Would you rather buy real estate at retail or at wholesale prices? Obviously the answer is “wholesale!” Just like in the stock market, the concept of buy low, sell high also applies to real estate.
And of course, other real estate investors are also scouring your local real estate market for great deals. Clearly, real estate investors flush with cash aren’t going to miss this opportunity. As an individual looking to buy just one or two foreclosure homes in your local market, you may be surprised to find that you’re competing with very large and sophisticated Wall Street venture funds with tens of millions of dollars that are buying pools of bad loans or foreclosed properties.
After completing the foreclosure process, the lender takes title, at which point it owns the property. The lender has to maintain and manage the property, so it turns the property over to asset managers in the lender’s in-house real estate–owned (REO) department. The asset managers may keep the day-to-day property management in-house as well, but most lenders hire local property management firms to inspect the property, repair any emergency items, and essentially operate the property until the lender can sell it — usually within a few months unless the borrower has redemption rights (see the “Redemption period” section later in the chapter). Many major lenders call the department holding their repossessed properties Other Real Estate Owned (OREOs). No matter what the name, the savvy real estate investor willing to do the extensive due diligence required to find the rare diamonds in the rough will be rewarded.
Taking a closer look at foreclosures
The term foreclosure actually describes a process by which a lender takes title to a property on which a loan is in default. The two most common high-risk mistakes homeowners make that lead to foreclosure are
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Failing to make the mortgage payments as required: For example, homeowners who overstretched and bought their homes using up to 100 percent financing (they made little or even no down payment towards the home’s purchase price) and were, in effect, living on the edge.
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Borrowing too much when refinancing: Low interest rates combined with the tremendous increase in real estate values in most parts of the country in the early- to mid-2000s led many homeowners to refinance their properties. Although there’s nothing wrong with refinancing, as long as you don’t borrow too much, some lenders promoted 110 to 120 percent loans that tempted homeowners to pull all of their equity — and more — out of their homes. The recent trend toward no-documentation or stated-income loans also greatly contributed to the real estate mess of this period.
The flawed theory was that real estate values only increased, so these folks were simply tapping their future equity. However, one slight stumble with a loss of a job or a drop in income, a serious illness, death, or divorce can lead to a missed mortgage payment or two and ultimately, foreclosure. That’s what happened to millions of property owners who were overextended with mortgage debt when the real estate market turned against them in the late 2000s. Although some folks couldn’t afford to keep up with their payments, others chose to walk away from properties worth less than their outstanding mortgage balance.
But properties can also be subject to foreclosure for other reasons:
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Owners fail to meet other loan requirements. Examples include not maintaining proper insurance coverage or not keeping the property in good physical condition.
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Absentee owners are unable to effectively manage the property. Good property managers regularly visit and inspect their properties. This level of involvement isn’t practical from a distance.
This category of foreclosures is extremely prevalent in many of the most popular real estate investment markets for out-of-town speculators such as Las Vegas and Phoenix. If you’re in these markets you may be able to pick up some great bargains, but don’t make the same mistake that the earlier investors made when they purchased properties out of their comfort zone.
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Owners walk away from serious problems. Some properties fall into foreclosure because the property has serious and irreversible problems that are so bad that the current owner chooses to walk away rather than deal with them. Environmental hazards and serious physical problems where the cost of repair can exceed the value of the property (such as cracked slabs or landslides) often top the list. (In Chapter 14, we cover research you can perform to help avoid these types of problems.)
Many foreclosure properties also fall into this category because some real estate investors felt that the market was so strong that literally any property they bought would increase in value. Although this may have been true to a certain extent in some markets for a couple of years, the reality is that investors who bought properties without conducting proper due diligence often found that they had purchased white elephants, or properties that they can’t sell for what they paid for them (or even rent out to cover their carrying costs).
Before you pursue foreclosure properties, determine the type of foreclosure process commonly used in your state. Check with your favorite lender, real estate agent, real estate attorney, or title company representative to find this information. Your state falls under one of two categories:
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Deed of trust state: When a loan is placed in a deed of trust state, the property title is held in the name of a third party or trustee. If the loan payments aren’t made as promised or the loan is in default for another reason, the trustee can foreclose or take back the property. No court action is necessary, so a foreclosure in a deed of trust state can happen in 60 to 120 days. This process is referred to as nonjudicial foreclosure.
Be sure to check that you have the latest information on federal, state, and even local efforts by legislators and courts that have been quite aggressive in extending the timelines to give borrowers more time to avoid foreclosure.
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Mortgage state: In a mortgage state, no trustee or third party is named. When a mortgage goes into default for nonpayment or other breach, the holder of the mortgage must go to court and seek legal remedies including judicial foreclosure, which can take much longer than a nonjudicial foreclosure.
