What is the secret of making money with real estate? Don’t overpay for the property. As we discussed in the article “How to Make Money with Rental Property”, the price you pay for the property affects your return on investment for the entire time that you own it. What is a great way to acquire inexpensive property? Buying bank-owned foreclosures.
Before we can dive into making money with real estate by buying bank-owned foreclosures, we need to understand what a “foreclosure” is.
A foreclosure is when the holder of the mortgage note on a piece of property (a bank or individual investor, for example) seizes the property from the property owner. This is typically due to non-payment of the mortgage loan.
The entity that loaned the property owner the money to buy the property is exercising their legal right to be repaid by taking back the property that is securing the loan. The ownership of that property (the title to the property) is transferred away from the original owner that bought the property (using the loan), to the entity that made the loan in the first place.
The property is then sold at the foreclosure auction, and the proceeds are used to pay back the loan and all of the costs incurred by the foreclosure process.
A “bank-owned” foreclosure (also known as an REO – “Real Estate Owned”) is used to describe a property that has gone through the foreclosure auction and has failed to sell (typically due to bids being below the reserve price at auction, usually the balance owed on the mortgage note plus the legal expenses of foreclosure). The property is now owned by the bank.
The bank has taken title to the property from the original owner and is now beginning the process of marketing and selling the property to get their money back from the original loan. As part of that process, the bank will typically clear the title of any title defects (liens on the property for example), evict squatters, and even do some minor repairs.
So, why buy a foreclosure properties and specifically why buy a bank-owned foreclosures?
The secret to making money in real estate is to acquire quality properties at the absolute lowest price.
Bank-owned foreclosures are properties owned by banks, institutions that are in the business of lending money, not of owning property. These institutions are primarily interested in the getting their money back as quickly as possible, and putting it to work (in the form of another loan) as quickly as possible.
As part of this process to dispose of the properties as quickly as possible, banks price these properties to move quickly. If the bank had a 75% loan-to-value ratio on the property, they have that extra 25% to work with to move the property and still collect back the original loan amount (excluding any equity the previous owner had built up in the property).
Buying bank-owned foreclosures also reduces the risk versus buying foreclosures directly at auction. A few of the benefits are:
- Being able to tour the property before purchase.
- The bank clearing title defects as part of marketing the property.
- The bank evicting existing tenants/ squatters.
- You as the new owner being “separated” (by an intermediary – the bank) from the previous owner.
A great source of available foreclosures nationwide is Foreclosure.com. They are America’s largest provider of distressed properties, not only foreclosures, but pre-foreclosures, bankruptcy and tax lien properties.
Take a look at properties in your area (they even have a free trial).
What do I need to look out for when buying bank-owned foreclosures and foreclosure property in general?
It is important to remember that when you are buying a foreclosure, you are buying a “distressed property”. The property was seized from the previous owner due to lack of payment of the mortgage note. The foreclosure process takes time, and during that time, a lot of bad things can (and typically do) happen to the property.
Here are a few thing to look out for when purchasing a foreclosed property:
Problems with the Title
The “title” to a property can be thought of as a public ledger. Anyone can look up the title of a property (usually at the clerk of court) to see the current owner, but also see any other “claims” that are made on the property.
These “claims” are also referred to as “liens” on the property. Typical liens include:
- Mortgage (property purchase loan, usually in first position, meaning the bank gets paid back first)
- Tax Lien (municipalities or the federal government will attach to the title for non payment of taxes)
- Mechanics Lien (if you don’t pay your contractor for repairs to the property)
- Permit Issues (repairs or alterations to the properties done without permits that have been cited by the city)
- Judgements (lawsuit judgements against the owners of the property)
All of these liens must be cleared before the property can be transferred to a new owner. If not, the new owner assumes all of the debt and exposure of the pre-existing liens.
Properties going through the foreclosure process have owners that are having financial issues such as bankruptcy, tax problems, or judgements. Creditors will go after the biggest asset in the hopes of being repaid, which is usually the person’s home. This leads to an inordinate amount of liens attached to the title of foreclosed properties.
Condition of the Property
Again, as these are distressed properties, the condition the properties is usually poor. If the owner can’t afford to make mortgage payments, they cannot afford to maintain the property.
