Some affluent homeowners have been walking away from a second home or investment property that is worth less than what is owed on the mortgage, even though they can still afford to make the payments.

But dumping that beach condo or country cottage, or even a home bought for an adult child — a practice known in the industry as a “strategic default” — is not the same as discarding a poorly performing stock or bond. Among the lingering effects is wrecked credit that can prevent the homeowner from getting another loan of any kind for 7 to 10 years.

In July, a study by researchers from the European University Institute, Northwestern University and the University of Chicago concluded that the strategic default trend was “large and rising” among homeowners with an equity shortfall of $100,000. As of last March, it said, strategic defaults accounted for 35.6 percent of all foreclosures, compared with 23.6 percent a year earlier.

“I’m increasingly seeing people who are middle class or higher on the pay scale coming to the conclusion that ‘I may be able to carry it, but should I?,’ ” said David Shaev, a bankruptcy lawyer in New York who assists homeowners in distress.

“But the question is, can the bank come after you, and if so, what is your position? What is your liability?”

The answer depends largely on where the property is.

In “recourse” states, a lender can come after you, and usually other assets like a primary residence, for the full mortgage amount. In “nonrecourse” states, a lender agrees to accept whatever the property fetches at a short sale, foreclosure sale, or a deed-in-lieu, in which the property is taken back but not formally foreclosed on, and generally can’t sue for the full loan amount. Florida, Connecticut and Arizona are among the nonrecourse states, while Colorado, Maine, New Jersey and Hawaii are recourse states.

There is a third category of state, called “single-action” or “one-action,” which allows the lender either to foreclose on the owner or file a civil lawsuit for the full loan amount. New York, California and Idaho are in that category.

Even in a nonrecourse state, however, those homeowners who opt for a strategic default on a previously refinanced property may not be protected from lenders, because the mortgage in such a case was not accorded for a first purchase, said Philip Faranda, a mortgage broker for J. Philip Real Estate, in Briarcliff Manor, N.Y.

When home-equity loans are involved, he added, it gets more complicated. In nonrecourse states like Florida and Connecticut, the lender cannot sue to collect any home-equity loan taken out on the property. But in nonrecourse states like Arizona and California, the lender can still sue for repayment of a second mortgage or line of credit.

Filing Chapter 13 bankruptcy protection, in which the homeowner arranges to pay off debts at lowered amounts over a maximum of five years, is typically the only way to avoid being on the hook for the second loan, mortgage experts say. Affluent homeowners who strategically default on a second home often don’t qualify for Chapter 7 bankruptcy, which leads to liquidation but limits eligibility to those earning no more than state median income levels.

Though not illegal, strategic defaults are controversial, because they are viewed in some circles as unethical. The practice is common among property developers.

For homeowners under water, experts say, it can make economic sense. “It’s a business cash-flow decision,” Mr. Faranda said, “but the risk is that you’re rolling dice with your future credit.”

A foreclosure from default stays on a homeowner’s credit report for 7 years, while filing for bankruptcy stays on the report for 7 to 10 years, he said. A default can lower a credit score by 85 to 160 points, according to FICO, the company that created the scoring method.

Guarded optimism returned to the hallways at NAREIT’s conference last week, replacing the economic gloom and doom that shrouded the last real estate investment trust industry gathering in San Diego last November. But for all the talk of “green shoots” in the credit markets and broader economy and this spring’s stock market rally, it still remains to be seen whether the recent rallies in REIT share prices and the raising of nearly $15 billion through 45 public equity offerings since the beginning of the year will take root in an economic landscape littered with continuing job losses and weak property fundamentals.

Certainly, attendees of the National Association of Real Estate Investment Trusts REITWeek conference were in a less dour mood. And why not — equity REIT share prices, which fell 15.7% in 2007, nearly 38% in 2008 and another 39% in 2009 before reaching a low in 2010,  have since rallied by more than 60% through June 9, according to the MSCI US REIT Index.

The optimism has been fueled by the “re-equitization” of many REITs through secondary offerings over the last few months. NAREIT released an analysis last week predicting that publicly traded REITs will raise $582 billion for acquisitions representing $728 billion in property value, including debt, by the end of 2012. The surplus equity should begin to create acquisition activity by the second quarter of next year.

