Fantasizing about foreclosures? Novice investors beware
Buying homes at auction is fraught with risk, and it takes a big investment of time as well as money.
The allure of foreclosed properties to a would-be real-estate investor is nearly irresistible: Buy valuable properties for pennies on the dollar with little or no risk to your own money, work when you feel like it and grow rich.
Countless seminars and how-to books promise to turn even the novice buyer into a high-powered real-estate investor through the magic of foreclosed homes. The problem is that instant, safe, trouble-free wealth often turns out to be like most things that sound too good to be true -- a scam. If it were easy money, everyone would be getting rich off of foreclosures.
True, some people do, just like some people get rich in the stock and commodities markets, from oil wells and from foreign currencies. But, just like these other forms of investing, profitably buying and selling real estate takes research, knowledge, experience, money and time. And nearly every deal with a huge profit potential comes with an appropriately sized risk.
Beyond get-rich-quick seminars and informational classes offered by nonprofit agencies and local sheriff's offices, few professionals teach novice investors the ins and outs of foreclosure sales. Why should they show you how to buy a great property at a deep discount instead of doing the deal themselves?
Still, if you are willing to go it alone and invest the time and cash required to deal in foreclosures, your first step should be to understand the process as thoroughly as possible.
Foreclosure is the legal method by which lenders or governmental agencies take properties from owners who fail to make payments, and then resell those homes to recoup money owed them.
Nonpayment of a mortgage or home-equity loan is the most common reason a home is foreclosed, but it is far from the only reason. Homeowners could be facing a foreclosure because of a balloon payment on an adjustable-rate mortgage, not paying property taxes, not carrying enough insurance, or even failing to keep the property in good working condition, says Rande Johnsen, a trustee for Trustee Corp. in Irvine, Calif.
Foreclosures have three phases, each with its own advantages and each fraught with peril.
The 3 phases of foreclosure
• Preforeclosure: The period after the homeowner has stopped making payments but before the land is put up for sale at auction. Investors take this opportunity to deal directly with the homeowner.
• Auction: The process of the courts seizing the property from the homeowner and selling it to the highest bidder. The county sheriff or a trustee handles this process, depending on the state.
• REO: If the property fails to sell at auction, or if the lender ends up as the highest bidder, the home becomes "real-estate owned" (REO) by the bank. Banks then try to sell these REO properties on the open market, usually through a real-estate agent or third-party marketing company.
Often these homes are sold to buyers who don't know they are buying a foreclosure and go through the entire process as they would with any other home.
Going once ...
The typical foreclosure is literally bought on the county courthouse steps during a sheriff's auction or a trustee's sale. These auctions typically are held on a weekday morning, and bidders must come to the sale armed with information and flush with cash or its equivalent. Plastic, personal checks and IOUs are almost universally shunned at auction and, depending on where you live, investors usually must make a sizable deposit or pay the entire sum on the spot, says John T. Reed, editor of Real Estate Investor's Monthly newsletter and author of the book "How to Buy Real Estate For At Least 20% Below Market Value."
Details vary by state, but as a rule, prospective buyers are not allowed inside the house before bidding begins. This is a frightening concept for many buyers, who must lay down thousands of dollars in cash knowing about the home only what is available through basic public records searches and a curbside appraisal.
The house could be infested with termites, gutted to the rafters by previous residents, or filled with lead paint or asbestos, and a buyer wouldn't know until after the sale is final.
This as-is aspect of auctions is only part of what can make foreclosures so perilous for beginning buyers. Another is that these homes aren't guaranteed to have a clear title.
"You can never be absolutely sure you are going to be buying a house with a clean title in any sale, but foreclosures are particularly problematic," says John Mixon, law alumni professor at the University of Houston Law Center.
During a typical foreclosure auction, the homes that will be sold are listed in the legal-advertising section of the county's newspaper of record at least a week before the sale. That gives you a week to research the records and history for each house scheduled for auction. However, many homeowners settle their disputes with the bank at the 11th hour, halting the sale -- and rendering pointless any time, effort or expense you invested to research the home. Given these constraints, obtaining title insurance is out of the question.
But choosing to forgo title research could be infinitely more costly. "There are so many regulations, so many procedures, that if you leave out a step, a previous owner may come out of the woodworks and show this to the court and you lose everything you put into the deal," says Reed.
Even if a title blunder doesn't invalidate the sale, overlooking a lien that wasn't wiped out by the foreclosure, such as an IRS debt you now have to pay, could wipe out any profit you hoped to earn. Procedural errors and court rulings also can halt a foreclosure sale. What's more, some state laws include a statutory redemption period, allowing the original homeowners to repay the past-due amount on their loan, regain ownership and leave the investor holding the bag.
Not all hopeless
But all that doesn't mean every auction deal is hopelessly risky.
"Very few institutional foreclosures are defectively handled," Mixon says, so the best bet is to stick to homes that were foreclosed by reputable lenders -- but only if they were the first lien holder, usually through a first mortgage. If the deal was done properly on the front end, complete with title insurance, there's less likelihood that a skeleton is lurking, and about a 90% chance of getting a good title.
"If you are buying a foreclosure brought by a small or shady lender, or by a family member who lent the money, you may be looking at odds that are no better than you would get at the roulette table," Mixon says.
Another variation on the auction is buying properties foreclosed by a government agency, such as the Department of Housing and Urban Development or the Department of Veterans Affairs.
These auctions typically are conducted online through a marketing company. Buyers are allowed to tour the homes in advance and conduct inspections, and they often can get title insurance.
The catch? It's not much of a deal. The number of homes is limited, and multiple buyers bid on the small stock. This competitive market means prices are discounted only slightly, if at all, from market value.
Numerous seminars and real-estate gurus advocate directly approaching homeowners delinquent in their payments, found through legal ads or online services that search public records and courthouse documents.
Proponents call this private deal "buying equity." Investors pay the owner a fee and then take over the existing debt and the home. This protects the homeowner's credit report from the black mark of foreclosure.
Buying equity this way is difficult in a seller's market because the owner could just as easily sell the home and usually pocket a greater amount in appreciation than an investor would be willing to pay.
"Some people call this stealing property," Reed says. "It is a situation fraught with ethical problems."
And, similar to auction situations, the slightest slip-up could blow the deal, leaving the homeowner in the house and the investor out significant amounts of money. All of the title problems inherent in an auction apply in preforeclosure sales, too, except that without the legal proceedings of a foreclosure, all subordinate liens, such as home-equity loans and construction liens, remain in place.
Despite all of the potential pitfalls, interest in foreclosures runs high. Part of the attraction comes from the same motivation that makes bargain shopping trendy, says C.J. Gehlke, editorial director of The Resource, a monthly newsletter published by REO Nationwide.
"What you find is a frenzy similar to what you get at a department-store sale," she says. "When you buy a house at foreclosure, it has the same mystique. You can brag to people at a cocktail party about how much you saved."
Reed agrees that get-rich-quick fantasies are driving most buyers' interest in foreclosures. "Buying foreclosures is not something a beginner should try. Many of the gurus are out there telling crowds anything they want to hear, true or not, just to sell some books."
By Mike Giusti, Bankrate.com