May 5, 2008 in Mortgages

Someone’s tragedy your golden opportunity

Editor’s note: Bobbi Dempsey is the co-author of “The Complete Idiot’s Guide to Buying Foreclosures.”

While foreclosures wreak havoc on the finances of their victims, they also can be golden opportunities to buy.

In recent years foreclosed homes have become popular targets for real estate investors — even novices have been lured by the dream of getting rich quick through foreclosure “flips.”

How good — or bad — an idea is it to buy a foreclosure, given the current housing market?

Let’s start with the bad news: Buying foreclosures for profit is now much less feasible and practical for the average Joe or the newbie investor than it was just a few short years ago. Many sources of easy financing are now just a memory, and with home prices dropping, the potential for a big profit in the short-term is not as great.

But with so much inventory to choose from at bargain prices, investors with available capital or ready financing — combined with the financial wherewithal and patience to wait for housing prices to rise before trying to sell — might want to consider buying foreclosures.

It boils down to supply and demand.

There’s plenty of supply. Would-be investors have their pick of foreclosed homes — often choosing from several different foreclosures on the same block.

The other side of the coin is demand. To make quick profits, the investor has to buy properties cheaply and then flip them quickly at a significant profit. The faster you can flip it — at a profit over the cost of purchase, repair and updating — the more money you will make.

Right now, demand is not so good for investors. The same low demand that makes foreclosed houses attractive because of low prices turns right around and bites the investor when the updated house is put back on the market. Buyers are scarce, demand is low. The flip often turns to flop.

Traditionally, investors flipped a lot of homes to first-time buyers, who didn’t mind putting some sweat equity into a fixer-upper. They would also sell to people who had gotten approval for questionable subprime loans. In some cases, they would sell to people who wanted the properties as investments and planned to rent them out. Or, the investor might not sell the property and might decide to be a landlord himself.

Dwindling options

But now, loans are much tougher to get. Landlords now may be struggling to make their mortgage payments on properties they financed several years ago. And then there’s the added burden of rising costs related to rental properties, such as soaring fuel prices and rising costs of construction materials needed for repairs.

What’s more, the investor may be in a very crowded field. The popularity of TV shows featuring flippers who make nice profits after a few weeks of work has created the notion that anyone can do it. The veteran investor finds himself competing with a bunch of newcomers, all trying to unload rehabilitated foreclosures.

Bottom line: Many investors, caught unaware when the housing bubble burst and the subprime lending market melted down, found themselves holding a bunch of properties they couldn’t get rid of — properties quickly becoming expensive to maintain.

If it still sounds like a good idea for you to buy a foreclosed property, keep reading.

Three types of foreclosures

First, consider the three options when it comes to investing, which coincide with the three stages of foreclosure:

1. Preforeclosure: This is when the borrower is in default on the loan, but a formal foreclosure has not yet been filed. To buy a property at this point, you deal directly with the homeowner, possibly while involving the lender, such as in the case of a short sale. If you try to acquire a preforeclosures without notifying the lender — say, by simply taking over the mortgage — you risk triggering the “due on sale” clause found in most mortgage agreements. This clause in the homeowner’s mortgage means the note becomes due and payable in the event of any title transfer of the property.

2. Auctions and sales: This is where the property is sold at an auction or sheriff’s sale. The good side of this is that there are no negotiations with homeowners, and existing liens and encumbrances typically are wiped out. The downside is that you often cannot inspect the property beforehand, you usually need significant and immediate cash and you may need to evict the occupant from the home.

3. Real estate owned properties: At this point, the lender has reclaimed the property, and the homeowners have vacated. The condition of real estate owned, or REO, properties can vary widely. Generally, liens and other clouds on the title have either been satisfied or wiped out. You can tour the property before making an offer. You will usually get the property for less than market value, but not drastically lower. Discounts are more likely if the property is in less-than-perfect condition. However, the lender is eager to unload this home and therefore will probably be willing to offer favorable financing terms or throw in other incentives.

Finding foreclosures

Finding properties in foreclosure isn’t hard these days:

How do you pay for it?

The biggest challenge in foreclosure investing is the money issue. Riskier, subprime and “creative financing” loans from most lenders have disappeared. There are some perfectly legal techniques still available, including subject-to deals and lease-option and lease-purchase transfers, but these are risky because of “due-on-sale,” or DOS, clauses in many existing mortgages. Keep in mind that while DOS clauses are common, they’re not universal. Mortgages written prior to the 1980s, for example, commonly do not contain them.

Financing options include
Conventional financing. Opening a line of credit.
Borrowing against existing equity. Enlisting a partner/investor.

For new investors, foreclosures can be risky. There are two major concerns:

1. Problems with the title. Perhaps the single most important part of the process is the title search. Have an experienced title search professional or real estate lawyer conduct the search for you. This is an extremely worthwhile investment. Buy a property with a cloudy title, and you could be in for big problems. After all, when homeowners can’t pay the mortgage and know they’re losing their home, they usually stop paying all the other bills too, and so it’s likely there’s a whole line of lien holders that can make a claim. Also, make sure it is the primary lien holder who is doing the foreclosing. If not, you will probably still be liable for that loan if you buy the property.

2. Maintenance and structural issues. Foreclosures are notoriously high-maintenance. Assume you’re getting a fixer-upper. If the homeowner couldn’t afford the mortgage, it’s likely that he couldn’t afford upkeep and repairs, either. These homes are often neglected — and, in some case, they’ve been deliberately trashed. It’s a good idea to have a home inspector or professional contractor give the home a thorough evaluation.

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