Foreword — Real Estate Owned

Ian Galloway
Federal Reserve Bank of San Francisco

The collapse of the housing market has devastated neighborhoods and balance sheets alike. Millions of homeowners have defaulted on their mortgages and holders of mortgage-backed securities (MBS) have suffered massive write-downs. Banks and servicers have been increasingly called upon to renegotiate payment terms and reduce mortgage principle to slow the tide of foreclosures and stabilize the housing market. Despite such attempts to “work out” troubled mortgages, however, the foreclosure rate continues to rise at a steady pace.1

Lost in the current economic turmoil is a discussion of what happens to properties when they have completed the foreclosure process and revert back to the primary mortgage lender.2 In some cases, foreclosed properties are auctioned off or converted to rental housing. In others, they are razed or put into public use. In many cases, however, foreclosed properties remain unoccupied and become a financial drain on their owners. Such properties are known as real estate owned (REO).

Barclays Capital estimates that as of November 1, 2008, mortgage lenders and investors held 871,000 REO properties–up from 414,000 a year earlier. That inventory is expected to peak around 1.4 million in mid-2010.3 For communities that experienced rapid housing appreciation, the REO fallout has been particularly acute. In this issue of the Community Development Investment Review, Dan Immergluck provides city-level data that raises alarming questions about the stability of communities overwhelmed by abandoned properties. Yet from a community development standpoint, this large inventory of REOs offers an unprecedented opportunity to increase the nation’s stock of affordable housing. Community organizations and housing authorities across the country have been exploring ways to acquire REO properties and make them available to low-income homeowners and renters.

Holding REO properties can be a significant ongoing expense. Taxes, insurance, and repairs slowly erode owners’ equity in a down housing market.4 Concern over these costs has led many lenders to sell their REO properties at significant discount; recouping, on average, only 70 percent of the attached mortgage principal balance.5

These discounted prices have allowed some community organizations and housing authorities to purchase REO properties and put them back into effective use for low-income homeowners and renters. To date, these purchases have been sporadic and uncoordinated, mostly because of capacity and funding constraints.

Locating REO properties for potential purchase and rehabilitation can be a time-consuming and costly process. Few community organizations are equipped to identify, bid on, and acquire properties efficiently and cost-effectively. To assist these organizations many advocates have proposed online platforms to catalogue REO properties in an easily searchable format. Prabal Chakrabarti notes in this journal that such a database will soon be available in New England, and others are expected to follow. These online tools will lower REO acquisition costs and give smaller community organizations better access to REO properties. Large nonprofits have also emerged to provide capacity-building support. In her article, Mary Tingerthal discusses how the National Community Stabilization Trust (Stabilization Trust) has supported community organizations operating in neighborhoods experiencing a high incidence of foreclosure.

The Stabilization Trust has also advocated for increased neighborhood redevelopment funding. According to Tingerthal, the Stabilization Trust successfully lobbied Congress to set aside $3.92 billion of the $300 billion appropriated for the Housing and Economic Recovery Act of 2008 to fund the Neighborhood Stabilization Program (NSP). The NSP will directly support REO disposition through the Community Development Block Grant (CDBG) program. Other sources of federal funding are available as well. For example, Anna Steiger explores the use of the New Markets Tax Credit program as a vehicle to acquire REOs. As the foreclosure crisis worsens, more federal and state programs will undoubtedly be tapped to mitigate its effect on community stability.

In general, housing authorities and community organizations can reduce the national inventory of REOs in three key ways:

Scattered Site Acquisition and Rehabilitation
REO properties are disproportionately concentrated in inner-city communities.6 Housing authorities and community organizations can acquire and rehabilitate these properties to help address the national urban affordable housing shortage. In their article profiling three federal asset-disposition programs, Ellen Seidman and Andrew Jakabovics point out that this approach has been successful in the past. They maintain that targeted REO acquisition and rehabilitation, if sufficiently informed by previous attempts, could achieve two community development goals simultaneously: returning abandoned homes to occupancy, and increasing the stock of affordable housing in low-income communities.

Land Banking and Deed-Restricted Affordability
While an acquisition and rehabilitation strategy would result in a one-time increase in available affordable housing units, those units will become unaffordable as housing market appreciation resumes. One solution to this problem is “land banking”—limiting a property’s resale value through deed restriction. Tina Brooks discusses this strategy in this issue as she explores the possibility of making land banking a sanctioned municipal activity in Massachusetts. As Brooks notes in her article, capping appreciation allows land-banked properties to remain affordable for an extended period. Housing authorities and nonprofits can adopt this approach with REOs and price discounts can be passed directly to the homeowner. The flip side of this tactic is that homeowners will be unable to capitalize on significant gains in the housing market.

Blight Remediation and Housing Stock Contraction
A foreclosed home can significantly affect the value of the properties surrounding it. Some researchers have estimated that a foreclosed property can depress adjacent home values by as much as 8.7 percent.7 Although this effect decreases over time and distance, most homeowners would agree that living next to an unoccupied home is undesirable for a number of reasons, not the least of which being crime and fire risk. In cities that have suffered significant population decline, housing-stock contraction may be the best long-term strategy for rehabilitating neighborhoods racked by foreclosures and abandoned properties. This contraction might involve combining property parcels or razing buildings and auctioning off the underlying land to prospective mixed-use developers. In either case, blight is eliminated and local housing supply is reduced (potentially increasing the value of the homes that remain).

These approaches, and others explored in this journal, are just a few of the ways that REO properties can be used for public benefit. As foreclosures continue to mount and house prices continue to decline, more homeowners will find themselves in a negative equity position or unable to make their mortgage payments, or both. Already, one in five American homeowners is underwater—owing more on their homes than they are worth—and that number is expected to increase.8 This presents a community development challenge on two fronts. First, there is an immediate need to put millions of recently foreclosed-upon families into homes with affordable mortgage or rental terms. Second, the inventory of REO properties must be reduced before it threatens to destabilize neighborhoods across the country. For either of these goals to be met, Carolina Reid offers three lessons to the community development field: more data are needed for targeted intervention, cross-sector collaboration is critical, and complex sources of funding must be managed and leveraged to achieve maximum impact. With billions of newly disbursed federal funds, the community development industry should heed these lessons and develop a coherent national strategy to put REO properties back into effective use.

1 Les Christie, “11% of Mortgages are Troubled.” CNNMoney, March, 5, 2009. 2 Foreclosed properties do not always become the possession of the primary mortgage lender. When the foreclosed mortgage has been securitized, trusts (typically servicers) operate on behalf of the investors that own the security. For the purposes of this article, “mortgage lender” will serve as shorthand for the entity that controls the property upon foreclosure. 3 James Hagerty, “Real-Estate Finance: Lenders Tiptoe Into Bulk Sales—Glut of Foreclosed Homes Spurs Some Trial Runs,” Wall Street Journal, December 2, 2008, C12. 4 Kate Berry, “REO Strategy: From Daily Task to Damage Control,” American Banker, October 12, 2007. 5 Brian Collins, “Fannie Having Debt Woes,” National Mortgage News, November 21, 2008. 6 Teresa Lynch, “Foreclosures and the Inner City: The Current Mortgage Crisis and its Inner City Implications,” ICIC Policy Briefing, March, 2008. April 2009 7 Z. Lin, E. Rosenblatt, and V. Yao, “Spillover Effects of Foreclosures on Neighborhood Property Values,” Journal of Real Estate Finance Economics 38 (4) (2009). 8 Jonathan Stempel, “One in Five U.S. Homeowners Are Underwater,” Reuters, March 4, 2009.