Buying foreclosures can be extremely tricky. While the allure of huge upside gains are strong, there are many pitfalls. Often, just the uncertainty around the process can make an investor’s head spin.
While buying/investing in a foreclosure is not for everyone, it can bring huge returns to those who do it right. However, as they say – you have to learn to walk before you run.
In this article, I hope to provide some clarity on the fundamentals of foreclosure buying. I’ll drill down into the main areas that you should focus your attention on when purchasing a foreclosure. I’ll also give you tips on what you can do to manage these headaches.
Ready? Let’s proceed!
1. Massive repairs – all costs are borne by you, the buyer
Foreclosures present a huge opportunity to purchase a property at a massive discount. But watch out! Is it really a discount when you consider what’s going on under the hood (or in this case, beneath the floorboards)?
Always be suspicious – why is it going for so little? It’s likely because both buyer and seller are aware that there’s lots of work to be done on the property before it even becomes fit for habitation or use.
Furthermore, it’s commonplace in a foreclosure sale that the seller will not undertake any repairs on the property as a condition to the sale. This can lead to massive headaches when it comes to things like financing (which I’ll talk about later.)
Is it always the case that a home requires such an intense overhaul? In my experience: not always, but often.
Let’s take a look at why that is:
Owners are already in financial distress
If given a choice between:
- Repairing a small leak in the roof, or
- Getting creditors off your back and putting food on the table
Which would you choose? Probably getting the creditors off your back right? Similarly, because the current owners are already in financial distress (they’ve defaulted on the mortgage payments etc.), it’s likely that they may have let some minor home problems get out of hand.
A small leak in the roof can rot weatherboards, the attic and the ceiling. A moist environment can provide a conducive environment for growing mold. Mold can invite mites. See how the problems spiral out of control after a while?
The foreclosure process takes ages
All homes fall into disrepair if left unattended for long enough. Foreclosures are especially prone to this problem because the foreclosure process, and the sale of the property can take many many months.
Imagine if the current occupants had to move out of the property. Give the house a few months alone – you can bet that it would soon be overrun with pests. All it takes is for someone to leave some food out somewhere. If you take the example of the leaky roof from earlier, you might end up with an even bigger leak, or severe structural rot.
If the property is situated in a less desirable neighborhood, it is the perfect target for theft and vandalism. So don’t be surprised to find broken windows and spray paint on the walls.
With that in mind, what should you do?
Firstly, always get an inspection done. You can usually get a property inspection expert for a few hundred dollars. Yeah, you might balk at a few hundred dollars. But if a professional finds issues with the house, then you might be able to knock down the price of the home by a few thousand dollars. In my mind, it’s worth it!
Not all stages in the foreclosure process allow you to carry out an inspection. I’d advise that you stay away from an sheriff auction because they often do not allow you to inspect the home. Ideally, you’d get in with a Real Estate Owned (REO) property. This means the bank has taken hold of the property, and much of the sale follows the familiar procedure (including inspection.)
Secondly, budget in the cost of repairs when going on the hunt for a foreclosed home. This is an upfront fee that can be quite costly, you’ll need to be able to do up the place quickly after the sale in order to get rental flowing in, or to even make it inhabitable (if you’re moving in yourself.)
Many people don’t have these upfront costs in mind when they start their buying process. In the end, they find that the deal is untenable because of the large upfront costs. This leads to wasted time and money. Don’t let it happen to you!
Remember: the seller is under no obligation to let you know of any problems that your inspection does not cover. So buyer beware!
2. A long, seemingly unending foreclosure sales process
Unlike a run of the mill sale, selling a foreclosure takes an insanely long time. It could take months from the time you first view the property, to the time your offer is accepted. This is usually due to masses of red tape around the process.
You need approvals and communication between numerous parties. Yes, you deal with the current owners. But because foreclosures are so risky, you’ll spend a long time communicating with the primary lender and lien holders as well. Running communication between each of these parties can take weeks at a time, and these weeks easily add up to months and months.
You might be thinking to yourself: I don’t mind sticking it out for the long haul. What’s the big deal?
Long waiting times isn’t a problem in itself. Having a long sales and negotiation process means that another interested buyer could jump in with a higher offer. This could circumvent your efforts and lead to massive frustrations. In addition, these competitive offers could blunt any perceived cost advantage of a foreclosure. The home may end up being sold for less than normal, but the final discount may not be as attractive as you once thought.
