Smart Ways to Profit from Foreclosures
By Matt Woolsey, Forbes.com
Jun 18th, 2008
With 700,000 bank-owned homes on the market, and another one million in some state of foreclosure, according to RealtyTrac, an Encino, Calif., provider of foreclosure listings, you might be tempted to add a distressed property to your portfolio.
Beware. Buying a home in foreclosure is not for the meek. Those with an appetite for risk, however, will find the tumultuous market stocked with plenty of investment opportunities.
These may include the sale of brand new luxury homes in an upscale Nashville community for half their marked value or a bank giving away a foreclosed property in a poor Detroit neighborhood for back maintenance.
But this complex arena is teeming with professionals. Private equity juggernaut Blackstone Group alone this year raised an $11 billion war chest to chase distressed properties, and large homebuilders looking to recapitalize, like Centex and Lennar, unloaded over $1.5 billion in homes to vulture funds between December 2007 and April 2008, for between 30 and 40 cents on the dollar.
Whether you're looking to flip a home, buy into a neighborhood you couldn't otherwise afford or planning to rent the home, you, like these big companies, must have heaps of cash on hand.
There are properties that can be turned within a few months, but the overall market is still slow. Even if you have a renter lined up or have enough money for a 10% to 20% down payment, you should be ready to weather a depressed market for another two or three years.
Go to the county assessor's office and study recent sales for price-per-square foot and time spent on market to determine what sort of price you can expect at resale. Be conservative. If you are renting, calculate a capitalization rate, and subtract 10% or more of the annual yield for maintenance and depreciation. Make sure that your endeavor is still profitable if you incur two to three years of carrying costs and depreciation.
It's also crucial to remember that bad loans that plagued speculators and unprepared borrowers don't simply disappear when distressed owners sell their properties. Unless the property goes through foreclosure auction and becomes bank-owned, outstanding liens and fees are simply transferred to the new owner. If you plan to buy out of pre-foreclosure, make sure the property has a clean title; otherwise you'll just be trading places with the distressed homeowner.
In such situations, outstanding fees, second liens and the like aren't automatically washed away. It isn't always the case that pre-foreclosure homes lack clear title, but once a home goes into the auction on the courthouse steps and is bought back by the bank, it is clear of all the bad loans that got the original owner into trouble. Making sure a home has clean title is a critical first step to a sound investment.
It's also important to note that you make money on a foreclosure the moment you buy the home. You can make a good return if you're selling in a sinking market, for example, by unloading a home at 70 cents on the dollar, if you bought it for 50 cents on the dollar. In heavily hit foreclosure areas, banks are juggling so many properties that offers on distressed homes, out-of-business homebuilders' developments and excess inventory are being entertained at under-listing prices.
Just don't get attached. As in any market, falling in love with a home--and overpaying--is a surefire way to lose money in a highly risky one.
When you've located an appealing property, order a new appraisal and study foreclosure patterns in the neighborhood. You'll also want to explore creative financing options to defer costs.
However you do the math, the most important thing to keep in mind is that the investment has to be worthwhile--even if you can't sell the home at your desired price for two or three years and the current housing market deteriorates a further 10% to 20%.
If that's a model you can live with, it might be time for a subscription to a foreclosure listing service.
Outstanding Liens
The same sort of reckless borrowing that put the previous owner in a predicament can come back to bite a foreclosure buyer. Unless the property goes through foreclosure auction and becomes bank-owned, outstanding liens and fees are simply transferred to the new owner. If you plan to buy out of pre-foreclosure, make sure the property has a clean title; otherwise you'll just be trading places with the distressed homeowner.
Bidding
If you're planning on reselling the property, keep in mind that holding costs, transaction costs, marketing costs and a depreciating market are all in play. (The depreciating market is a particular concern since it's unknown how close the market is to bottom.) Your bid needs to reflect all of these costs. Pre-foreclosure sellers tend to be in denial until the 11th hour, but banks are willing to knock anything between 25% and 50% off the outstanding loan's value, which makes negotiating with them in the bidding process easier.
Pay Attention to Foreclosure Concentration
Neighborhoods overrun with foreclosures are the most likely to suffer further depreciation. It can be particularly tempting to buy homes out of foreclosure in these areas, because they offer the steepest discounts. If you insist on buying into such a market, make sure you can still make money in the market if it dips a further 10% to 15% over the coming year. Check the neighborhood by walking around and by checking foreclosure-listing services like RealtyTrac.
Be Aware of Appraisal Timing
Part of the reason that some homeowners owe more on their homes than they're worth is because the appraised value does not reflect the true market value. This scenario is common in boom markets--and especially the case with homes appraised before the market took its biggest hit in August.
Bank Rate Financing
If you have a good credit score and are buying a bank-owned home, many banks will offer you below-market rate loans. Unlike paying down with points, this doesn't cost anything in fees, and it gives you the ability to spend more for a home: Since present dollars are more valuable than future dollars, the real value of the loan, over its life, will be less.
Rental Market
Unless you're a savvy local landlord with considerable experience in single-family home rentals, it's probably a bad idea to expect to rent a foreclosure property with a positive cash flow; current rental yields will depress in a market affected by foreclosed homes. Besides, if you're working in a market ripe with foreclosures, there are hundreds of other investors with the same idea
Have Cash on Hand
There are properties that can be turned within a few months, but the overall market is still slow. Even if you have a renter lined up or have enough money for a 10% to 20% down payment you should be ready to weather a depressed market for another two or three years. Make sure that your endeavor is still profitable if you incur two to three years of carrying costs and depreciation.
Research Comps
A trip to your local assessor's office is mandatory if you're thinking about buying a home out of bank-owned status, or pre-foreclosure. Check every house on the block with a focus on recent sales, with a focus on price-per-square foot. This is the best way to establish what sort of deal you're going to get on the home, should you try to sell it in the current market.
Control Emotions
If you're looking at buying a home out of foreclosure--either as an investor or simply a home buyer--you cannot fall in love with a house. If, in the process of buying the home, you're competing with other buyers, or if a bank is stubborn and won't offer a sharp reduction, it isn't worth coming up to meet the asking price.
Neighborhood Quality
In this market, potential buyers have the ability to be extremely discriminating and are going to expect good neighborhoods at a discount. This means that buying in areas that were once considered up-and-comers or that lack good schools, parks or other amenities will not bring much more than low-ball offers. Even in high-end neighborhoods, homes are sitting--at discount--on the market for long spells of time.
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