As a real estate investor, you might associate the word “foreclosure” with opportunity. If you’re like me, you’re always looking for money-making real estate opportunities – and foreclosures can be a great opportunity.
However, as simple as foreclosure investing might seem, it can get pretty complicated. For example, did you know there are three stages in the foreclosure process? And that there are significantly different strategies for finding and buying properties in each stage?
The pre-foreclosure stage is the first of these stages. It presents one of the best opportunities for finding real estate deals. With that in mind, the following is a guide to investing in pre-foreclosures.
What Is A Pre-Foreclosure?
A pre-foreclosure refers to a property that is in the early stages of the foreclosure process. In most cases, a pre-foreclosure occurs when the lender files the demand notice, also known as the notice of default (NOD).
The NOD informs the borrower of the lender’s intent to foreclose. Some lenders file this notice when the homeowner misses their first mortgage payment, while other lenders may wait until the homeowner is three to four months behind on their payments.
The foreclosure process can take anywhere from a couple of months to a year. However, it’s important to note that state rules drive the foreclosure process, so be sure to review the foreclosure timeline for the state you are investing in. The pre-foreclosure process continues until the foreclosure sale or the public auction.
A Quick Rundown On The Foreclosure Process
As I previously mentioned, there are three stages of the foreclosure process: the pre-foreclosure, the foreclosure sale, and the post-foreclosure stage.
- Pre-Foreclosure: The pre-foreclosure stage includes everything leading up to the sale. Many investors consider this the best stage to focus on because you’ll find the least amount of competition and the best opportunities for great deals.
- Foreclosure Auction: The foreclosure auction consists of the actual sale when the trustee or the government auctions the house to pay the lender. These auctions are open to the public, so anyone can attend and bid on any property.
Some investors prefer to bid for properties at auction, but it’s important to note that auctions can be very competitive and always involve a fair amount of risk.
- Post-Foreclosure: The trustee will transfer the house to the lender if nobody bids on the foreclosed property at the auction. If this occurs, the foreclosure process enters the post-foreclosure stage. Properties in the post-foreclosure stage are almost always listed on the multiple listing service (MLS) or other public sites.
Compared to buying foreclosures at auction, they are easier to find and safer to buy. This is because you’ll have time to inspect the property and do your due diligence once they are under contract. As a result, the post-foreclosure stage is the most common stage during which investors buy foreclosed properties.
Reasons Foreclosures Typically Happen
A foreclosure occurs when a borrower stops making loan payments. Many unique challenges can cause this. I believe it’s good to understand some of the main reasons for foreclosure so you know what to search for when you are hunting for your next deal:
1. Rising Interest Rates
Homeowners with adjustable-rate loans are often vulnerable to foreclosure if interest rates rise. If a loan has an adjustable rate, the interest rate can change based on the market. If market rates go up, the monthly mortgage payment will also go up, which can put the borrower at risk of default if they can’t afford the new payment.
When interest rates go up, it can cause massive ripples in the real estate market, leading to substantial numbers of foreclosures. In fact, my own real estate investments were affected in this way.
In 2007, I saw a spike in the vacancy rates on my rental portfolio. Each time I had a property turnover, I had to lower the rent to get a new tenant. As a result, my rental income went down while my interest rates increased. This forced me to sell many of my rental properties in order to avoid foreclosure because I could no longer afford the mortgage payments.
Because many houses hit the market in desperate situations, it drives down property values. In fact, many property values went down during that time – to a point where you could no longer sell the house for enough to pay off the loan. As a result, many investors started defaulting on their loans, and there was a wave of foreclosures. It all began with rising interest rates.
2. Unfortunate Death
Death is a very sensitive topic for many – however, I have to bring it up. When a homeowner passes away, their property will go into probate, a legal process determining how the deceased person’s assets will be distributed.
