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Ask The Experts: What are the Pitfalls of Buying a Foreclosure?

Experts Discuss Pitfall Buying Foreclosure

House flipping is back in style. Before the housing market collapse of 2009 you could make some fast money by buying a house and turning around and quickly selling it. Sometimes you had to make some improvements but often you didn’t. That’s because average real estate prices were rising.

When the foreclosure wave hit, many investors waded into the market to snap up these distressed properties at bargain prices. At first they converted them to rental property, but as the housing market has recovered and prices have risen, many investors are “flipping” again – and many are finding the best bargains among homes in foreclosure.

But buying a foreclosure – especially one at auction – is not exactly for the faint hearted. If you don’t have a thorough grasp of the process, you could end up losing a lot of money.

Many Unknowns

Often, it’s hard to even know when and where a foreclosure auction is to be held. The schedules are subject to change at the last minute. If the homeowner is somehow able to cure the loan or arrange a short sale, the auction can be put off indefinitely. Legal ads in the local newspaper may be the most reliable source of information.

At the same you may be competing with some very experienced and well-financed investors. Investors, including some hedge funds, have been among the most active participants in the foreclosure market lately.

Banks will be represented as well. Very often the lender will purchase the property at auction and put it back on the market.

A Different Process

The process of buying a home at a foreclosure auction is very different than buying it from an owner with both parties represented by Realtors. You will likely not have access to the property until just before the auction, so you won’t be able to conduct a thorough inspection.

There may be damage to the property – both the kind that is visible and the kind that you don’t see. You won’t discover it until you get into your renovation. By then, you’ll own it.

You have to know exactly want it is you are buying. The danger is that the property may have more than one lien against it. If the foreclosure auction is to settle the second mortgage, you better be clear on the disposition of the first lien.

Having access to someone who can conduct a title search on the property before the auction is a necessity. If the search turns up unexpected items, that may drastically reduce the amount you are willing to pay and may cause you to walk away and continue your search elsewhere.

Auction Alternatives

That doesn’t mean you should never buy a foreclosed property. After all, there are other ways to get a foreclosure without mixing it up at an auction. As mentioned earlier, banks often buy the properties and put them on the market, listed with a Realtor.

These are called REO, which stands for Real Estate Owned. When a bank sells one of its foreclosed homes it tries to move it quickly and isn’t too concerned by how much it gets for it. On average, a buyer can purchase an REO property at a 30% or more discount.

While you can inspect the property with a Realtor, just like any other home in the Multiple Listing Service (MLS), keep in mind the property is being sold “as is.” That means the seller – the bank – isn’t fixing anything or making any repairs.

This can be an issue when it comes to financing. If damage is extensive you may not qualify for a conventional loan but instead, may have to take out a renovation loan, at a higher interest rate.

Still, foreclosures offer would-be homeowners and investors an attractive opportunity, as long as you are careful. The experts below offer advice on staying out of trouble.

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Keith Baker

Professor of Mortgage Banking at North Lake College, Irving, TexasHow can you tell if a property has a second mortgage or other lien?

Some new investors or hopeful new homeowners think that the foreclosure process has eliminated all liens, when actually it has eliminated all liens junior to the senior lien of the first mortgage loan holder. Except that tax liens for federal, state, county or local are more senior and have to be taken care of by legal process, usually payment. Investors should always try and use a title company or abstractor to conduct lien searches on properties they're considering buying. At closing, if it appears that there might be surviving liens on a foreclosed property's title, an adjustment in price should be attempted or get the lender to maybe remove them by going to court and asking to have liens on it eliminated by court order. This is referred to as "Quieting Title” and it will increase the cost and time to rid any remaining liens on a property’s title.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

The biggest issues are deferred / nonexistence of basic repairs such as un-repaired small leaks in a roof, bathroom sinks or utility rooms may have caused serious damage or even black mold problems. Also, deferred normal maintenance such as lack of regular pest control and changing filters can mean termite damage or overworked heating and air-conditioning systems. Just remember that since the former homeowner lost their home for not being able to make their payments, it is highly likely that they were not able to pay for broken light switches, roof leaks, plumbing problems, and a broken dishwasher or stove, either. If there are any structural issues like termite damage or roof or foundation damage, the home may not pass inspections for a new certificate of occupancy in those cities that require this before a new homeowner may take up residence or rent a property.
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Steven F. Brown

Professor of Real Estate at Cedar Valley CollegeWhat are some of the risks associated with buying a property at auction?

