Profiting from Foreclosures
In an arm's-length transaction, the buyer pays a fair price for a property, assuming that both buyer and seller have ample time to respond to market conditions, have readily available credit, and where neither the buyer nor the seller are pressured to close the deal. Foreclosures do not satisfy these criteria; hence, foreclosured properties sell for less than market value. The most common reasons for foreclosure are job loss, divorce, accident, illness, or business failure. Because purchasing foreclosures is generally not at arm's length, many a guru has pronounced that the best profits can be made from foreclosures, but the reality is far more competitive, since many buyers compete for those properties. Moreover, foreclosed properties have many pitfalls that must be avoided; otherwise, the buyer can incur significant losses. Real estate gurus assure their clients that profiting from foreclosures requires little effort, time, cash, credit, or even risk, but if it were that easy, then why wouldn't the gurus be making their fortunes buying and selling foreclosed properties rather than creating a lot of competitors for those properties?
Successfully profiting from foreclosures requires that you understand the foreclosure legal process for your state, and that you are able to research real estate markets diligently, and are able to accurately value properties and any costs required to renovate the property. And being able to negotiate the best prices is paramount.
Although the main reason for a foreclosure is that the borrower defaulted on a loan secured by the property, other causes of foreclosure include:
- failure to pay related homeowners association fees or special assessments
- transferring a mortgaged property without the lender's approval
- damaging the property or allowing it to diminish in value.
To initiate a foreclosure, the lender files a legal notice of default with a trustee or a lawsuit to foreclose, depending on whether the state is a trust state or a judicial state. The legal filing is published in newspapers or on the Internet and recorded in the deed to formally notify property owners, other holders of legal claims against the property, and the general public. Although uncontested foreclosures can be completed within 120 days, if the borrower contests the foreclosure, such as for due process violations, or for violations of consumer rights, then the litigation can extend foreclosure by several years. Sometimes, property owners file for bankruptcy to delay the foreclosure process by a month or 2, in which case, the lender must petition the bankruptcy court to lift the automatic stay, so that the foreclosure can proceed. When the property value is less than the remaining loan amount, many property owners simply walk away from the property and leave it for the lender.
Usually, foreclosed properties are sold at auction, but many times a lender takes possession by submitting a bid $1 greater than the value of the loan and associated costs, such as accrued interest, attorney fees, and other foreclosure costs. In this case, the foreclosed property becomes a real estate owned property of the bank, otherwise known as a REO property, often shortened to just REOs. During this holding period, the lender incurs insurance costs and taxes, and possibly other liabilities, such as environmental liabilities. Hence, lenders want to sell their REOs as quickly as possible. The lender will either list the property with a real state agency or sell it through an auction, especially if there are many properties to sell. Because most lenders do not have the wherewithal to rent the properties to await better selling prices, they strive to sell the properties as quickly as possible. The FHA, VA, Fannie Mae, Freddie Mac own many properties that are sold through real estate agencies.
Investors wanting to profit from foreclosed properties can negotiate with the property owners before the sale, bid at the foreclosure auction, or buy the property as a REO from the lender. In many cases, investors can negotiate a short sale when the value of the property is less than the loan amount plus the associated costs of foreclosure. The successful buyer of the property at an auction will usually receive a sheriff's deed, so there may be clouds in the title that must be cleared: there may be other liens on the property by other creditors, such as tax liens, mechanic's liens, or a lis pendens notice because the homeowners are being sued.
Homeowners with significant equity are unlikely to sell before foreclosure, since they can conserve whatever equity they have by filing for bankruptcy. In most states, the amount of equity that is protected is limited, but in a few states, such as Texas and Florida, the homestead exemption is unlimited. Although bankruptcy will reduce the creditworthiness of borrowers, if they have a stable income, they can acquire credit within 2 years after the bankruptcy discharge. Bankruptcy can generally preserve their retirement accounts, life insurance cash value, furniture, clothing, possibly a car, depending on its value, and other exempt items. What is exempt and the value of the exemption is determined by state law. Even the FHA or the VA will guarantee loans for people who declared bankruptcy, if they show for at least 2 years afterwards, that they have stable income and that they can manage their finances more successfully. So homeowners are unlikely to transfer a large amount of equity to potential buyers for the sole purpose of protecting their creditworthiness.
In a foreclosure, all lienholders are notified of an impending auction sale, the house is sold, then lienholders are paid in order of their priority. Generally, earlier liens have priority over later liens. However, tax liens have priority over all other liens. So the most senior lienholders are paid 1st, then any remaining amounts are paid to junior lienholders. In the end, either all lienholders are paid in full while junior lienholders may get little or nothing from the sale. Thereafter, all liens are stripped from the property so that the buyer can buy the property unencumbered. This is necessary because if the buyer would have to pay off all liens and those liens exceeded the value of the property, then no one would buy the property and the tax authorities would not be able to collect taxes. Thus, all liens are either paid or stripped from the property, giving the buyer at a foreclosure auction a lien-free property, but not necessarily a clear title. However, if the property is purchased before a foreclosure sale, then the buyer would have to deal with the liens, either paying them off or negotiating lower payoffs. For junior lienholders, getting something is better than getting nothing, which may be their dilemma if the property is seriously underwater. If the value of the property is less than the remaining mortgage amount, then the lender would have to agree to a short sale; otherwise, the property would not be worth buying. Many liens on the property may be based on debt held by debt collectors, who usually pay pennies on the dollar for the debt. Hence, these creditors would be more willing to accept a much lower payment, since they can still profit.
