The Liquidity Risk of Real Estate

September 27th, 2009 by Potato

Somewhere out there, a friend-of-a-friend-of-a-friend has run into marital and financial difficulties. About 2 years ago they bought a house with ~<5% down and a long amortization mortgage. Today, they’re splitting up and have to sell the house.

Even if you plan to stay in your home for 7, 10, or more years, life happens: divorce or job loss/change can sneak up on you and you can find yourself needing to move. Even without considering a potential dip in the housing market, it can cost a good 7-10% of your home’s value to get out of it: an agent will take 4-6% as commission — a strong case can be made for selling on your own, but then you might still lose out on that much due to kicking back something to the buyer’s agent, and the fact that a buyer will expect to at least split the savings with you. The lawyers and any repairs/repainting you have to do to move it will take a chunk, as will land transfer taxes if you buy a new place (and capital gains tax if it wasn’t your primary residence). Your bank will also want a hefty fee to break your mortgage early, particularly if you’re not rolling over into a new mortgage with them. A house simply is not liquid: it can take weeks or months to sell, more months to close, and there are high fees for doing it when it does finally get done.

In this 4th-hand anecdote, the couple in question doesn’t have any savings outside their home, and in such a short timespan they’ve paid basically none of the principal back beyond that initial 5% downpayment. If they sold, they wouldn’t get enough money from the sale to pay back the mortgage and all the other fees.

They can’t afford to sell.

In this case they may default on the mortgage and let the bank foreclose. I don’t know if they tried to negotiate a “short sale” with the bank, to have the bank forgive the few percent shortfall if they sold now, but I doubt that option will be as popular in Canada as it has been in the US. After all, even after foreclosing and auctioning off the house, the bank can still come after them for the remaining money owed. If it’s substantial enough that the bank will go to the effort of suing, they’ll probably have to declare bankruptcy. They probably could have sold, lost their downpayment/equity, and worked out a payment plan for the remainder, but it doesn’t look like they consider their credit worthiness for the next decade to be worth that.

So, a lesson for all the would-be 5%-downers: be sure that if you get caught off-guard, having to sell, that you can come up with at least the extra money needed to cover the closing costs. You can call paying down your mortgage “forced savings” all you want, but nothing beats actual savings in a time of crisis. Also, consider that the first ~7% that you put into your home is not “equity”, but is actually lost to you forever, your selling costs pre-paid. A 5% mortgage then can be seen as a de facto negative-equity one.

A somewhat similar story was featured in the Globe this Saturday. It was focusing on the issue of involuntary part-time work, with the added wrinkle of a declining rather than flat housing market, but also highlighted that a job issue can force one to sell their home at a loss, and unless one declares bankruptcy, payments will still have to be made on the debt even if the house isn’t lived in anymore:

When he landed a well paying job at TransAlta Corp. in early 2008, running the electricity company’s computer systems, one of the first things Mr. Jones did was buy a house.

He wanted to live the homeowner’s dream, so he plunked down mid-six figures on a full-sized house in Calgary, which he helped finance with a salary that paid him a comfortable $120,000 a year.

It didn’t last long. Things took a turn in February when the slowing economy humbled energy prices and TransAlta, like many companies, began to slash costs. As one of the newest additions to the company, Mr. Jones, 57, was among the first to go.

Immediately, he began looking for work, but found little in the form of full-time opportunities. Instead, Mr. Jones was forced to pick up a few days of work each week to try to make ends meet.

“When you’re unemployed, people can catch you at nickels and dimes,” he said. “They know it when they have got a guy who’s probably worth a fortune, but he’s unemployed and he’s got a mortgage. So they offer him peanuts. And you take it because you’re scared. And because three days a week is better than no days a week.”

In June, unable to keep up with his mortgage payments, Mr. Jones sold the home in a hurry, in a slumping real estate market. The sale came at a considerable loss, forcing him to absorb tens of thousands of dollars on the mortgage. He now continues to make monthly payments, albeit smaller ones than before, on a home he doesn’t live in. “I was falling so far behind that they were going to take it anyway,” he said.


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