If the property is left to someone, that person will be responsible for making the mortgage payments. If there is no will or the property is not left to anyone, then the estate generally has to sell the property to pay off the mortgage.
Probate can take a long time – sometimes up to two years – during which the house will often sit vacant. And if the mortgage payments are not being made, the foreclosure process will begin. In addition, family members are often motivated to sell the house because they can’t afford the mortgage payments and don’t want the house to go into foreclosure.
3. Divorce Of Homeowners
When I went through a divorce, I was lucky enough to find common ground with my ex-spouse. We were perfectly aligned with our parenting goals and didn’t even have to use attorneys. Despite what you may call a “perfect divorce,” it was still costly. However, the process could have been even more expensive if the divorce didn’t go as smoothly as it did.
Unfortunately, most divorces lead to tremendous financial pressure, especially for homeowners. Many households depend on two incomes to pay the bills, which means that once a divorce occurs, neither party can afford to make the mortgage payments.
As a result, whoever gets the house in the divorce is forced to sell the property or risk facing foreclosure if they can’t keep up with payments.
4. Credit Card Debt And Other Bills
Credit cards have to be the single biggest reason for personal financial stress. There are a few simple reasons for this. First of all, credit cards typically have very high interest rates. If you don’t pay off your credit card every month, the interest can add up quickly, and you’ll start to owe a lot of money.
Spending money you don’t have using credit cards is incredibly easy. If you are not being careful with your spending habits, then it’s easy to rack up a lot of debt without even realizing it. This type of spending can result in a spiral of debt that is very difficult to get out of.
Once a homeowner falls into credit card debt, it can lead to missed payments. Eventually, if the debt gets too high, debt collectors may take them to court, and the courts could end up garnishing the wages of the homeowner. As a result, the homeowner may no longer have enough income to cover their mortgage payments. And suddenly, the homeowner is facing foreclosure.
When I lived in Colorado Springs, I saw people moving around all the time. This is because there are two military bases there – the North American Aerospace Defense Command (NORAD) base and the Air Force Academy.
Anyone that has worked in the military knows how often members are forced to move around. People forced to move for work often find themselves having to pay two house mortgages. If they cannot sell their previous home quickly, they could end up in foreclosure.
Of course, there are countless other reasons why someone may need to move and are motivated to sell because they don’t want to risk being foreclosed on. I have bought homes from people who needed to move to care for a parent, transfer for a job, and even because they got accepted into an out-of-state school program.
6. Income Loss
Arguably the most common reason a homeowner faces foreclosure is that they simply cannot afford their home loan anymore. It almost always comes down to total monthly income and total monthly expenses. Any reduction in income, like a job loss or furlough, will create financial pressure and can lead to a foreclosure situation.
Why It Is Better To Purchase A Pre-Foreclosure Property
When finding real estate opportunities, you can find great deals at every stage of the foreclosure process. It’s most common for investors to buy foreclosure properties in the final stage, post-foreclosure, as it is generally considered “safer.”
However, I’d like to argue that the pre-foreclosure process is the best stage to find a deal. The following are a few reasons why I think it’s better to look for pre-foreclosure deals:
More Attractive Financing Options
Investing in pre-foreclosures gives you a ton of flexibility. Because you are buying from the owner, you can negotiate any deal that works for both sides. For example, you can offer the homeowner moving cash to take over their payments and have them carry some financing or include personal items in the sale.
I have seen some investors lease the property back to the owner, partner with the owner, or offer discounted rent on one of their other properties. You can get as creative as you want when financing a pre-foreclosure property.
You will have much less competition as homeowners often do not list these houses for sale. This is because they want to avoid the public stigma associated with a foreclosure. They may also not be aware that they can sell their home before it goes into foreclosure.
As a result, you may be the only investor who knows about the property and has a chance to buy it. Since there is less (or no) competition for many pre-foreclosures, it’s more likely that you will be able to negotiate a better deal.