Foreclosure properties aren’t that hard to find. Whether you’re in a deed of trust state or a mortgage state, the filing of a Notice of Default (NOD) or a judicial foreclosure lawsuit are matters of public record. An additional public notice announcing a pending foreclosure sale must be published in a local legal newspaper. The timing of the publication prior to the sale varies by state. Many title companies and real estate firms track the Notices of Default and all the steps right through to the actual foreclosure. This information is public record and filed with the county recorder or equivalent, but subscribe to one of the local services offering this information via daily or weekly e-mails or faxes, because gathering this information on your own is time consuming.
Technically, there are four steps, and thus four buying opportunities, for a property subject to the typical foreclosure process. Knowing these steps, which we outline in the following sections, and the techniques or negotiating points necessary at each step to motivate the owner or lender is essential to mastering one of the best strategies of buying real estate at below market or wholesale prices.
Preforeclosure
Every potential foreclosure begins when the owner misses a payment on her debt service or is notified in writing by the lender that a condition or term of her loan isn’t being met. The preforeclosure stage is the period of time before the lender formally files the Notice of Default, which triggers the legal foreclosure process.
The period of time before the formal foreclosure begins is an important buying opportunity: You can get in ahead of competing investors to identify properties on which the owner is delinquent on mortgage payments or violating other conditions of his loan. The key is to track and locate these defaulting owners.
This is the time when you want to offer a solution to the owner that’ll get her out of the property and preserve her credit status so she can purchase property in the future. Also, every owner facing a mortgage delinquency needs some cash to pay for moving and relocation costs. Understanding the motivation of the owner and lender can allow you to formulate an investment strategy that meets everyone’s needs and allows you to own a property before it becomes heavily exposed on the local multiple listing service!
Notice of Default
The first formal legal action in the foreclosure process is the filing of a Notice of Default. If the owner wasn’t concerned when he first began missing loan payments, the filing of the Notice of Default should be a real wake-up call.
An owner who has received the Notice of Default is likely to be motivated to sell because she knows that the lender has begun the formal steps toward repossessing her property. But not all owners facing foreclosure are aware that the late charges, penalties, and hefty legal fees further erode their shaky financial position. They may not understand the logic that if they can’t make their regular monthly payments, they’re unlikely to catch up and pay all of the additional costs, which can literally double the delinquent amount.
The 60 to 90 days following the filing of the NOD are a great time to offer solutions to an owner facing a foreclosure. Most owners truly believe that their financial problems are temporary, so make your offer sensitive to the fact that preserving the owner’s credit record is a key consideration: If you can buy the property quickly at a discount and then cure the default or pay off the delinquent mortgage, the seller only has the slow payments on his credit report rather than a foreclosure (or possibly a bankruptcy, which is often the only alternative for owners who are unwilling to voluntarily resolve their cash flow problems). Preserving credit has always been a key motivator to owners who are delinquent on their mortgage payments. However, legislative efforts in 2008 to forgive defaults have changed the dynamics significantly, and many homeowners are simply walking away with little concern that their credit will be an obstacle to entering the homeownership ranks at a future date.
Determine the loan balance and the value of the property to ensure that the owner has equity. Generally, the more equity the better, because this equity allows you to provide the owner with some quick cash so he can cover the costs of vacating the property and finding a new place to live. It’s also this equity in the property that provides you with a profit potential after all of your costs of acquisition plus the required repairs and upgrades to maximize the resale value of the property.
Some real estate gurus recommend that you simply offer a nominal amount of cash to the owner facing a default and then begin making the payments on the existing loans or, in other words, purchase the property subject to the current loans. Be wary that the lender may not allow you to just step into the shoes of the original borrower and may still declare the loan to be in default. Have your legal advisor (see Chapter 6) look for an assumption clause in the loan documents that would allow you to properly assume the loan. Usually this process requires a loan application and a fee. You may also want to watch out for a due on sale clause that accelerates the entire loan and makes it due immediately upon the transfer of the property to a new owner. Foreclosure transactions aren’t risk free; your legal advisor can tell you the potential downside of your proposed transaction with a defaulting buyer.
Many of the problems that occur in buying foreclosures can be avoided by structuring the purchase offer to require the owner to vacate the property immediately. It’s difficult for an owner to lose her home, and it’s often even more difficult for her to accept the fact that she’s no longer the owner when she’s still living in the property.
Foreclosure sale
Although the foreclosure process varies from state to state, the main difference is whether the loan is secured with a mortgage that requires a judicial foreclosure or by a deed of trust, in which case the nonjudicial process is used (for an introduction to these two types of states, see the beginning of this section).
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Judicial foreclosure: In a judicial foreclosure, the lender files a lawsuit against the borrower to get the property. Like any other lawsuit, it begins with the serving of a summons and complaint upon the borrower (along with any other parties with junior liens or encumbrances against the property). If the borrower responds, the court holds a hearing and rules that either the borrower has presented a legitimate issue (and alternate payment terms are arranged) or the lender is permitted to foreclose.
The most common scenario is that the borrower doesn’t respond and the lender receives a judgment by default and can proceed to have a referee appointed by the court. The lender then advertises the sale for four to six weeks and then, if full payment hasn’t been made, a public sale is held, typically on the courthouse or town/city hall steps. The time frame for this entire judicial foreclosure process is usually between 4 and 6 months, although the process can take from as little as 3 months to as long as 12 months.