Just two months ago, analysts said the amount of equity being raised would come nowhere near the need. Citigroup estimated that REITs would need $35 billion in total equity to bring the sector down to 50% leverage at a presumed 8% cap rate. To reduce leverage to 45% would require $57 billion in equity.

While conference panelists agreed that raising the necessary equity will be a tall order, REITs could reduce their average debt from the current 53% to as low as 25% if NAREIT’s prediction comes true. That would free up capital for a reprise of the early 1990s, when investment trusts led the way out of a previous commercial real estate recession by using equity raises to fund massive purchases of distressed assets.

Survival of the Equity-Richest…

Meanwhile, many public companies that went private during the private-equity boom of 2005-07 will likely re-emerge in coming years as REITs, at vastly lower leverage of course. With stepped up IPOs, acquisitions and increased market capitalization, REITs could grow to a 31% share of the broader commercial real estate market by the end of 2012 from roughly 5% at present, according to NAREIT. Firms raising equity capital in recent months include retail and office owner Vornado Properties Trust, mall operators Simon Properties and Kimco, data center developer Digital Office Properties Trust, among numerous others.

A number of entities have filed for initial public offerings, mostly to become mortgage REITs. Most recently, Starwood Capital said in a filing that has launched Starwood Property Trust (SPT), which will register as a REIT and raise as much as $500 million in an IPO to buy distressed commercial and residential real estate. Barry Sternlicht, former chairman of Starwood Hotels, will be the CEO.

The entity will use financing from the government’s Term Asset- Backed Securities Loan Facility (TALF) and Public Private Investment Program (PPIP). Starwood Property said in its filing, “we believe that the next five years will be one of the most attractive real estate investment periods in the past 50 years.”

Access to public markets will separate the REIT “haves” from the “have-nots” over the next three to five years, but will also provide a distinct advantage over their debt-riddled and capital challenged rivals in the private sector, panelists agreed during a session on REITs and investing last week.

“Re-equitization creates a huge opportunity,” said Thomas Carr, former head of CarrAmerica Realty Corp. and current managing partner of Federal Capital Partners, a private REIT specializing in acquiring assets in and near Washington, DC. “This is one of those watershed events like the early ‘90s where the public companies have an opportunity to dominate. Private market fundamentals will continue to deteriorate for at least the next 12 months.”

“Demand for REIT equity has been incredibly robust,” said Debra Cafaro, chairwoman, president and CEO of Ventas, a healthcare REIT, during another session. “The mere act of raising capital by REITs has fueled a virtuous cycle of an improving equity market for REITs that has in turn led to more equity raisers and engendered more investor confidence.”

“With confidence returning to the REIT, debt and equity markets, the REIT picture looks brighter, although certainly not clear,” Cafaro said.

The public markets are likely the only source of capital that can fill the void in the commercial real estate industry’s “huge mess” of maturing debt and weak fundamentals, said Mike Kirby, chairman and director of research at Green Street Advisors.

“There needs to be enormous amounts of new equity coming in to recapitalize the commercial real estate industry,” Knott said. “That number is certainly over $100 billion; it’s probably a multiple of that in terms of total equity capital that real estate needs.”

With private equity mostly unable to raise new funds and pension funds for the most part unwilling to allocate capital to real estate, “the public market will be driving everything. Its cost of capital will be driving real estate pricing,” Knott said.

“It could be a very profitable time because when your cost of capital drives the prices of the assets you’re buying, it’s almost guaranteed to be a pretty good business.”

Recovery: Still a Gleam in the Eye…

Despite the opportunities for REITs, recovery from the worst recession since the 1930s is nowhere on the horizon for either commercial property markets or the broader economy. Job losses will extend well into next year. Occupancy and lease rates continue to deteriorate.

“The fundamentals I think are going to be as big of an issue that the financing issue has been in the last six months,” said Knott’s co-panelist Kenneth Rosen, chairman of Rosen Consulting Group.

The new money that will flood into the system from equity, new Federal Reserve policies and government stimulus could help reverse some of the pain from job losses by next year, Rosen said, “but it’s only going to create a more moderate recession. We’re not going to go into a recovery. We’ve lost 5.8 million jobs, most of them in the last six months. We can’t really say there’s light at the end of the tunnel for the real estate sector.”

