How to Buy Foreclosures

How to Buy Foreclosures

What Exactly is Foreclosure?

The term “foreclosure” refers to any method of enforcing payment of the debt secured by a mortgage by taking and selling the estate. All rights of the homeowner covered by a mortgage are terminated. Foreclosure is a process in which the estate becomes the absolute property of the lending institution.

Foreclosure numbers are growing daily. Of the one hundred twenty or so million homes in America, more than 4% or roughly 4.8 million of them are facing foreclosure. Some of these homeowners are able to work their way out of foreclosure. However, according to Mortgage Bankers Association, there were about 500,000 homes that went through foreclosure last year.

Foreclosure proceedings typically start with a formal demand for payment which is usually a letter issued from the lender. This letter of notice is referred to as a Notice of Default. Depending on your state, the lender will issue this notice when the homeowner has been 3 months delinquent on the mortgage payments. It is a notice of intent to sell the property, terminate all the borrower’s rights in that property and evict the borrower from the premises.

You have up to three opportunities to buy foreclosed properties:

  • From the owner in foreclosure (pre-forclosure)
  • At the auction (forclosure sale); and, if the property doesn’t sell,
  • From the lender who ends up with it

For the forclosure buyer, these are each entirely different scenarios from an operational standpoint. There is a strong tendency to favor one method over another in your business initially, although experienced investors eventually may use all three. If you are new to buying foreclosures, you’ll probably start by buying directly from the owner. In each scenario, the keys to your success are organization and persistence.

Pre-Foreclosure

The goal of buying pre-foreclosures is to create a situation where everyone wins. This type of strategy involves just you, the homeowner, and possibly the lender. Because the homeowners have been delinquent on their mortgage payments, they have motivation to entertain offers made by investors. While you may not be the only investor looking at this property, when buying pre-foreclosures you can usually expect little competition.

When buying pre-foreclosures for the purpose of reselling them at a profit, you must do some research on these properties. Here are some basic guidelines:

  1. Locate loans in default.
  2. Evaluate each property by comparing and contrasting location, price and property condition.
  3. Narrow your selections to a few.
  4. Inspect the properties.
  5. Determine the property owner’s needs, motivation and flexibility.
  6. Determine the market value of the property, fix-up costs, potential sales price and profit.
  7. Arrange default work out by negotiating with the owner and the lender.
  8. Close on the property, fix it up, and flip it quickly.

Since the vast majority of foreclosures are single-family residences, most of the owners can be found at home.  There are several philosophies about how best to reach owners.  The most obvious is the telephone – if it’s listed and if it’s still connected. Knocking on doors is probably your least efficient way to reach owners, however some professionals will tell you it is the best method of all. For some reason, owners in foreclosure are rarely home.

Generally, your most efficient method will be a letter writing campaign targeted at a handful of properties at any given time. A letter is virtually guaranteed to reach the owner. Keep in mind that it may take numerous letters before you attract the attention of an owner in foreclosure. It may take up to 6 or 8 letters for each owner before they’re convinced you’re serious and can be helpful.  Results are highly likely if you mail consistently. Every month, a number of people will contact you asking if you can assist them.

Experience has shown that a low key approach, whether in person or by mail, is most effective.  Letting the person know you occasionally buy foreclosures and that you may be able to help them after evaluating their situation is really the essence of your communication with them. Although you don’t say it, try to convey the impression that you are a non-professional.

Your goal is to have a meeting in which you can discuss their problem and how to resolve it.  The usual approach is to offer a sum of money in addition to paying the existing arrearages.  You must leave significant profit for yourself and the best way to explain this is that if you take over the mortgage, pay the owner money, fix up the property for sale, and wait for it to sell, you have to receive a profit for your efforts and risk. Your ultimate goal, of course, is to pay the owner the smallest amount of money possible for his equity.  Unless you receive this profit, you should move on to other properties.  

But what if there is no equity? The way to make money with properties that have no equity is through a short sale with the lender, paying them off at an amount lower than the existing balance. In a hot retail market this is extremely difficult because the lender has no motivation to reduce their loan.  But in a soft market, some lenders may be interested in receiving a lower sum and walking away from the foreclosure.

Remember, foreclosures usually take about six months and this can cause the lender significant loss due to property neglect.  Lenders incur large expenses to repair and sell properties.  You will also need the cooperation of the buyer in a short sale and normally he will receive nothing except relief from the foreclosure.  But for many, this is enough because of the extreme pressure they have been under.

Buying Foreclosures at Auction

If no one is successful in buying a property from the owner in foreclosure, it will go to sale.  You need cash to participate in foreclosure sales, although many investors use a combination of their own capital and a line of credit.  The day before the sale, they borrow the amount they believe they will need.  If they don’t use the money they return it to the lender or use it for the next sale.

Buying foreclosures at the auction is an effective way to purchase property at less than market value. Most properties are auctioned on the courthouse steps. The property is auctioned off to the public and the highest bidder walks away with the property. This can be very rewarding to those who are in a position to buy the property within a short amount of time and can be disasterous to those who bid without proper financing in place.

