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

ForeclosureHouse 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 of heart. 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.

  • Norman G. Miller – Professor, Burnham-Moores Center for Real Estate University of San Diego
  • John Baen – Professor, Department of Finance, Real Estate University of North Texas
  • Bennie Waller – Professor of Finance and Real Estate, Longwood University
  • 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 Cincinnati
  • Ken H. Johnson – Florida International University College of Business Administration Department of Finance & Real Estate College of Business Administration
  • Anjelita Cadena – Doctoral student University of Texas San Antonio

Norman G.Miller, University of San Diego

Norman G.Miller, PhD

  • 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.

 


 

John Baen, University of North Texas

Professor John Baen

  • What 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.

 


 

Bennie Waller, Longwood University

Bennie D Waller, PhD

  • What 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.

 


Shaun A. Bond, University of Cincinnati

Shaun A. Bond, PhD

  • What 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.


Ken H. Johnson, Florida International University

Ken H. Johnson

  • What 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.

 


 

Anjelita Cadena, University of Texas

Anjelita Cadena

  • What are some of the risks associated with buying a property at auction?

The greatest risk is in purchasing a property for which the buyer has not done their homework. Prior to the auction date, the public can purchase lists, or go to the courthouse to see the filings for foreclosures and create their own list. They should then conduct a search of the county’s records to look for liens. This can be a tedious process and it is easy to give up too soon.

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

Some of the purchased lists come with memberships; these companies conduct the research for their members prior to the auction, however, you are still responsible for any liens that turn up later but were not found during the title search. When you purchase a property through the regular channels, you can buy title insurance which covers the possible unknowns but this is not possible for a foreclosure.

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

Most of the research into “foreclosure discounts” has been on the sale of those properties that are listed for sale on an MLS after being sold at foreclosure auctions. The results of this research depends on the methodology used to identify the foreclosure. Previous studies have used the ownership or agent remarks to identify foreclosures and have found a foreclosure discount ranging from 24% to none-found.  This current study introduces a new identification method, that of matching foreclosure data to MLS data. Properties listed on the MLS are then identified as foreclosures using all methods available and we find a 12.5% discount. In one model, we looked at the foreclosure discount for both foreclosure properties marketed as foreclosures and those not marketed as foreclosures and the discounts are the same suggesting that it is not the label of being a foreclosure but other characteristics that are impacted by the foreclosure status such as lack of maintenance and property condition. There are many other considerations that impact the discount; for example, listings that mention HUD/FHA garner an additional 4.6% discount while those that mention the VA will see a decrease in the discount of 2.15%.

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

When a property is sold at the courthouse it is on an “as-is” basis. If the property is purchased through the regular channels, the owner will give permission to the potential buyer to conduct an inspection and they can hire a qualified inspector and, unless they have not lived on the property recently, they are required to provide a “Property Condition” disclosure. However, properties being sold as foreclosures do not come with the same privileges, there is no inspection allowed and there will not be a property condition disclosure.  This is a buyer beware situation. Remember, it takes anywhere from 3 months to over a year to foreclose on a property. For that time, the person who could not make their mortgage payments more than likely did not make any repairs, keep up the maintenance of that property, or, in the worst case, caused intentional damage to the property.

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