Perhaps you’ve heard of someone who acquired a foreclosure property and netted great profits from the transaction.  Most people have a preconceived notion that buying a foreclosure is the sure way to a great investment.  Maybe you’ve heard the hype and think that you’d like to purchase a foreclosure.

Certainly, we’ve all seen late night, polished and compelling infomercials that litter the television waves and seen the countless books that exist on the subject.  Most of these “plans” sell the idea—buying foreclosures can be lucrative.  They hardly scratch the surface of when a foreclosure is actually a bad deal in disguise or goes bad, and it certainly can go south for any number of reasons.
Buying foreclosed property requires a special bit of finesse and know-how.  A well-intentioned investor can quickly fall behind in the profits column when they run into an issue-laden foreclosure acquisition. In order to understand where the potential risks and rewards lie, we must be sure that we have a fundamental understanding of what foreclosures are.

Foreclosure is the process that allows a lender to recover the amount owed on a defaulted loan.  The mortgage (loan) that was written for the home implicitly places the purchased home as collateral for the amount loaned for the purchase.  Generally speaking, the lender has three options for how to recover the money they loaned:

Borrower can sell to a third party during the pre-foreclosure period.  In this case the borrower repays the loan and avoids a foreclosure on their record.
A third party buys the home at public auction
REO (real estate owned) - Lender takes ownership of the property, with the intent of selling the property to a third party to recover the loan amount.

When a borrower has defaulted, a lis pendens (Latin for lawsuit pending) becomes public record.  This is the first chance the public has at acquiring a property that has been foreclosed.  This is usually at example 1 above.  Savvy investors have the ability to find properties at this stage of foreclosure, and by addressing all potential issues and assuring the bank recovers their money, they can purchase at 30%-40% below market value.  This is the absolute best-case scenario in buying a foreclosure.  Take note, this certainly isn’t for the first-time foreclosure buyer.

In this strategy, the difficulties lie in identifying the appropriate properties. When potential foreclosures are uncovered, a diligent title search must be completed to make sure that the property is free of any liens or encumbrances. Unless the potential buyer has the time and know-how, this can cost hundreds, even thousands of dollars.  A successful title search addresses several questions:  Are there any second mortgages that were taken during the life of the originating loan? Are there any prior judgments outstanding? How about zoning ordinances—Will the property be usable?  Are there tenants present?

Any of the above can be a “deal breaker” in whether or not a foreclosure is going to truly be a good deal.  Any outstanding tax issues must be addressed, and this can be as little as hundreds and as much as tens of thousands of dollars.  For example, getting a foreclosure at 10% below market value that has a $15,000.00 tax lien might not be a sound investment.

Does the property have tenants?  In a perfect world, tenants would acknowledge the foreclosure, pack up their things, and move along on their way.  Unfortunately, most people realize they can live in a foreclosed property rent-free, perhaps for months, until the judicial system begins to turn its wheels.  That foreclosure you bought might be unusable for half a year or longer, undoubtedly reducing the profit or use of your acquisition.

As in case 2, foreclosures also exist on public auction.  These are usually sold before the bank officially takes ownership of the property.  Public auction is an opportunity for the bank to recover their lost loan money without including the additional cost and resources required to take ownership of the foreclosed property.  Savings in these cases are less than if the purchaser of the foreclosure buys the property before it reaches public auction.  Furthermore, the environment of the auction floor can artificially inflate the prices, decreasing the profit for the buyer.

Auction homes are also usually bought, sight unseen.  It only stands to reason that homeowners  who couldn’t keep up with the mortgage might not have been able to afford the appropriate maintenance a home requires.  Furthermore, the foreclosure process can take a year to get to the auction block, a time during which the property was most certainly not maintained.  This is an additional risk that a potential investor must factor in when assessing their potential profit margin on a foreclosure.

This brings us to example 3.  REO (real estate owned) is the designation a foreclosed property takes when the foreclosure process of the bank reaches fruition with no intervening sale transaction.  Any purchaser of a foreclosure at this point will be officially buying the property from the bank, and they generally sell for 5% below market value.  Forget about any “pennies-on-the-dollar” notions you may have about foreclosures that are free of encumbrances.

Remember that banks and lending institutions are in the business of making money.  When property is acquired through foreclosure, the bank will want to recover the money they lent.  REO is the safest point at which to buy a foreclosed property but its also has the lowest potential for getting a great deal.  The bank will have taken care of all the title searches, encumbrances, liens, etc., but it comes at a cost.

In our current market, foreclosures are readily available.  If you are tempted by the potential to purchase real estate foreclosures, consult with an expert about whether or not buying a foreclosure would be right for you.  Clearly, all foreclosures are not a cut and dry case, and each foreclosed property has its own potential for profitability or loss.  Unique challenges will face any prospective investor interested in foreclosures.  A licensed real estate professional can help guide you through the process and identify what might be right for you.

There are certainly many foreclosure opportunities in our area right now.  Don’t forget about the fact that many non-foreclosure homes are available and serious sellers are motivated to negotiate due to the downwards pressure the foreclosures that are present are applying on the conventional sale home prices.  These are opportunities to own a well cared for and move-in-ready home.