Most auctions require a small fraction of the purchase price on the spot and the remaining balance usually within 1-30 days.  Make sure you have your deposit ready and your financing is in order before you bid. If you are unable to get financing within the allotted time, you will most likely lose your down payment and they will auction the property again.

Buying foreclosures at an auction is also the riskiest place to pick up a foreclosure. You are buying the property in completely AS IS condition so it’s very important to do your homework before you go to an auction and bid on a property.

When buying foreclosures at auction, we recommend you:

  1. First visit a local auction to get a feel for the bidding procedure.  Find out how much is required as a down payment and when the rest is due.
  2. Get proper financing in order.
  3. Research properties and do your homework prior to the auction date.
  4. Calculate potential profits.
  5. Determine the most you will bid for the property.
  6. Follow the property to the auction and participate.

Since there is no title insurance available at foreclosure sales, you will need to know precisely what is on the property before you make a purchase.  You’ve had several months to get information from a title company so you will know what the liens are, but beware of last minute filings by creditors.  You can check with the title company the day before the sale, preferably in the late afternoon.  

Make every effort to inspect property before the sale because foreclosure properties are often in disrepair.  You may have to buy properties without inspecting the interior.  All sales are final and there is no recourse.

It is sometime said that foreclosure delivers the clearest title available because it nullifies all liens after the one in default.  But remember, notes and liens ahead of the note in default will remain on the property and become your responsibility.  

As a general rule, you will not want to buy properties for more than 75% of the retail value at any point in foreclosure.  Remember, buying property at auction is risky so always leave yourself sufficient profit to make your business worthwhile.  Don’t fall into the trap of believing that any property purchased at a foreclosure sale is a bargain.

Buying Foreclosures from the Lender (REO Properties)

When a property does not sell at auction, it then reverts to the lender.  Lenders are generally not happy to receive properties out of foreclosure since they are in the lending business and not the property management business. They are usually understaffed to handle REO properties and they don’t have good management systems.  

REO, or Real Estate Owned (an accounting term), just means the lender reclaims the property and establishes control over it to minimize its losses. Buying foreclosures that are REO can be the easiest way to acquire distressed properties if your timing is right. Lenders are always listing properties that come back from auction because they don’t want REOs on their books.  However, banks do tend to be bureaucratic and you need to be persistent.

Most of the time they will hire a broker or real estate agent to handle the REO’s just because there are so many of them. Lenders in this situation are very motivated, especially if they do have a large number of such properties. These properties are generally a large expense that needs to be eliminated. This gives the investor numerous ways to creatively negotiate with the lender on a purchase price.

One disadvantage of buying foreclosures that are REO is that you might have to pay close to current market value for these properties because the lender must pay off any outstanding liens, taxes, and other expenses. This can be beneficial, though, because most of the time you’ll find these types of foreclosures with clear titles.

Immediately after the lender becomes the owner, attempt to reach the person who has responsibility to resell the property.  Convince him or her that no one knows the property better than you do and you will buy it immediately.  Of course, for this convenience you’ll need to get a discount.

If the price is around 75% of market value, you can borrow the entire purchase price from a hard money lender.  Afterwards, you can refinance to a better loan or simply resell.  

You will have to be persistent with lenders.  They will say paperwork is needed before they can sell the property or that it has not been released for sale, but it is important for you to make contact with the lender early and for you to submit a written offer as soon as possible.  The truth is that they can sell you the property at any time.  

Concerning price, lenders are obviously going to be less negotiable in a good retail market.   However, since you are going to cash them out above their current loan amount, in most cases they are being made whole even though your offer is below retail.  You will also be relieving them of the necessity for reports, paperwork, inspections, repairs, and other time-consuming procedures.  Put an offer in front of them to get their minds working. 

As mentioned, try to pay no more than 75% of retail when buying foreclosures.  A common rule is that you will need 1% to 5% for repairs and 8% for selling expenses leaving you with about 10% to 15% profit.  If you follow this rule you will always have a healthy profit in the foreclosure business.

What if I don’t have cash?

If capital is a problem, you can usually borrow the amount you are paying the seller from a hard money lender who will put a second or third on the property you are buying.  Later, after you have taken title, you can usually refinance to a good long-term loan and pay off all debt.  If you sell the property the hard money lender will be paid off.  

Always use a grant deed or warranty deed (or equivalent) when transferring property to yourself.  Never use a quit claim deed.  Also, use an escrow or attorney so that you pay the seller cash only when you are receiving a deed.  Never give someone in foreclosure money outside of an escrow or you may end up as an unsecured creditor in a bankruptcy with no chance of getting your money back.

What if there are other liens or mortgages?

Most properties in foreclosure have only the loan that is in default on the property.  But if there are other liens or mortgages, you have an opportunity to create additional equity for yourself.  

You can ask the lien holders for a discounted payoff or they will face the possibility of being wiped out at the foreclosure sale.  Discounts of 50% or more are not uncommon.  In general, these other lien holders will be interested in your offer.  You might suggest that you will not do the transaction unless they cooperate (although you may end up going forward anyway).  Pay them off through escrow so that you will know for certain you are getting the deed.