Tuesday, March 3, 2009

Literally Underwater Property, Workouts, and Maintenance

You can temporarily fix almost any plumbing link with an inner tube and two hose clamps. Cut a strip of rubber long enough to cover the leak and wide enough to wrap around the pipe. Orient the long edge of the patch opposite the leak and clamp on either side of the leak. Here’s how it should look:

plumbing leak

I know this from inspecting the aftermath of a ceiling collapse in an apartment building we had foreclosed on. The water lines were corroded, the borrower was strapped for cash, and rather than replumbing, the borrower simply slapped another patch on every section of pipe which sprang a leak. By the time we took the property back there were more patches than there was visible pipe. The cost to repair the water damage was double what it would have cost for us to advance the funds to replace the water lines.

Most of the concern expressed over underwater properties (i.e., properties whose value is exceeded by the mortgage debt) is that the borrowers have become “mortgage slaves” (see, for example, this Calculated Risk post). But, the situation has risks for the lender too. If a property is under water (i.e., the borrower has no equity), what incentive does the borrower have to maintain it? If all the cash flow from a rental property is taken for debt service, what happens when the roof starts to leak?

A frequent mistake lenders make in trying to restructure debt is to leave no incentive for the borrower to maintain the property. Best practices are to allocate enough cash flow to a controlled capital account so funds are available for repairs, and to structure some up side for the borrower if the property value improves. In the short term this results in less cash flow and a larger loss for the lender, but preserving the collateral value generally results in a higher ultimate recovery.