Actually, there are many. One of the keys to purchasing real estate wisely is knowledge. Knowledge is power. If you can do the requisite research prior to purchasing, you can obtain the information you need to buy wisely. Many times auctions don’t give you the time, information, or access to do what you need to do to safely acquire real estate and make it a good deal. So exercise caution before you take on purchasing distressed property. Gain as much information as you can before purchasing a property. You can never know too much about a property before you buy.

Primary risks of purchasing property at auction are as follows:
  • Unknown or undisclosed adverse property conditions: Like any other purchase, make sure you know what you’re buying. Most auction purchases are “as is” with no representations to the condition, or even inhabitability, of the property. “The best surprise is no surprise.” You don’t want to find out after you’ve won the auction that the property you’ve purchased has innumerable defects that were previously unknown to you.
  • Unknown or undisclosed liens: Buying real estate isn’t like buying personal property like a desk where “possession is 9/10’s of the law.” When you buy real estate, there may be loans or other claims (also known as encumbrances) that are secured by the real property you purchase at auction. You need to know about these – all of them - before you buy. Last thing you want to find out in purchasing auctioned property is that you actually purchased something that’s got a loan/mortgage/encumbrance against it that you didn’t know about.
How can you tell if a property has a second mortgage or other lien?

Each county has a county records building where deeds, liens, and other encumbrances against real estate are filed for record to provide constructive notice to outside parties of the claim against the property. This information, taken together, is called an Abstract of Title and is accessible to the general public by going there, or one may also hire a Title Abstractor to research and report this information to you.

Having this information from the County and interpreting it are two entirely different matters. To properly and conclusively research this matter, hiring an attorney to review this information and provide a Title Opinion Letter is highly advisable.

As a final point to consider on this matter, Title Companies also may produce Ownership and Encumbrance reports (O&E reports) with information on second mortgages and other liens, but these are not to be confused with Title Insurance. The two are entirely separate. O&E reports provide only information on title and encumbrances (like mortgages and liens). Title Insurance, as the name implies, actually insures the title to the property with certain constraints.

REO properties, when they are put back on the market, are generally sold at a discount. How much of a discount?

REO properties are “real estate owned”, taken back by a lender typically through foreclosure. Once the lender has foreclosed, it normally wants the property to be resold and not be held in its inventory of assets. So it will generally hire an appraiser to independently value the property to establish an estimate of fair market value (FMV). This FMV will be used to help the lender determine an asking price for the property.

As you might expect, discounts are dependent on myriad factors including the condition of the property. In a local real estate market that is “hot” (typically called a “seller’s market”), any discount on the purchase price of a foreclosure will probably be minimal. One can still find discounted property in a hot market if that property is in poor condition. Most homeowners don’t want to take on the task of substantially rehabbing a home, so that home in poor condition may be purchased at a discount from its FMV.

In a local real estate market where properties are selling slowly (typically called a “buyer’s market”), discounts may be quite sizable, especially if the property requires substantial rehab work. It’s not unusual to find REO property selling in this kind of market at 20-30% below its FMV.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

Buying a foreclosed property that is sold “as is” generally means you’re in for some work rehabilitating and improving the condition of the property. It may be something as simple as cosmetic work like painting or wallpapering. Or it may be far more complex work involving foundation work or structural or mechanical changes/improvements.

Most homeowners want a home that is already in good to excellent condition. They typically don’t want to have to do the work of fixing up the home. So one of the reasons “as is” purchasers are getting a discount is because they’re willing to do work that someone else is not willing to do. As an “as is” purchaser, you can either elect to do the work yourself or hire someone to do it for you.
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Ruth Ann Bowe

Instructor at Santa Barbara City College and Realtor at Keller Williams Santa BarbaraWhat are some of the risks associated with buying a property at auction?

In some cases, you won't have an opportunity to inspect the home or even view the interior. That means you really don't know what you are buying. If you are buying just for the land and intend to rebuild, that is fine, however that is not most people’s intention. In addition, you don't know what other liens or debts come with the property. A client of mine purchased a home at auction a few years ago. Fortunately, he was very familiar with the property and the debts. For the most part, it worked out well for him. Getting the occupants out was the most difficult aspect. He had to go through the eviction process and pay the deposit and first month's rent at an apartment for them.

How can you tell if a property has a second mortgage or other lien?

