Buying a foreclosure? Plot your strategy

May 26, 2009

Buying a foreclosure property is neither easy nor a guaranteed bargain. Here’s a beginner’s guide on how to approach this complicated part of the market.

By Melinda Fulmer of MSN Real Estate (© AP)

You’ve probably seen the ads: Investors in expensive suits boasting about the easy money they’ve made snapping up foreclosure bargains. But truth be told, buying a foreclosure property is neither easy nor a guaranteed bargain. Sure, with the number of foreclosures surging, it’s possible to find a distressed home selling at a discount to those around it. But often there are pitfalls surrounding these abandoned homes that buyers should be aware of. “By the time you get them fixed up, in some cases you have paid more than retail (or market value),” says Washington, D.C., real-estate investor Lance Young, who has authored a series of books on buying foreclosures for real-estate data firm RealtyTrac. (RealtyTrac is a partner of MSN Real Estate.)

To effectively shop for a foreclosure home, says Los Angeles real-estate attorney Laurence R. Clarke, you need to understand the foreclosure process, the risks and the timing necessary to close the deal. It also doesn’t hurt to have some help from a seasoned agent who has handled a lot of bank-owned sales as a buyer’s representative. But be wary of anyone who claims to know too much about what lenders will accept and when, Young says. “This market is so crazy I would be cautious of anyone who says they know where the market is going,” he says.

The foreclosure process

Let’s start with a basic definition of foreclosure, how it works and how long it takes. The foreclosure process is a means by which a bank can recover the amount owed on a defaulted loan, by repossessing the property that secured the loan. The average foreclosure starts when a homeowner misses a mortgage payment and the lender files a notice of default. This is a public record and can be a first step for buyers in finding distressed properties, says Alexis McGee, co-founder of and author of “The Guide to Advanced Investing Techniques You Won’t Learn Anywhere Else.”

If the property owner doesn’t pay the owed amount in 60 to 90 days (or whatever timeline is dictated by the state you live in), a public auction notice is generally recorded that sets a sale date for the home. If the property doesn’t sell at auction, the lender takes ownership of the property with the intent to sell it and recover its money. These bank-owned homes are often referred to as REO properties, a term that stands for “real-estate-owned.”

However, the foreclosure process differs widely from state to state. States with so-called judicial foreclosure laws require banks to go to court or file a lawsuit to repossess a home. This initial filing is called a “lis pendens,” meaning “suit is pending.” Nonjudicial states do not require this. The deed of trust signed by buyers typically includes a power-of-sale clause, authorizing a trustee to sell the real estate to pay off the debt if it’s in default. The notice of default kicks off this process.

It’s important to be familiar with what the laws are in your state before embarking on your search, as they can affect the amount of risk you must shoulder and the timing for buying a foreclosed property, McGee says. A foreclosure in a judicial state such as New York can take more than 12 months, while one in Texas can take as little as 60 days, she says. Now that you know the process, let’s move on to your options in buying distressed properties, and the risks and rewards of each.

3 ways to buy a foreclosure

1. Short sale

When the value of a home has sunk below the balance of the mortgage or mortgages on it, owners will often try to get the bank to agree to a short sale.

Under this arrangement, if you make a fair-market offer on a home that is less than the amount owed, a bank can agree to accept this offer and forgive the remaining debt on the property, staving off a foreclosure for the owner.

It can be a good deal if it works, experts say. But getting the bank to agree can be a lengthy and aggravating process both for the seller and the buyer.

“What you are going to find is many potential buyers go into a short sale, then the bank won’t say ‘yes’ or ‘no.’ This can go on for six months where they won’t give you an answer,” attorney Clarke says.

There’s a lot more paperwork for the owner to prove his insolvency, and if there is a second mortgage on the property, you have to persuade that lender to remove or reduce its lien, something that may or may not happen. Short sales do not wipe out these junior liens.

It’s best for: buyers who are in no hurry to move, or investors who are having a hard time finding deals in their community.