Invest In Short Sales
A short sale occurs when the owner does not have enough equity to sell the home and repay the loan. When a homeowner doesn’t have enough equity to sell the house, it is challenging to complete a deal. In many cases, the lender will accept less than what is owed, which is known as a “short sale.” Short sales can be beneficial for everyone involved because:
- The owner gets to avoid foreclosure
- The lender avoids losing even more money on the foreclosure process
- The investor gets a good deal
However, investing in short sales can be time-consuming. Not only do you have to find the deal, but you’ll have to negotiate with both the owner and the lender. As a result, many investors avoid short sales.
Of course, this also means that there will be more opportunities for you to take advantage of and less competition to deal with. You just need to have the time and patience to negotiate these types of deals.
Opportunity To Do Onsite Inspections
Bidding on foreclosures at auction enables you to purchase properties well below their value. Doing so also requires a much smaller investment of your time than buying pre-foreclosures. However, there are significant risks involved with buying foreclosures at auction. For example, you won’t be able to inspect the property.
As a result, you could end up with a house you initially thought was a great deal, only to find that it needs a huge amount of costly repairs.
Unlike foreclosure auctions, you will have time to inspect and see the property once you locate and negotiate a pre-foreclosure deal. That makes the pre-foreclosure stage a safer stage to be buying in.
How To Buy A Pre-Foreclosure Home
Now that I’ve discussed the advantages of buying pre-foreclosures, let’s discuss how to actually do it. The following guide is a step-by-step process that you can use to find, negotiate, and purchase pre-foreclosure homes:
1. Neighborhood Evaluation
If you’re going to be successful in buying pre-foreclosures, you need to start by looking in the right neighborhoods. Not all neighborhoods are created equal, and some will offer much better opportunities than others. You may think that a pre-foreclosure is a good deal, but if it’s in a neighborhood that isn’t desirable, you won’t attract many buyers.
As a result, you could end up stuck with a property that you can’t sell. The following are a few things to look for when evaluating different neighborhoods:
- Well-Maintained Properties: This indicates that other homeowners are invested in the neighborhood.
- Low Crime Rate: Obviously, you don’t want to buy a pre-foreclosure in a dangerous neighborhood.
- Proximity To Good Schools: Families with children always look for homes near good schools. As such, research the neighborhood’s school district.
- Proximity To Amenities: Homebuyers are also attracted to neighborhoods close to amenities like shopping, restaurants, and parks. The presence of trendy retail stores, such as coffee shops and juice bars, is also a good sign.
- Airbnb Presence: If there are a lot of Airbnb listings in the area, it’s a good indication that people want to stay in that neighborhood – even if they’re just visiting. Pay close attention to nightly rates and the number of 5-star reviews for Airbnbs in the neighborhood.
- Young, Tech-Savvy Millennials: The presence of this particular demographic is a good sign that the neighborhood is up-and-coming.
2. Generating Potential Leads
The next step is to create a list of potential leads. Unfortunately, pre-foreclosures aren’t listed, so you will have to work on finding opportunities. Although this can be more time-consuming, it does mean you’ll have less competition, which means you’re more likely to find a great deal. The following are a few tips on how to find potential pre-foreclosure deals:
- Drive Around: One of the simplest ways to find pre-foreclosures is to drive around and look for properties that appear to be in disrepair. Homeowners struggling with mortgage payments typically don’t have the money to take care of their properties. As a result, finding a run-down house is often a good indication that it’s in pre-foreclosure.
- Direct Mail And Email Campaigns: You can also reach out to homeowners directly with a direct mail or email campaign. In addition to finding properties in disrepair while driving around, you can also find potential pre-foreclosures by searching for properties with delinquent taxes or utility bills.
You can create a direct mail or email list to reach out to these homeowners.
- Cold Calling: Another option is to simply call homeowners in the neighborhood you’re looking in. You can find contact information for homeowners by searching for the property on your county’s public records website. In speaking with various homeowners, you can also ask if they know anyone who might be motivated to sell.