Hamid Moghadam, chairman and CEO of industrial owner and developer AMB Property Corp. (NYSE: AMB), said that unlike debt-free companies like Microsoft and Cisco, it’s very difficult for real estate companies to operate without leverage.

“Real estate has this huge private market on the side that is highly levered. I maintain it’s because nobody is prepared to tell their investors that real estate is a low teens return business,” Moghadam said. “Unless you tell people that it’s 25-30%, you can’t raise money. It’s a circle that keeps picking up speed until it hits the wall and everyone gets super conservative again.”

People just got mesmerized by astronomical returns, Rosen noted.

“Core real estate is a 6- 7% return, with growth into the low teens. Anything else is produced by leverage and high risk. That’s enough return. If you want more than that, you’re gambling.”

Carr said one of the main lessons of the last two real estate cycles is “anytime you get too much cheap money in the hands of real estate people, it’s a dangerous moment. You start seeing massive investment at unprecedented levels.”

“The one question I would urge any investor to ask is, ‘what do you have to believe in terms of the future and growth rates, order to think this is a good investment?’”

Zell, Zuckerman Weigh In…

Not surprisingly, two of CRE’s most conspicuous icons, publisher and Boston Properties Chairman Mort Zuckerman and Tribune Company head and Equity Group Investments Chairman Sam Zell, remained bullish on REITs and predicted that companies with strong cash positions will absorb weaker rivals weighed down by maturing debt and troubled assets.

The men differed during an exchange at the conference on such issues as whether a large number of IPOs will be launched or whether government stimulus and the Federal Reserve policies such as the TALF will help the market. But they agreed that REITs have a bright future.

“The REIT model has worked,” Zell said. “17 years is not a very long period of time for an industry. The last 12 months have been a test and the industry has passed. Frankly it has passed with flying colors.”

Judith Johnston owned a home in Mobile County, Ala., In 2001, the county placed drainage culverts on her property to drain runoff into a creek behind Johnston’s property. Johnston complained to the county that the drainage system was flooding her lot, although it did not flood her actual home. The county claimed it could not do anything about the flooding, and Johnston decided to sell the property, according to court records.

Wylene and Ross Teer offered to buy it, and Johnston provided them with a disclosure statement that expressly represented “that there were no ‘flooding, drainage or grading problems’ with the property and that the property had never flooded,” after which the Teers and Johnston signed a purchase agreement for the home.

The purchase agreement stated that the sale was an “as-is” transaction with the exception of a warranty Johnston would provide on the appliances, and also provided that the “contract constitutes the sole agreement between the parties and any modification hereto and any modifications of this contract shall be signed by all parties to this agreement. No representation, promise, or inducement not included in this contract shall be binding upon any party hereto.”

While the Teers claimed that they were induced to sign the purchase agreement by the disclosure statement, both the Teers and Johnston acknowledged that the disclosure statement was not formally incorporated into the purchase agreement.

The Teers purchased the property in 2005 and moved in, after which the property flooded several times. The Teers filed suit against Johnston in 2007, seeking to rescind the purchase agreement, reverse the sale and recoup damages they incurred in buying and moving into the home.

Their primary claim was that Johnston intentionally and fraudulently induced them into buying the property by representing that it had no flooding issues, when she knew that it did.

The trial court granted summary judgment in favor of Johnston, citing Alabama’s rule of caveat emptor in the “as is” purchase of real estate, and dismissed the Teers’ case.

The Teers appealed to the Alabama Supreme Court, which affirmed the trial court’s ruling. The high court of the state rejected the Teers’ invocation of the rule that when a seller knows or should know of a material defect in the property that affects health or safety, both the seller and the listing agent are required to disclose the defect to the buyers.

The court agreed with the trial court that the Teers had not shown that the flooding on the rear of the property’s lot was, in fact a material defect that affected health or safety.

Further, the court explained, in an as-is real property sale contract in Alabama, a fraudulent misrepresentation in pre-contract disclosures does not survive the execution of the purchase contract, unless that contract incorporates the pre-contract disclosures, which the Teers’ contract did not.

