Recession Financing - when decline in value eliminates equity

[Edward Kuk]

Hi everyone,

I'm trying to understand any risks to a mortgage during a recession and happened historically. This will help me understand how much debt I want to take on as I continue to look for opportunities. Two main questions here:

1) What happens when home value drops? Does the drop in home value hit 100% of the owner's equity or does it it split with the bank. I assume its the former as appreciation in a good market rewards the owner 100% since they hold the same mortgage. Should the risk not be the same in a bad market?

2) What happens when the home value drops wipes out the owner's equity? Can the bank call the loan or force a payment to equalize the loan to the new home value? For example, if there is a 200K home and I own 20% (40K). The home value then drops to 100k. I lose all my equity but still have a 160K loan on the table. The bank now doesn't have enough home value to cover their loan, can they call the loan? I heard what they might do is make you cover 60K and reset the loan to 100K, the new home value of the house. If you don't have the 60K on hand, property is gone.

Does this actually happen? In my situation, ask long as my rents are fine and I keep my job, I would rather continue paying off the loan and wait for a turn around. But if the bank forces a move to take my house, I might not have 60K handy, worst yet, what if it happens again.

[Jay Hinrichs]

Originally posted by @Thomas S.:

Generally a recession does not impact most rental owners too hard since a recession will drive more renters into the market. It's a domino effect that ripples through the industry. Greatest risk is tenants that lose their jobs requiring landlords to act swiftly to evict. 

Probably not a major threat that markets will drop too significantly in the future, certainly not in my market. If banks are offering mortgages to high risk home buyers that should never qualify for loans then major drops could occur in specific markets.

I have taken a position of removing equity from my cash flow properties and diversified my investments. If markets shift I don't want my money to be first to vanish.  Absolute worse case, which is highly unlikely, I walk away and the bank gets burned.

Where the last GFC really affected landlords were in Markets in the US that were very heavy to New construction Like Phx AZ

and Vegas  in those markets I had clients with 4 plexs that went 100 % vacant and stayed that way for more than a year and many owners even if they wanted to simply did not have the reserves to keep paying  and lost the properties to the bank and got their FICO trashed.  that's the down side of max debt..  so jobs is a big one.. 

Also its important to note.. that during the GFC the US govmit put a moratorium on banks filing deficiency judgements against borrowers. In addition moratorium on 1099C phantom income.. 

For most investors these days.. walking from a mortgage is not as simple as here are the keys.. They risk a suit for deficiency ( like banks in Texas go hard at this they always have).. and the 1099c  debt forgiveness comes back to haunt the investor in the form of ordinary income. So you may hand in the keys lose all your cash equity.. trash your credit for years to come.. Owe the IRS a big chunk of tax money and get sued by the lender for a deficiency..  Now of course not many people talk about what can happen .. but this is reality. 

I have sued many a borrower for deficiencies and you win hands down.  although frankly push's most of them into personal chapter 7.. which of course ruins their life for a good many years. 

As well as loans that had 5 year calls did not get extended in those days and banks foreclosed.. 

Bottom line is real estate has a significant amount of risk in the US .. so choose your markets well.. make sure you have LOTS of reserves for the unknown.. other wise there are much safer investments out there frankly.  Like Thomas talks about funds.. that type of thing.