2. Auction

Another way of purchasing foreclosures is to buy them at auction on the courthouse steps. Plenty of investors do this, often because it’s a way to buy an attractive property with multiple liens. But for most people, this option is fraught with risks, experts say. For one thing, you don’t get to see the interior of the house before you buy, you don’t get to conduct your own inspection, and often you have to evict the former owner.

“There could be horrendous things wrong with it,” Clarke says. “You better know what you’re doing or know that the price is so good, that even if it’s a disaster inside it will still be worth it.” You also have to be ready with a check that day for the full amount you plan to bid. Moreover, you must do your own title search — there are no title insurance policies here — or else liens on the property could prevent you from getting clear title when you are trying to sell.

And many states offer a right of redemption for the previous owner — a time period in which he can get his property back if he pays the lender the outstanding loan amount, plus interest and the lender’s costs in foreclosure. You’d hate to buy a property at auction, pour money into it to fix it up and then have the owner reclaim the property and these improvements. It’s rare, but investors typically try to head this off in right-of-redemption states by purchasing the “redemption rights” from the previous owner for a few hundred or a few thousand bucks before or after the auction.

It’s worth noting that online auctions are emerging in the foreclosure space. If you investigate this option, be careful that the auction house you’re dealing with is selling the property and not a lien on the property, experts caution. It’s best for: seasoned investors only. There is too much risk involved for people who don’t make their living in real estate. And frankly, investors say, often the minimum bid is no great bargain.

3. REO

These are the properties that went to auction but were not bid on, and so they reverted to the lender holding the mortgage. In a hot market, these properties will sell for full market value. But these days, with sales sluggish and banks holding large inventories of these REO properties, many lenders are motivated to discount the price to move the properties off their books. Just how much depends on the market, the financial condition of the bank and how many other foreclosure properties are in the area.

“If you are willing to buy into a neighborhood with some blight — a lot of foreclosures — that’s where you will see your heaviest discount,” as much as 40%, McGee says. However, it’s more common to find REO properties running 10% to 20% lower than market value. That may not sound like much of a discount, but on a $450,000 house, a $45,000 discount can mean the difference between qualifying for a loan or not.

The good news, experts say, is that REO homes are lot less risky to buy than properties bought through a short sale or auction. For one thing, all of the junior liens have been wiped out. And, unlike an auction property, you can tour and inspect the home just like any other home on the Multiple Listing Service. But, investors say, they are not without their own set of complications, including damage from an unhappy former owner. Some agents recall irate borrowers pouring cement down the toilet to mess up the plumbing, or intentionally flooding the house to inflict water damage and mold.

If a property has been sitting empty for a while, there’s a chance it might have missing appliances, dead landscaping or damage from squatters. So it might be a good idea to bring a contractor along to find out what kinds of repairs are needed and what they will cost before you make a bid. McGee suggests that for every dollar you spend on repairs you should knock $2 off the price of the home. “You shouldn’t do the work for free,” she says.

Investors caution that while you want to look for a fixer, you don’t want to choose a place that needs to be gutted, because you will have a hard time getting financing for it. Conduct a little research with the home’s last listing agent, if you can. Some REOs have wound up in foreclosure multiple times, because there’s something wrong with the property or its location. “Sometimes there’s a reason the thing went into foreclosure,” Clarke says. “Just because it’s a foreclosure doesn’t make it a good buy.” It’s best for: anyone who is interested in buying a property below market value and who is willing to do a little research.

The key pieces of advice for successful foreclosure buying, experts say, are to be educated, be thorough and be unemotional about the houses you bid on. There’s a lot of competition for some of the better bank-owned properties, says REO broker Leo Nordine of Nordine Realtors in Hermosa Beach, Calif. His office fields dozens of offers a day on some properties. “The good ones get multiple offers. I’ve had people who’ve made offers on 10 of our houses and haven’t gotten any of them,” Nordine says.

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