debt, etc.
Also, CMBS loans are generally reappraised quarterly but balance sheet loans at banks might not be reappraised unless there is some other impairment or covenant breach on the deal that triggers a risk rating downgrade. So, the only way to know that the loan is underwater would involve a deterioration of the risk rating resulting in a new appraisal coming back below the current loan balance.
In my opinion, the key difference between SFR real estate (assuming you are living in the home and not renting it out) and commercial real estate is the source of income/repayment. In non-owner-user CRE, the source of repayment is your NOI, while in residential real estate it is your household income. The ARM loan defaults in 2008 were caused by mortgage rates suddenly spiking which caused the debt service to exceed household income across a very large amount of households which caused them to have to sell their homes. The sudden influx of homes on the market cratered home values so it made more financial sense to just give back the keys to house rather than try to sell it and compensate the lender for their loss in principal. In commercial real estate, it is very similar in the sense that the cause of landlords giving back the keys is caused by a combination of a decrease in values and the delta between income and debt service going in the wrong direction.
I wouldn't say it's unfair for lenders not sharing in the upside since they are granted a much lower downside. If LTV is 100% for example, then in theory the lender is not losing any principal. They are likely just forgoing their interest income while the borrower loses all of their investment.
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