Because foreclosure investing is a rush to wait, wait to rush affair, I’d recommend that new investors don’t start with a foreclosure property. You could have cash tied up for months waiting for a property sale that will never eventuate.
I’d also recommend that you don’t jump the gun and hire a lawyer to draft a term sheet/sales contract until you’re absolutely sure that your offer will be accepted. I made this mistake once and ended up paying nearly a thousand dollars just to have the deal fall through. Wasted!
3. Foreclosures carry baggage – take none of it!
I don’t want to over generalize here, but remember that an owner in financial distress might have defaulted on other loans besides their mortgage. If that happens, another lender (or even the IRS) can place a lien on the property. Yikes.
Unfortunately, a lien is tied to the property. Generally, a sale can’t be closed if the lien isn’t paid off. However, if by some chance the property is sold without clearing the lien, then the lien remains on the property. To avoid this, you need to ensure that the lien will be paid off as a condition to sale. This will guarantee that you receive a property with clear title.
How do you know if a property has a lien on it? A simple search at your county clerk’s office or on the internet will do the trick. If in doubt, ask the real estate broker or seller to double check.
Home Equity Lines of Credit (HELOCs) follow similar lines. Essentially, they’re a form of lien and cannot be transferred to the owner’s new property (if they have one.) This is another thing that you must check before closing.
4. It’ll be much tougher for you to get a mortgage
As I mentioned earlier, it might be a lot harder for you to get financing to purchase a foreclosure. There are a few reasons for this:
- Your lender requires repairs as a condition to the closing
- The property probably has a severely depressed valuation compared to sales price
Firstly, because foreclosures can be in less-than-mint condition at the point of closing, lenders will often require significant repairs on the property before they extend you a mortgage. As I noted earlier, the seller will often not include repairs as a condition to sale. This traps you between a rock and a hard place. And that’s not all of your worries.
Secondly, because the foreclosure embodies some inherent risks, it can receive a a very low valuation. Sometimes, the valuation might be much lower than what you’re expecting to transact at. If your state or lender has a particular loan to value requirement, you might not be able to get much of a loan at all. This might mean you’d have to come out of pocket more for the deposit. Worse, you might have to give up on the deal entirely.
While not 100% guaranteed, I’d recommend trying the following:
- Use your existing equity in a current property as collateral for a loan to supplement the mortgage
- Get a bridging loan to close on the deal. Make the necessary repairs. Then take out the mortgage from the bank.
In both cases, you’d assume some level of risk. In the first option, you’d subject yourself to less flexibility in the short term, and you’d risk the equity you’ve built up in your current investments. In the second option, there is a risk that you might not be able to secure the second mortgage.
Some people do advocate getting pre-approval for a foreclosure. In such instances, it’d be best if you scope out a real estate broker who works with foreclosures. They’d be able to hook you up with lenders that allow foreclosures. I’d imagine that there would be few of these lenders. However, it’s a low risk way to go about things and certainly worth a shot.
5. Be prepared, be very prepared
In recent times, foreclosures have become ever more popular for investors. This creates a lot of competition at auctions and with offers. Given how tough it is to secure a loan, you’ll usually be placed at a disadvantage compared to investors who can offer all-cash.
Think no one in their right mind offers all cash? Think again. I’ve seen Chinese businessmen going head to head on an auction, driving the price up to crazy amounts. I learn later that they’re still able to pay it all in cash. Now I don’t know if this is money laundering or what, but all cash deals definitely exist.
Some investors specialize in foreclosed homes, so if you’re just starting out, know that you’ll be up against some sharks. If you don’t do the necessary due diligence, you could get eaten alive in a bidding war. Worse case – you might win, but end up with an undesirable home. That’s why it’s so important to know what you’re doing. Go read up on foreclosure lingo. Reading this article on the potential pitfalls of foreclosure investing is a good starting point.
If you’re inexperienced, having a professional in your corner is a must. I’d recommend working with a real estate agent who is familiar with foreclosures. Ideally, they’d be aware of which foreclosures are on the market, and which lenders typically deal in foreclosures.
This is one of my longer articles, but I hope you’ve taken the time to read through it. It represents just the tip of the iceberg when it comes to purchasing a foreclosure. Remember that doing your homework is the first step of any successful real estate investment. It is ever more important in foreclosure buying. So please take note!
Have you had any experience in buying a foreclosure? Tell us of any pitfalls you faced in the comments below!