The state’s Supreme Court reiterated that in Alabama, on the resale of residential property, the caveat emptor rule applies, and sellers have no duty to disclose any property defects to buyers, unlike in many other states — even in cases of seller fraud; the court went on to expressly reject the Teers’ plea to reverse this “clear and consistent” line of cases upholding this rule.

The court concluded: “Because the ‘as is’ clause in the purchase agreement negated any reliance the Teers may have had on previous representations made by Johnston in the disclosure statement concerning the property in question, the Teers cannot establish their fraud claim against Johnston.” Accordingly, the trial court’s ruling was affirmed and the Teers’ case was dismissed.

A new jumbo reverse mortgage option has finally surfaced for seniors with higher-value homes who have been seeking to tap more home equity than the federally insured FHA program can offer.

The Generation Plus Loan now available through Atlanta-based Generation Mortgage, targets owners over 62, with homes appraising between $500,000 and $6 million.

Unlike the popular Home Equity Conversion Mortgage (HECM) offered by HUD, the jumbo reverse mortgage requires no mortgage insurance but the interest rate on the program is higher.

According to Jeff Lewis, chairman of Generation Mortgage, the new offer not only fills a niche for current seniors, but it will also serve aging boomers who are still raising children and helping to support their own parents.

This “sandwich generation” will eventually need a way to halt their mortgage payments and stay in their homes even though they still have a mortgage. Homeowners with existing mortgages can qualify for a reverse mortgage.

“I was at a conference where attendees were asked if they, or their parents, had a reverse mortgage,” Lewis said.

“No hands went up. When they were asked how many were writing a check every month to help their folks, more than half the people in the room raised their hands. For most of their parents, a reverse mortgage would make sense.”

A majority of seniors are better served by the HECM. Not only can customers receive the funds in a variety of ways (lump sum, monthly draw, line of credit, or a combination) but the interest rate on that fixed-rate product, at the time I wrote this column, was about 5.5 percent. The upfront mortgage insurance brings the actual rate closer to 6.75 percent.

The Generation Plus loan carries a fixed rate of 7.78 or 8.78 percent, depending on the program. All funds must be taken at closing. A minimum FICO score of 700 is required.

Why is a credit score critical in securing a jumbo reverse mortgage? Since there is no mortgage insurance requirement, the institutional investor supplying the funds for the loan wants assurance that the property owner has the ability to maintain the property and pay taxes and insurance, especially in a slumping market.

“While customers can use reverse mortgage funds any way they please, the funds do not come without obligations,” Lewis said.

“The owners are obliged to keep up the property like the other properties in the neighborhood. Since there is no mortgage insurance to protect the lender, the lender wants some assurance that the owner will continue to maintain the property when there is a potential for a negative adjustment (value decreases).”

Jumbo reverses first became available in 2000 when Financial Freedom introduced its Cash Account reverse mortgage. Since then, jumbo products brought to market by Seattle Mortgage (acquired by Bank of America), Senior Lending Network, Sun West Mortgage and Bank of New York (now MetLife) and others were beginning to pick up momentum and a sliver of market share.

The credit crisis decimated the jumbo reverse market in 2008. Wall Street investors not only were shy about buying loans secured by real estate, but they were also opposed to acquiring jumbo packages.

Lehman Brothers, which filed for bankruptcy protection in September 2008, was the world’s biggest supplier of jumbo reverse mortgage funds. The Senior Lending Network offered its Equity Plus Advantage program and its Simple 60 plan (minimum age 60 years, rather than 62) until its Belgium-based parent, KBC Group NV, announced an open-ended moratorium on the products.

Also screeching to a halt were the Rex Agreement and Equity Key, financial contracts whereby the homeowner trades a portion of future equity for a cash payment today. They were intriguing options for savvy investors who believe they can realize a greater return on investments than on home appreciation. The Rex Agreement was backed by troubled insurance giant AIG.

Equity Key is similar to the Rex Agreement. The main differences are that the Rex Agreement has no age restriction while Equity Key is aimed at homeowners 65-85.