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Nonjudicial foreclosure: In a nonjudicial foreclosure state, lenders are allowed to foreclose without a lawsuit, using the power of sale provisions of the deed of trust. The deed of trust actually has three parties to the original loan agreement — the borrower (grantor), the lender (beneficiary), and the trustee who actually holds title during the term of the loan. In the event the borrower defaults, the trustee files a Notice of Default and a Notice of Sale in a legal newspaper.
As with the judicial foreclosure, if the loan in a nonjudicial foreclosure isn’t fully reinstated prior to the date and time of the trustee’s sale, the public auction or sheriff’s sale occurs on the steps of a prominent public location in town such as a courthouse. If no one bids, the lender bids the amount of its loan plus accrued penalties and fees and takes title to the property. This is the most common scenario unless the property is desirable and has equity, in which case many interested bidders may compete in a free-for-all.
Bidding on and purchasing properties at the foreclosure sale can be exciting and even profitable if you do your homework and know everything about a property before you bid. But getting a little lazy or going with your gut feeling can lead to a disaster, and it often takes quite a few home runs to offset even one disaster. Something as simple as an unrecorded tax lien or latent physical problems like a cracked slab or expansive soil can turn your lemonade back into a lemon! Be sure to get a title report showing clear title and an owner’s title insurance policy.
Redemption period
Some states allow the borrower the right to redeem her property after the sale during a redemption period in which she can pay the full amount owed, including the loan balance, late charges, legal fees incurred by the lender, and all of the costs of sale, and get title to the property back. The length of the redemption period varies from state to state. This period is also an opportunity to reach an agreement with the borrower for her deed. If successful, the purchaser then essentially obtains the borrower’s redemption rights and has the right to redeem the property.
Even if you’re the successful purchaser at the foreclosure sale, you still have to give the borrower the opportunity to redeem the property per the state-required redemption period. Don’t make significant improvements only to have the borrower redeem the property and then thank you for renovating his distressed property from the worst on the block to the model home!
Because the majority of properties at a foreclosure sale end up with the lender (because most properties aren’t desirable investment properties at this time due to foreclosure risks and limited due diligence, as we discuss in this section), you have a great opportunity to make a deal with the lender just after the foreclosure sale and before they’ve incurred the expense of hiring an agent to market and sell the property.
You may also be able to make a better deal if the property has significant deferred maintenance or code violations, because the local building inspector or code enforcement departments know when a deep-pocketed lender has title to the property, and they expect all citations for substandard conditions or code violations to be corrected immediately. You may be able to relieve the lender of this liability while allowing yourself to negotiate a favorable transaction.
Examining lender REOs (Real Estate Owned)
Because titles to the majority of foreclosed properties end up with the lender, you may find that your next opportunity to purchase the property is from the lender’s real estate–owned (REO) department that specializes in handling foreclosed properties. Some investors have found that this is one of the best times to buy a property because they’re not dealing with an emotional or unreliable owner. Discovering the ins and outs of the lenders’ policies and procedures of disposing of these foreclosed properties can be invaluable to your goal of buying real estate at below market prices.
The days of stealing prime REO properties from the Resolution Trust Corporation (RTC) are gone. The RTC was a quasi-federal government entity established by Congress to dispose of the tremendous number of foreclosed assets of the major lenders during the real estate market downturn in the early ’90s. Due to the numbers of properties and the relative inexperience of and limited due diligence by the RTC in some areas of the country, a once-in-a-lifetime real estate investment opportunity did fall into the lap of savvy real estate investors who had large amounts of cash, could act quickly, and then had the financial horsepower to ride out the market downturn.
Lender REOs remain one of the favorite strategies for the late-night infomercial gurus, but the reality is that today’s lenders are neither foolish nor benevolent. Although these nonperforming loans are a negative on their balance sheet, they’re not going to sell a property below its market value just to get it off their books.
The disposition specialists in the REO department are professionals who understand the real estate markets well and are usually wired into the best real estate brokers in the market. These real estate brokers are often compensated as a percentage of the sales price and thus also motivated to achieve the highest value as is reasonably possible.
The only angle a real estate investor usually has with an REO is financing and the continued operating losses that often occur because the lender is merely holding the property and isn’t willing to invest the time and money necessary to enhance the property physically and reposition it to perform better in the market.
Sales are as-is, and lenders are often exempt from the standard disclosure rules.
When lenders have an excessive number of REOs, they become more flexible, but they’re often limited by the Office of Thrift Supervision (OTS), a government agency that oversees many savings banks and savings and loan associations and routinely audits their loan portfolio and their REOs.
Mastering foreclosures and REOs
Our experience is that auctions are rarely great opportunities for investors, because too many people compete for the unusual, quality property. Plus, the reserve or minimum prices are set so close to the actual market value of the property that the buyer essentially pays retail under the illusion that she’s buying at wholesale. But some good opportunities do arise now and then, so check out these auctions to see if you can find anything worth pursuing.