Buying before Foreclosure
When buying from owners going through foreclosure, empathize as much as possible, since the foreclosure process leaves many owners irritable and combative. Before the 1990s, many properties were bought by assuming the mortgage of the borrower, even by buyers with less than stellar credit. However, nowadays, non-qualifying assumptions are generally prohibited by most mortgage contracts, since the lender wants to gauge the creditworthiness of the buyer. Even qualifying assumptions are limited, but FHA and VA mortgages do allow assumptions for buyers who intend to occupy the house, have good credit, and intend to live in the house. The FHA and the VA do not allow assumptions for buyers who are not creditworthy or who have uncertain income or who plan to flip the property or rent it out.
To determine a good price, potential buyers need to estimate accurately the costs of renovation and repair, which can only come after a thorough property inspection. Additionally, any potential environmental problems should also be investigated.
There are number of factors to consider when deciding whether a foreclosure will be profitable:
- the amount of equity that the owners have in the property
- the cost to remove any clouds in the title
- accurately estimating the amount of money it will take to repair or renovate the property
- whether the amount of time and money required will be greater than your opportunity cost of doing something else.
Additionally, if the property is underwater, then the lender will have to concede to a short sale or reduce the loan balance to make the purchase profitable. Other factors that will influence profitability are any prepayment penalties and the interest rate that the lender would charge for a new loan for the property.
The most profit can generally be earned by finding financially stressed homeowners before the filing of the legal notice. This reduces competition for the property and the owners may be in a better state of mind to consider viable exit strategies. Pre-foreclosures are generally found by networking with various people, especially in neighborhoods with many foreclosed properties. Additionally, you can drive through neighborhoods looking for properties that are not maintained or that seem vacant. In such cases, you can contact neighbors to determine the whereabouts of the owners so that you can negotiate a solution before the foreclosure process begins. Many investors looking for pre-foreclosures advertise for them in the newspapers or on radio. However, because owners are in distress, never rely on information that they provide, especially regarding the property or the title.
Many properties in pre-foreclosure are vacant. Vacant houses present both an opportunity and a problem. The opportunity is that the owners will be more likely to sell the house, since they were willing to walk away in the 1st place. The problem is locating them. Often, married owners will be separated (financial distress is a major cause of divorce), in which case, any negotiation would have to be with both of them. There are several methods by which absent owners can be located:
- contact neighbors
- contact family or friends
- call the owners phone number, since most people have cell phones
- find out where the owners were employed and ask coworkers or management
- if the owners had children, or if you see signs that children have lived there, such as abandoned toys, then you can ask around at local schools
- check for a forwarding address at the post office
Owners who have vacated the property should be willing to sell, since a foreclosure does not go on their credit file and they may avoid a deficiency judgment from the lender.
After the legal notice is filed, then there are several different methods of finding those properties:
- reading listings in the local legal newspaper that reports court filings
- reading the legal notices section of local newspapers
- going to the courthouse and examining deeds for legal notices of default
Nowadays, many foreclosures can be found online. However, once a legal notice is filed, competition increases for desirable properties, so the most experienced buyers will be the ones who can profit most from their purchases.
If the owner has already listed the property with a real estate agency, then real estate commissions can lower the profitability of buying a foreclosure. Moreover, many realtors tell the property owners that they can sell the house for a higher price than is realistic, in order to get the listing. Afterwards, the property sits unsold, but property taxes and maintenance costs accumulate in the meantime. Property owners and investors often do better through an FSBO sale.
Foreclosed properties always sell for less than market value, and for good reasons:
- in a market sale, the buyer and seller are both well-informed, whereas there is scarce information on foreclosed properties
- buyers and sellers can usually negotiate a transaction over several months, whereas decision must be made at the auction to buy the property or not
- market purchases can be financed, whereas foreclosure sales require cash, with some of the money required immediately and the rest, shortly afterward
- most general sales provide clear title to the property or the seller provides a discount if there are any clouds; on the other hand, foreclosure sales do not guarantee clear titles
- whereas a regular buyer obtains a warranty deed, the foreclosure buyer usually obtains a sheriff's or a trustee deed, depending on the state
- regular market sales require seller disclosures, whereas for foreclosures, the property must be bought as is
- in many cases, walk-through physical inspections are not allowed, or must be done within a short time
In many foreclosure sales, there may be little more information about the property other than its legal description. Furthermore, there are no contingencies in the purchase contract for a foreclosure. Additionally, there is no guarantee that the property will be vacant, so the buyer of the property may have to spend several months evicting the tenants. Furthermore, the people may destroy the property before they are evicted. This is why many companies that specialize in foreclosures offer keys for cash, offering the tenants a certain amount of money to vacate the property immediately or soon afterward.
To make profits at foreclosure sales, you must learn as much about the property beforehand in a time-efficient manner, since there is a good chance that you will not win at the auction. Hence, it helps to investigate several properties. You can investigate the neighborhood and you can look at the property externally, you can talk to the previous owners about the problems with the property and clouds in the title and you should research all liens including their amounts. Often, you can win at a foreclosure auction by bidding slightly more than the primary lienholder, who will usually submit a bid $1 higher than the loan amount plus expenses.
Although junior lienholders are usually wiped out in a tax sale, tax liens, special assessments, and homeowners' association fees will usually survive, so they must be paid to obtain clear title.
Foreclosures must be financed with cash, so a buyer needs cash in some form to pay for the property. If the buyer is not wealthy, other methods will have to be used to finance the property, including:
- a home-equity loan
- cash advance on a credit card
- sell or borrow against investments
- obtain a signature loan
After the property is purchased and the title is cleared, then the owner can obtain a regular mortgage on the property.