“The No. 1 priority of seniors is they want to stay at home as long as possible, and it’s the least expensive place for them to be,” Lewis said. “The Generation Plus simply gives more of them an opportunity to do so.”

Seniors approaching retirement with a mortgage balance and financial assets are faced with the question of whether they should liquidate assets to pay off the mortgage.

With income declining at retirement, the mortgage payment becomes more of a strain. Yet liquidating assets to repay the mortgage reduces the income being generated by the assets, and leaves the borrower with less to liquidate later on when needs may be even greater.

This is not the first time I have written about this topic, but the world has changed and so have some of my perspectives. I never squarely confronted the core problem, which is that we don’t know how much money we will need to support our lifestyle in retirement because we don’t know how long we will live.

The only foolproof solution to that problem is to accumulate more wealth than we can possibly outlive, but most seniors can’t manage that. For all the others, the question of whether to pay off the mortgage looms large.

My general view is that for most seniors, paying off the mortgage (or paying it down by enough to reduce the payment significantly) is a prudent move. The major reason is that for most borrowers, the interest rate they are paying on their mortgages exceeds the rate they can earn with a reasonable degree of safety on their assets.

Paying off a 5 percent mortgage is an investment that yields 5 percent with no risk, so if you can do it by liquidating assets yielding 2 percent, you increase your wealth.

In comparing the return on mortgage repayment with the return on alternative investments that are taxable, it doesn’t matter whether the comparison is made before-tax or after-tax.

If mortgage repayment earns the higher return before-tax, it also earns the higher return after-tax. If income on the alternative investment is not taxable, however, returns should be compared after-tax.

Some borrowers facing retirement don’t want to deplete their cash by an amount sufficient to pay off their mortgage, but they will have excess cash flow for a period, which they can allocate to mortgage repayment. The borrower in this situation confronts a new investment decision every month.

Adding one’s excess cash flow to the mortgage payment is prudent if the mortgage rate is higher than the return that can be earned on newly acquired financial assets.

One of the foolish ideas that I hear about from readers is that seniors should set up a special account into which they deposit their excess income until such time as they have enough to pay off the mortgage. This is foolish because it leaves money behind.

For example, John has a $100,000 balance on his 5 percent mortgage with 15 years to go. If he makes additional payments of $500 a month, the balance of his mortgage is paid down to zero in 94 months. If he puts the $500 in an account paying 2 percent, after 94 months his account is worth only $50,661 while his mortgage balance is $57,223!

Some seniors have enough liquid assets to repay their entire mortgage loan balance. This is a one-time investment decision that is irrevocable, which means that the borrower must anticipate what the return will be on the assets that would be liquidated if they were held instead.

If the judgment is that the return would be below the mortgage rate, the proper move is to liquidate them and pay off the mortgage.

To help deal with this problem, I developed a spreadsheet that allows a borrower to enter any scenario for future interest rates, and compare his wealth in every future month in the two cases: where he liquidates his assets to repay the mortgage at the outset, and where he retains both the mortgage and the assets. The spreadsheet is on my website and is titled Loan Repayment Versus Investment.

A feature of the post-crisis financial landscape that reinforce the case for paying down the mortgage balance is that the returns available on low-risk investments today are lower than they have been at any time since the 1930s.

While some seniors may have opportunities to earn high returns on their assets — in a family business, for example — the great majority can’t earn a return above their mortgage rate without taking excessive risks.

The case for paying down the mortgage balance is strengthened by the emergence of reverse mortgages as a legitimate and tested product for seniors. I noted above that the core challenge facing all but wealthy seniors is in assuring that they will have sufficient income over the remaining period of their lives, regardless of how long that turns out to be.

Reverse mortgages can play a key role in reducing uncertainty about that. Paying off the existing mortgage clears the way for a reverse mortgage in the future.

Suppose Mary retires at 65 with a mortgage and significant financial assets. She pays off the mortgage and lives on the assets, without any certainty about how long they will last. The reverse mortgage is a backstop if she is still alive when her assets run out.

The reverse mortgage allows her to borrow against her house without incurring any repayment obligation as long as she resides there. The longer she lives, the more likely it is that she will deplete her financial assets, but the larger the amount she will be able to draw on a reverse mortgage. Her draw increases because her life expectancy declines as she gets older.

