Risk Reward
Do Your Diligence on Foreclosure Homes
by Rick Sharga
Buying a property always comes with some degree of risk. That is true when buying a brand-new home or buying a property that is a century old. The trick, for real estate investors and homebuyers alike, is to do the due diligence necessary to minimize that risk.
Foreclosure Properties: Higher Risk, Potentially Higher Returns
Buying foreclosure properties adds a few elements of risk that aren’t generally factors in a traditional home purchase. Investors who specialize in buying foreclosure homes understand that, but are willing to take on that added risk due to the larger potential profits they often realize. There are three different types of foreclosure properties investors can purchase.
First, there are pre-foreclosure properties. These are homes in the earliest stages of the foreclosure process, called a Notice of Default in states that practice non-judicial foreclosures and Lis Pendens in judicial states. In this stage, the homeowner is typically 90-120 days past due on their mortgage, and officially defaulted on the loan. The clock has started to tick on the foreclosure process, and the homeowner has a predetermined period of time (which varies state-to-state) to make up the missed payments, or the home will be sold at a foreclosure auction.
If the default isn’t cured during this initial notice period, the lender sends a Notice of Sale, which informs the homeowner that the property is going to be put up for auction, either via a Trustee Sale or a Sheriff’s Sale, depending on the state laws. Properties at this stage of foreclosure are generally referred to as auction properties.
At the auction, one of two things happens: either someone attending the auction bids a high enough amount to meet the lender’s sale price, or the lender repossesses the property, which in industry parlance then becomes an REO—or “real estate owned” asset which the lender will ultimately resell on the open market. These properties are generally referred to as REO homes or bank-owned homes.
Those three types of homes—pre-foreclosure properties, auction properties, and bank-owned properties—all fall under the general heading of “foreclosure properties.” But there are significant differences in how to purchase them, the potential savings, and the respective risks involved in purchasing them.
Navigating the Foreclosure Risk/Reward Spectrum
Let’s take a look at the risk profile of each type of foreclosure property, and some of the things to look at in order to optimize results.
Pre-foreclosure properties are probably the least risky of all foreclosure homes. Investors can negotiate terms directly with the homeowner either with or without the assistance of a real estate agent, and usually purchase the property using traditional mortgage financing. An investor can typically buy the property at a modest discount compared to similar properties, since the owner generally needs to close a deal quickly and with a high degree of certainty in order to avoid losing everything to a foreclosure auction. Ideally, the investor and homeowner settle on a price that covers what’s owed to the lender, is below full market price, and still leaves the homeowner with some cash as they exit the property. Very much a traditional home sale, which just happens to be on a property in the early stages of a foreclosure.
But investors need to take a few extra steps before buying a pre-foreclosure home. First, they need to find out how much is actually owed to the lender before agreeing to a sale—there are often fees and fines that have accumulated during the default period and those will need to be covered by the sales amount. Second, investors should do a preliminary title search to see if there are any other encumbrances on the property, like a second mortgage, tax liens and mechanics liens – if the owner wasn’t making mortgage payments, there’s a good chance some other payments weren’t being made as well, and some of those past due amounts could be attached to the house. Finally, never buy a pre-foreclosure property without having a thorough property inspection done. Financially-distressed homeowners have been known to let maintenance slide (and sometimes do damage on purpose out of anger towards the lender), so diligence is critical.
Auction properties probably represent the highest risk and highest potential returns of any of the foreclosure homes. Lenders sometimes offer these properties for the amount owed on the defaulted loan, plus fees and fines, in order to avoid having to take possession of the home. It’s rarely that an auction property is sold at or above full market value, since the bidders are almost always investors, and investors need to buy at a below-market price that allows them to make a profit.
Property condition is probably the biggest risk with auction properties. There are no internal inspections available on these properties, since they’re occupied, and the residents aren’t generally inclined to be cooperative. Seasoned investors can get an idea about the interior by taking a look at the exterior, but there are often surprises and hidden issues to account for when estimating repair costs. There’s a risk of the occupant resisting the eviction order after the foreclosure sale, so it’s helpful to know how the local sheriff’s office handles those situations. Some investors set aside some “cash for keys,” where they offer the occupant a payment to entice them to leave without being physically removed (and hopefully without them damaging the property).
A very unique risk when purchasing this type of property is the auction itself. More than a few investors have found themselves caught up in the excitement of a bidding war on a property they ABSOLUTELY MUST HAVE! And over-paying significantly. So, doing research on local property values, then having the discipline to set—and stick to—a “not-to-exceed” bid, is extremely important. And the note above about doing a preliminary title search is even more important for these properties than for pre-foreclosures. Plan to attend a few auctions before you bid at one, just to see how the process works, and familiarize yourself with the environment.
Bank-owned homes are probably a middle ground in terms of risk and return. They offer less risk and lower discounts than auction properties and slightly more risk and better returns than many pre-foreclosure homes. Lenders sometimes sell these properties as/is, with no warranties (and sometimes without allowing inspections). Typically, these homes are priced to sell, but do carry some extra risk. Other lenders will do a minimum amount of work—removing any contents the occupants left behind and adding a fresh coat of paint and some carpeting. Generally, lenders list these properties with a real estate agent or sell them via an online auction company. Some can be financed while others require cash purchases. It all depends on the lender.
In addition to the recommendations for diligence mentioned above, especially checking the title to make sure it’s clean, investors should ask whether the property will be conveyed with a Grant Deed, which offers certain implied warranties, or a Quitclaim Deed, which does not.
Successful investors learn how to optimize the risk/reward balance in real estate transactions. And while even the most diligent investors will make a mistake from time-to-time, those who do their homework enter into foreclosure purchases with a good understanding of the potential risks involved, and some degree of assurance that the return on investment will be well worth the possible challenges ahead.
