Even in the best of times, foreclosures happen. But their numbers may soon increase sharply with unemployment rising and mortgage delinquency rates the highest they've been since 1992. For an investor with a strong stomach, a discerning eye, and considerable knowledge of the local real estate market and laws, this could be a chance to build a profitable property portfolio.
You assume a lot of risk with this kind of real estate investing. In some cases, you are acquiring an asset that you haven't inspected, except from the curb. And in some states, when you buy at a foreclosure sale, the defaulting borrower has from a few days to 12 months to reclaim the property.
But often you're getting an opportunity to buy real estate for less than the market price. And because "most people have no idea how the foreclosure process works," there's not much competition, says Robert Shemin, who has bought hundreds of foreclosed properties and is the author of Secrets of a Millionaire Real Estate Investor (Dearborn, $18.95), a primer on real estate investing.
Investors in foreclosures differ on what they deem an acceptable rate of return for the inherent risks. Most won't settle for less than 30% return. So if you think you can sell a property for $200,000, you'd better make sure that your bid, plus repairs and carrying costs, doesn't exceed $140,000.
Making an accurate appraisal requires savvy not only about property values but also about how and where court records are kept. When a creditor files suit to reclaim a property, this becomes part of the public record. You can find postings of pending foreclosure suits (or notices of delinquency in some states) at the local courthouse. Ward Hanigan of San Diego, who moderates a foreclosure discussion group at foreclosureforum.com, advises that you check a local legal newspaper, preferably a daily. "Why burn your eyeballs out looking at a daily microfilm court record if you can pay someone else to compile all the information for you?" he says. Many legal circulars have electronic versions that subscribers can receive via e-mail.
IN THE 'HOOD. The listings give the address of the property, along with the names of the defaulting party and the lender. If something catches your eye, you'll want to research what similar properties are going for in the neighborhood. Thomas and Tammy Plaster, foreclosure investors who own a construction business in Conroe, Tex., say it's best if you track foreclosures in an area that you know well, such as the area where you live. "That way, you're on top of what's going on in the neighborhood in terms of fluctuations in prices and taxes," says Tammy Plaster.
You'll want to visit the property to better assess its worth. But you probably won't be able to enter a residence, because it likely will still be occupied. "It's a good idea to estimate worst-case scenarios of what's inside," such as crumbling walls and leaky plumbing, says Robert Bruss, a syndicated real estate columnist who has profited from buying and selling seized properties.
To further vet the property, you'll have to perform or commission a title search that will show whether other mortgages or liens are due. Title searches can cost anywhere from $30 to over $200, depending on where you live. You might be able to get a house or office building for a song at a foreclosure sale, but that's no bargain if you end up liable for years of unpaid taxes and a slew of senior mortgages. Senior mortgages or deeds--loans taken out prior to the one in default--are your responsibility if you buy the property. Junior loans, such as second mortgages, are wiped out upon foreclosure of any previously established loan. Overdue taxes always carry over.
KNOCK, KNOCK. If you plan on selling the property for quick profit, you'll need to calculate the carrying costs and sale expenses as well as actual property value and repair costs. Carrying costs include the interest on money you borrow or would have earned had you left your money in the bank. You must pay title and transfer fees, and don't forget about interim property insurance. You might also want to factor in a sudden softness in the market or increase in local taxes. The Plasters add 5% to 10% for unexpected costs. "It may take longer to make the repairs or sell it than you thought," says Tammy Plaster.
Once you've arrived at a figure, you can try to work out a deal with the defaulting party before the property is repossessed. Depending on state laws, borrowers have anywhere from 21 days to 12 months following the lender's initial legal action or notice of default to pay up and avoid losing the property in a foreclosure. "They can sell it to you any time during that period," says Shemin. He recommends knocking on the door and making a proposal. Since defaulting borrowers face losing everything and ruining their credit, some are happy to get out with their equity.
A drawback to this strategy is that you would have to assume any junior mortgages. Foreclosureforum.com's Hanigan prefers to bid at foreclosure sales because he gets the property free and clear. These sales are usually held at the local courthouse the same day and time every month. The lender's attorney or trustee starts the bidding with the amount owed on the property, plus the legal and administrative costs associated with foreclosure. That's the only bid the lender will enter, because it isn't allowed to profit from a foreclosure sale. Top the asking price by as little as a penny, and the property is yours. If there's a bidding war, the defaulting borrower gets the amount above the lender's bid.
You'll need to have cash on hand. Most sales require 10% down, with the remainder paid within a specified period--usually only hours. As with any property, lenders will finance your purchase of a foreclosure if you can show it's a good deal, you have good credit, and can demonstrate your ability to repay the loan. You can also set up a line of credit with a bank, so you can make the initial payment and then negotiate a mortgage once you have title.
MARKET VALUE. If no one bids over the asking price, the property goes to the lender. As these represent failed loans, banks and secondary mortgage holders, such as Fannie Mae (FNM) and Freddie Mac (FRE), want to get them off their books quickly. But unlike at foreclosure, lenders now may profit from the sale, so they undoubtedly will raise the asking price to market value. An advantage to taking this approach is that you can inspect the inside of residences. Lenders also often offer favorable financing and may waive some closing costs. Most banks list foreclosures with real estate agents who post them on the Multiple Listing Service (MLS), a directory available to realtors. Fannie Mae and Freddie Mac use realtors, too, but also list properties on their Web sites (table).
If the loan on a home was guaranteed by the Federal Housing Administration (FHA) or Veteran's Administration (VA), those agencies acquire and market the property after foreclosure. They usually sell it through a real estate agent "as is," without warranty, whereas banks and secondary lenders usually fix up the place so they can ask a higher price. But the FHA, a division of the Housing & Urban Development Dept., and the VA often pay all or a portion of the closing costs. The VA will even finance the deal--and you don't have to be a veteran. Whether you're in the market for an investment or a home, it just might pay to take a chance on a foreclosure. By Kate Murphy