In addition, appreciation in the value of her home may also increase the amounts she can draw on a reverse mortgage.

Ginny,  I am in contract on a property that had an asking price of $159,000. My offer of $145,000 was accepted. The bank appraisal came in at $135,000, and the seller lowered the price to $141,000. Should I stick with the bank appraisal of the property? The contract is contingent on financing, so in order to finance this property I would have to make up the difference with the downpayment. — Maia A., Denver, CO

Maia, given that appraisals are notoriously conservative right now, resulting in homes frequently being undervalued, your situation is not at all unusual. What you should do next depends on three simple items: what you can afford; what the place is actually worth in your opinion; and what the place is worth to you.

One thing, first. My assumption is that the negotiation flow went something like this: You made your offer, the seller accepted it, the appraisal came in low, you notified the seller, and she agreed to reduce the price to $141,000.

If you’re concerned about the gap that still exists — the $6,000 difference between $135,000 and $141,000 — there’s nothing saying you can’t go back and request the seller to come down a bit more, or even offer to meet her halfway. All she can say is no, and even in that worst-case scenario, you’re no worse off than your current position. But at least you’ll have tried!

Now on to the three criteria you should factor in to your decision. First up: what you can afford. Your original offer — the price you were originally prepared to pay — was actually higher than the price the seller is currently willing to accept, so I’ll assume that you can afford the monthly payment at that overall purchase price.

However, as you know, your bank will lend your approved loan-to-value ratio on the appraised amount only, even if it’s lower than the sale price.
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So, for example, if you were planning to put down only 3.5 percent of $145,000 on an FHA loan, or $5,075, under the current terms, you would have to more than double your downpayment — coming up with the $6,000 difference on top of your original downpayment.

If, on the other hand, you were planning to put down at least $6,000 over the bare-minimum downpayment, your bank may allow you to simply redirect some of those funds to fill in the gap. This could change your monthly payment, but that change is likely to be slight.

The one possible item that could impact your affordability much more significantly is if you were planning to put 20 percent down, and the redirection of that $6,000 gap pushes your downpayment below the 20 percent mark. If that were the case, and you didn’t have enough extra cash to fill the gap and still put 20 percent down, this gap would require you to pay for a private mortgage insurance (PMI) policy you wouldn’t otherwise have had.

And PMI isn’t exactly cheap — if you are getting an FHA loan you’d incur a $1,300 flat fee (called up-front mortgage insurance premium, even though it can be rolled into the loan and paid over time), and about $100 a month on top of that (based on new FHA guidelines that went into effect Sept. 7).

On a non-FHA loan, you’d probably be talking about just the $100 per month. You’d have to pay this PMI for at least five years (FHA) or until you can document that you have 20 percent of equity in the home (non-FHA). You can see how filling in the gap to get to the seller’s $141,000 might actually cost you a lot more than the $6,000 — if, that is, it stops you from making a 20 percent downpayment you would otherwise have been able to make.

Beyond the issue of whether you have the cash to bridge the gap and can afford to do so without jacking your payment up due to PMI, you also need to consider whether you feel the home is worth the extra $6,000.

I can already imagine some folks citing the official definition of an appraisal to say, “If the appraiser says it’s worth $135,000, then that’s all it’s worth!” But that would be an extremely naive statement.

As we’ve discussed many times in this column, appraisers are under the gun and under some very tough guidelines right now — they are being extremely conservative, nationwide. What the appraisal means is that the specific comps that specific appraiser found upheld that value.

It’s possible — and even common these days — for buyers and sellers in your sort of transaction to strongly disagree with a low value. If you feel the home is worth more, for whatever reason, then it may not be bizarre to pay the extra $6,000.

Finally, and most importantly, what is the place worth to you? Put differently — how badly do you want it? Would you regret paying the $6,000 more or less than losing the home?

If you, like so many of today’s buyers, have seen dozens of homes, been outbid multiple times and this home is a great fit for your family, your finances and your lifestyle — even at the $141,000 — go for it!

Take your real estate agent and mortgage broker’s opinions and advice, locally relevant as it is, into consideration, then make the decision that will cause you the least regret.