3. Do Your Due Diligence
Once you’ve found a few potential pre-foreclosures, it’s time to do your due diligence. This step is even more critical with pre-foreclosures than with listed properties, as you won’t have access to the same amount of information. The following are a few things to keep in mind when performing due diligence on a pre-foreclosure:
- Financial Due Diligence: You’ll want to ensure that the property you’re looking at is worth investing in. This means evaluating the property’s value and the borrower’s ability to repay the loan, which will help you figure out how motivated they are to sell.
The more motivated they are (that is, the higher the risk of foreclosure), the more negotiating power you’ll have.
- Physical Due Diligence: You won’t want to lose money on a property because you didn’t realize that it would require substantial repair work. As such, it’s important to thoroughly inspect the property before making an offer. This includes looking for any signs of water damage, mold, foundation issues, and more.
- Legal Due Diligence: You’ll also want to ensure that there are no outstanding liens or judgments against the property. These can typically be found in the public records for the property. The issue with liens and judgments is that they have to be paid off when the property is sold, which can eat into your profits.
4. Take Out A Loan
Once you find a pre-foreclosure you want to invest in, you’ll need to find financing to afford it. Most investors will take out loans even if they have the cash on hand to pay for a property out of pocket. When it comes to financing, there are lots of options, including conventional loans or rehab loans.
One thing to consider is whether much renovation work will be required before you flip it. If this is the case, you may want to consider a short-term loan, such as a hard money loan.
5. Place An Offer
Once you’ve secured a loan pre-approval, it’s time to place an offer on the pre-foreclosure property. To place a bid, you’ll need to work with a real estate agent who can help you craft a competitive offer.
You should also be prepared to negotiate, as the borrower will likely be looking for the highest possible offer. Understanding the homeowner’s financial situation, the value of the property, and the repairs required should all play a role in your bid.
Hunting Down The Ideal Pre-Foreclosed Property
Though pre-foreclosure properties are not listed for sale, foreclosures must be put on the public record. As a result, it’s possible to get a list of owners and addresses facing foreclosure.
It is your job to find them, make contact, and negotiate a deal. As I previously mentioned, many investors do this by sending postcards and letters, while some investors pick up the phone or knock on doors.
You already know there is financial pressure, which should mean the homeowners are motivated to sell. But, of course, this can be a disadvantage as well. You are essentially cold calling homeowners who may be facing a difficult situation.
It can be hard to get them to open up to you, and you may get the door shut in your face more times than you’d like. But, if you are persistent and build a rapport, you’ll eventually find someone interested in working with you.
Property Condition Is A Major Factor In Decision-Making
Another thing to keep in mind is that pre-foreclosure properties are often in poor condition. This is because the homeowners usually stop maintaining the property once they fall behind on payments.
As such, you should factor in the cost of repairs when considering a pre-foreclosure property. In some cases, the property may even be sold “as-is,” meaning that the borrower isn’t responsible for making any repairs before selling.
The last thing you’ll want to do is buy a property that ends up being worth less than what you paid for due to its poor condition. This is why it’s essential to get a professional evaluation of the property value before making an offer.
Is A Pre-Foreclosure Property A Good Investment For You?
Pre-foreclosure properties can be an excellent investment for savvy investors willing to do the work. These properties can often be purchased at a discount and, if you find one in good condition, you can have a great return on investment. However, it’s important to remember that these properties are often in poor condition and can be challenging to finance.
As such, you should weigh the pros and cons before deciding if a pre-foreclosure property is right for you.
Locate The Best Pre-Foreclosure Property With A High Return
There are tremendous opportunities in foreclosure investing. Many of those opportunities will come in the pre-foreclosure stage. Successful investors focus their time here because this is where you can make a lot of money. It is a little more work than the foreclosure auction or a real estate-owned (REO) sale, but it is well worth it.