There’s little doubt that the COVID-19 virus has reshaped the economy and that the pandemic’s various impacts will take years to sort out. That said, one of 2020’s great oddities has been the strength of the residential real estate market. With millions of people out of work how come home prices – at least so far – have not fallen through the floor?
A big part of the answer concerns demand. Simply put, most people want to live indoors and supply has not kept up.
One example concerns the Nation’s younger adults. According to a new report from the Pew Research Center, as a result of the coronavirus 52% of young adults – those aged 18-to-29 – now live with their families. That’s a higher percentage than during the Great Depression.
“For real estate investors the housing shortage has produced divided results,” explained Rick Sharga, Executive Vice President with RealtyTrac, a leading source of investor leads and foreclosure data. “On one side there’s a strong supply of buyers and renters. But, on the other, the demand for residential property has pushed up prices in most markets. The result is that there are attractive opportunities but it takes a sharp eye and ready cash to find bargains.”
Part of the problem for many investors is a lack of liquid capital. You need cash-on-hand to move quickly because good properties may be snapped up in just a few days. While mortgage rates are at or near historic lows many investors simply can’t get financing fast enough with traditional lenders.
The same economic forces that have pushed up real estate prices have also created trillions of dollars in new equity. According to the Federal Reserve, household real estate equity amounted to $19.66 trillion at the start of 2020 – that’s up from $8.95 trillion ten years earlier.
Okay, so there’s a lot of residential equity out there but how do owners gain access to such wealth?
Since the equity belongs to the property owners it would seem that they should have instant access to their dollars but that’s not the case. Equity in theory and equity in the form of a check are very different.
Here, in capsule form, are several ways to extract real estate equity.
1. Sell. In this case you sell the property for its fair market value, pay off any debts as well as marketing and closing costs and what remains is yours. Instantly the owner’s equity is reduced by transaction expenses, the money spent for marketing and closing. Also, there will be more money spent to move and maybe acquire a replacement property.
2. Replacement cash-out refinancing. In this situation the owner keeps the property so there are no marketing or closing costs, nor expenses for a replacement property. An existing first loan is replaced by a new and larger first loan. For example, if you have a $400,000 property with a $100,000 mortgage balance the loan-to-value (LTV) is 25%. If you refinance to 80% of the fair market value you can get $320,000 in new financing. After paying off the existing $100,000 loan the borrower has $220,000 in cash.
Program guidelines limit the amount of equity that lenders will provide with cash-out refinancing. For example:
- FHA guidelines limit cash-out refinances to 80% LTV.
- Conforming cash-out financing for a single-unit prime residence goes up to 80%.
- Qualified veterans can get 100% cash-out refinancing under the VA program. However, many lenders will limit cash-out refinancing to a lower level, say 90%.
3. Cash-out financing with a HELOC or second loan. Instead of replacing an existing loan an owner can add a home equity line-of-credit (HELOC) or a second loan to the property. For instance, if there’s a $400,000 property with $100,000 in existing mortgage debt we can add a second loan for, say, $220,000, or a HELOC for the same amount. (A HELOC is essentially a secured line of credit against which the property owner can draw, much like a credit card.)
Notice that the dollars are the same when refinancing an existing loan or adding a second loan but something has changed. With a refinance we traded one first loan for a replacement first loan. This is important because in the event of a foreclosure the first loan has to be completely repaid before the lender with a second loan gets a dime. In other words a second loan represents more risk.
However, with a second loan or a HELOC we have added debt to the property. The first loan remains the first loan. If something goes wrong you very much want to be the lender with the first loan and not the second.
And now we get to the interesting part. The odds of getting a HELOC or a second mortgage have shrunk to near the vanishing point. For the week of August 30th, Equifax reports that fewer than 100 HELOCs were originated nationwide, down from more than 27,000 a year earlier.
Why so little lender interest in HELOCs? They’re second loans in most cases. If you’re a lender worried about possible value declines in the midst of a pandemic you don’t want to be originating second loans. You can see lender nervousness in the origination figures. First loans, fine. Second loans, not so much.
Investors should consider their available equity and the reality that it’s not spendable cash unless extracted. If you want to maintain a big cash balance then it can make sense to get a cash-out refinance and keep the money on hand – just in case something interesting pops up.