The easiest way is to purchase a preliminary title report from a title company. That will show if there are any recorded liens, mortgages and/or easements. In addition, when you drive by the home, be sure to look to see if any construction is currently going on. If there is any sign of construction including wood or other items that have been delivered, a mechanic's lien may not yet have been recorded and takes priority over some other liens and trust deeds.

REO properties, when they are put back on the market, are generally sold at a discount. How much of a discount?

In Santa Barbara, there doesn't tend to be much of a discount. Banks seem to take the approach most sellers should consider: Price the home just under market to create a serious buyer perception of value. In addition, if they sell the homes for too much under market, it could impact their customers who live in the area. The only time I have seen REOs sell way under market is when they are bought in bulk by cash buyers. That tends to happen prior to the property actually hitting the market. I had an offer on a short sale that the lender declined. They foreclosed and the property transferred ownership within two weeks to a private party with a recorded sale of about 20% below the offer I had submitted. It didn't make sense to me why a bank would do that. The new owner had it on the market within a week and sold it for a similar amount to the offer I had submitted, although not the same offeror.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

When you buy at auction, "as is" is just that. You pay cash, you own it with no inspections and no warranties. When you purchase an REO property, they say "as is", however I have been able to negotiate repairs if they were substantial. It makes sense for the lender to make the repair because if the escrow falls through, the lender may not get as much the second time around and would have to disclose what the necessary repairs are and the timeline would run on.
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J. Reid Cummings

Assistant Professor of Finance & Real Estate, and Director of the Center for Real Estate & Economic Development at University of South Alabama, Mitchell College of BusinessWhat are some of the risks associated with buying a property at auction?

When you buy a property at auction, it is typically sold on an “as is, where is” basis. Therefore, a buyer should thoroughly investigate the property prior to the auction to discover as much information, whether good or bad, as possible. By doing so, a well-informed buyer can bid on a property at auction with a good feel for any necessary expenses above the auction price.

How can you tell if a property has a second mortgage or other lien?

A search of the public records will reveal all liens, including those related to mortgages, judgments, or other types of tax and/or mechanic liens.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

In practical terms, a buyer should thoroughly inspect a foreclosed property prior to purchasing to discover any defects, latent or otherwise which may affect the property’s value. Additionally, a buyer should also be aware of any applicable redemption laws and understand the ramifications of how their ownership rights will be affected by any rights of redemption available to the foreclosed property’s owner.
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Chad J. Pomeroy

Professor of Law at St. Mary's University School of Law What are some of the risks associated with buying a property at auction?

The primary risk is that you don't have the time or ability to do traditional due diligence (such as a full title review and physical inspection). You generally go to the auction and buy a property you've only seen from the outside (because the defaulting party is still occupying the property and has rights of possession and control up until the moment of the sale). If you contrast that with how you typically buy a property (only after numerous walk-throughs and inspections), you realize the risk.

How can you tell if a property has a second mortgage or other lien?

You check the county records. Every state requires interests in property to be publicly recorded in order to have effect against third parties. As such, checking the county records will show the liens (or other interests) affecting the property. Interestingly, given the context of your question, you don't generally need to worry about junior liens - senior liens generally foreclose out junior liens (meaning that, if you buy at an auction held by a senior lienholder, you buy free and clear of a junior lien). There can be complications, but that is the way it typically works. Of course, that implies (and generally means) that you do have to worry about senior liens (and other interests).

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

This means that you're buying it without a chance to see what's wrong with it. That's particularly problematic because you're buying it from a creditor that is taking it away from someone else - and that "someone else" is not likely to have cared for it as much as a typical homeowner, given the negative situation. That's a generalization, and there are (of course) many exceptions, but the concern is that the prior possessor/occupant (likely the defaulting debtor) will not have cared for it properly and that you'll be buying it without knowing the nature of that lack of care.
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Kimberly R. Goodwin

Parham Bridges Chair of Real Estate and Associate Professor of Finance at the University of Southern MississippiWhat are some of the risks associated with buying a property at auction?

There are three main risks associated with buying a property at auction. First, in states with a statutory right of redemption, the previous owner can actually retain the right to purchase the property back for a period of up to one year following the foreclosure auction. Second, other liens against the property are not disclosed in the auction process. As the new property owner, you could inherit those liens along with the title. Third, you are not allowed inside the property for an inspection prior to the auction. So, you can’t be sure what you are getting, other than what you are able to see from the outside of the property.