Additionally, some owners blame the bank for their financial issues, and when they learn that they are going to “lose” the property, they will focus their frustrations on the property itself. Some examples include stripping the appliances out of the property and selling them, intentionally damaging the structure, or even pouring concrete down the toilets or other plumbing.
A new owner should expect significant repair and maintenance expenses when purchasing a foreclosed property and budget accordingly. It is always better to be prepared for expenses versus being surprised by them.
Dealing with an Abandoned Property
As the foreclosure process takes an extended period in most states, the property is usually abandoned when the bank takes ownership. Abandoned properties have additional maintenance issues as there is no one living in the property to resolve issues.
Probably the most common source of damage in abandoned properties is water damage. Leaking water pipes can run for weeks or months unattended, flooding entire houses and feeding mold issues. Broken windows and doors open the inside of the house to rain and all of the elements. Roof leaks can go un-repaired for years, rotting the roof structure and destroying the drywall throughout the property.
In addition to the inevitable water damage and vandalism, typically the grounds are not maintained, the electricity is off and the property may have been stripped of metal (think plumbing and electrical wire).
There are typically no seller disclosures when buying bank owned foreclosures. Banks want to dispose of the property and are selling them “as-is”.
Buy with caution, because enough problems with repairs to make the property habitable can turn your “good deal” into a bad one.
There are several different way of making money with foreclosure real estate. Foreclosure properties need a lot of work to make them marketable or livable, so the top two ways of making money with foreclosure real estate involve either fixing the properties and selling them for a profit (flip) or fixing the properties and renting them for income (rentals).
Making money with real estate by “flipping” properties is the process of buying a distressed piece of property, repairing it, and then selling it for a profit.
Flipping sounds simple, but it is not for the faint of heart. I would go as far as to say that “flipping” is not a real estate business, but more of a general building contractor business.
You make money on your ability to:
1. Acquire the property for a very low price.
2. Be able to make quality repairs for a very low price.
You have to be able to acquire and repair the property at “wholesale prices”. If you pay retail prices for both the purchase of the property and the repairs to the property, you cannot make money on the sale of the property (since you are selling the property at retail).
We discussed making money with rentals in depth in our “How to Make Money with Rental Property” article. The number one way is to acquire the property at an attractive CAP rate.
When buying foreclosures with the intention of renting them, you need to add a couple of things into your CAP rate calculations:
1. Add the cost of repairs into your acquisition costs.
2. Add the length of time for lost rent (due to the time it takes to repair the property to make it rentable).
Adding repair costs into your acquisition costs makes sense, but why would you add in the length of time for lost rent? Let’s take a look at the math.
For simplicity sake, lets assume the same 10% CAP rate (on purchase and repair costs only) on annual rentals for 2 different foreclosure purchases.
Purchase Price = $100,000
Repair Costs = $100,000
Annual Profit = $20,000 (10% CAP Rate on $200,000 investment)
Time to renovate property and find tenant is 6 months = cost $10,000
Actual CAP Rate = 9.5%
Purchase Price = $50,000
Repair Costs = $150,000
Annual Profit = $20,000 (10% CAP Rate on $200,000 investment)
Time to renovate property and find tenant is 18 months = cost $30,000
Actual CAP Rate = 8.7%
Time is money. Make sure you analyze as much as you can BEFORE committing to a new property restoration project (especially the repair costs).
Making money with real estate and with bank-owned foreclosures is all about acquiring and repairing the targeted properties quickly and inexpensively.
Foreclosures are listed on the MLS (Multiple Listing Service) and are available on virtually any large realtor’s website. This requires searching by location and then dialing the search in further to include foreclosure properties.
As Levered Income is about using different tools available to leverage your time for maximum effect, we seek out “all in one” platforms that maximize our efforts. One platform we like to find foreclosures at great prices is foreclosure.com. In addition to foreclosures, we can see pre-foreclosures, short sales, sheriff sales, bankruptcies, city-owned properties, “as-is” deals and “fixer uppers”.
Buying bank-owned foreclosures is a great way to acquire properties inexpensively, however these properties require some “elbow grease” on the part of the investor.
Don’t believe the hype on TV and the internet. It is not easy, nor is it cheap. This type of real estate investing is a “hands-on” renovation business that takes a lot of time and effort and has a substantial risk level.