How can you tell if a property has a second mortgage or other lien?

All liens against the property are registered at the county clerk’s office and placed on the public records. You could go do a search for these documents on your own or pay an attorney or title search company to do the search for you.

REO properties, when they are put back on the market, are generally sold at a discount. How much of a discount?

Academic research on this topic shows that the REO discount varies over time and by location, but on average you can expect a 10-20% price discount from normal market value.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

Buying a property “as is” means that the owner is not going to make any repairs prior to the sale or offer any price concessions due to the property condition. The seller, however, typically discloses any known problems or defects with the property. The risks associated with buying a property “as is” are compounded with foreclosures. Since a potential buyer cannot perform a property inspection prior to the auction, the condition of the property is completely unknown. Furthermore, the lender foreclosing on the property bears no liability for defects discovered after the property sells at a foreclosure auction. The reason foreclosures sell at a large discount is to compensate the buyer for these risks. It really is a situation where “caveat emptor” needs to be recognized.
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Jon A. Baumunk

Member of the Faculty at The Evergreen State CollegeWhat are some of the risks associated with buying a property at auction?

This depends on the terms according to which the auction is conducted. Some considerations would be whether the property may be occupied, whether it may be inspected prior to bidding, and any fees the buyer may be responsible for paying in addition to the accepted bid price.

How can you tell if a property has a second mortgage or other lien?

Generally, one would need to go the county in which the property is located and conduct a title search of liens on the property. A potential buyer should be able to find someone to perform this service for them.

REO properties, when they are put back on the market, are generally sold at a discount. How much of a discount?

The discount would depend on the supply and demand in the particular market in which the property is located. In addition, it would depend on whether the property is to be sold “as is” (see below). If the seller is willing to make at least some repairs, then I would expect the discount to go down.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

This means the buyer is to assume all risks of making repairs. In other words, if there is anything wrong with the property, the buyer, and not the seller, is expected to fix it.
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John Norquist

Former Mayor of Milwaukee (1988-2004) and Retired President and CEO of the Congress for the New UrbanismWhat are some of the risks associated with buying a property at auction?

Make sure you are only buying the property and not assuming any debt or liens.

How can you tell if a property has a second mortgage or other lien?

Pay for a title search.

REO properties, when they are put back on the market, are generally sold at a discount. How much of a discount?

Like other property, it depends on the condition and location of the property. It is a good idea to hire a structural engineer to examine the property. If the price is so low that the cost of an inspection is close to the sale price, the property is probably not worth owning.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

Plan in advance for the costs of repair and rehabilitation. If the building is unfit for habitation it will be your responsibility as the new owner to fix it. Your relationship with the City building inspector will have just begun.
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Norman G. Miller

Professor, Burnham-Moores Center for Real Estate University of San Diego What are some of the risks associated with buying a property at auction?

The biggest risk is the lack of time for due diligence to really check out the property. A drive by review and quick tenant review is about all you typically have time for. Environmental risks are a particularly large concern. If the property is not developed fully then permitting and utility access are concerns and budgeting for finishing. Another risk is getting caught up in the need to allocate capital as promised and bidding too high just to get some properties in the portfolio. Another factor is critical mass and being able to manage the property efficiently and effectively once purchased. Getting the scale right is important. Last, since you need to bid on many properties and few will work out as the high bid, you need to be sure to have capital access just in case more than expected come through, otherwise you will lose credibility as a future buyer.

How can you tell if a property has a second mortgage or other lien?

These are generally recorded.

REO properties, when they are put back on the market, are generally sold at a discount. How much of discount?

The long term average is about 20% but the actual discount varies with local market conditions, how many properties are being dumped and how much capital is chasing the property. Discounts of 10% are more typical when the hedge funds are chasing deals.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

Generally it means it will be hard to determine internal repairs that must be done immediately, and environmental concerns. Quick inspections will catch some but not all problems.
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John Baen

Professor, Department of Finance, Real Estate University of North TexasWhat are some of the risks associated with buying a property at auction?

One of the biggest risks of buying a property at auction is overpaying. The real question is what is the market value, minus transaction costs? It’s hard to know because many times you aren’t allowed to inspect it. You don’t always know what you’re getting. Another real concern is the title. You have to know if there are other claims on the property. Some people go to a foreclosure auction and they actually buy the second lien, and the first lien is in default and they get wiped out. There have also been cases where the address on the paper work was wrong and people actually bought the wrong house. The safest way to buy a foreclosed home is after it has already been repossessed.

How can you tell if a property has a second mortgage or other lien?

Anyone thinking about buying one of these properties at auction had better have a title company in their back pocket because you can’t do it yourself.

REO properties, when they are put back on the market, are generally sold at a discount. How much of discount?

I would say the average is about 30%. The banks don’t really case because someone else is paying the difference.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

The lender doesn’t want to put any money into the property in order to sell it. They’re smarter than the average bear. Repairs always cost more than you think.
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Bennie Waller

Professor of Finance and Real Estate, Longwood UniversityWhat are some of the risks associated with buying a property at auction?

The major consideration when buying a property at auction is that it will unlikely that you will have the opportunity to have a property inspection. As a result, this means you get the property “as is” and there may be significant issues with the property, structural, heating and cooling, plumbing.

How can you tell if a property has a second mortgage or other lien?

You or an agent (real estate or lawyer) should invest the time and visit the courthouse. Liens, mortgages or mechanic liens should be on file.

REO properties, when they are put back on the market, are generally sold at a discount. How much of discount?

It is hard to say, however a good starting point is the average of what other similar properties in the area are selling, keeping in mind that REO properties are likely to need to some repairs or remodeling and as such should sell at a discount.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

As with short-sales or auctions, many times the previous home owner is upset over losing the property and may have done vindictive things to the property. Some examples include obvious destruction such as holes in walls/ceiling, removal of lighting or plumbing fixtures as well as less obvious damage such as concrete in the drainpipes or pinholes in the water pipes. Such properties might be a great investment for a handyman, but could turn out to be a nightmare for the average homeowner.
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Shaun A Bond

West Shell, Jr., Chair in Real Estate and Director of the UC Real Estate Center Department of Finance and Real Estate Carl H. Lindner College of Business University of CincinnatiWhat are some of the risks associated with buying a property at auction?

Buying at auction can have advantages for investors but does carry other risks and is different from the house buying process that many people are familiar with. If buyers are using finance to purchase the house, they will need to have this arranged in advance. Some lenders may have a reluctance to deal with this process. Typically investors are acquiring properties at auction with cash, and this can put them at an advantage when compared to investors using debt finance. Another concern is that an inexperienced investor could overpay for a property in the heat of the moment of an auction. Also, it may be hard to carry out some of the usual inspections that might be part of the normal home buying process. Investors could encounter significant problems after they acquire a property that have a major impact on their returns.

How can you tell if a property has a second mortgage or other lien?

I am not an expert on this aspect of the process so I would rather not answer this question.

REO properties, when they are put back on the market, are generally sold at a discount. How much of discount?

During the depth of the recession, estimates of the REO discount were as high as 30 to 40% of pre-recession prices. However, in many markets discounts of this magnitude have now disappeared as investor interest has picked up. Financial institutions have higher expectations for the prices that the house may fetch. Some institutions are also doing some basic refurbishment of the properties before auction, which is further pushing up auction prices.
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Ken H. Johnson

Florida International University College of Business Administration Department of Finance & Real Estate College of Business AdministrationWhat are some of the risks associated with buying a property at auction?

Typically, the kinds of houses that make it to auction are not that good of a deal financially. They’re at auction because there was no room for negotiation prior to the foreclosure.

How can you tell if a property has a second mortgage or other lien?

Generally speaking, what will happen at an auction, if there is a second lien holder, almost always they will step in and buy the property before an individual will, because they want to try and get some of their money back.

REO properties, when they are put back on the market, are generally sold at a discount. How much of discount?

When a property is sold at auction they are legally required to satisfy as much of the indebtedness as possible. But it’s different once it gets to an REO. Generally speaking you can then buy that property at a discount. On average, I’ve found that you can get a bigger discount buying an REO property than if you bought it at auction.

Foreclosed properties are almost always sold “as is.” In practical terms for a buyer, what does that mean?

It means that part of the price discount you are getting is actually a quality discount. Maybe the house should be worth $100,000 but you bought it for $80,000. However, it needs $10,000 in repairs, so the discount was really $10,000, not $20,000. Don’t get me wrong, you’ll get a good buy. But so many people think they’re going to buy a foreclosure at 75 cents on the dollar, and that’s just not going to happen.
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Anjelita Cadena

Doctoral student University of Texas San Antonio

Image:  grekoff/Shutterstock

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