How To Buy A Foreclosure: A Definitive Guide
Foreclosure investing is an excellent way to buy deeply discounted properties and profit big! When real estate investors think about foreclosures, they think opportunity!
What Is A Foreclosed Home & Its Various Stages?
Foreclosure investing all starts with understanding the process. This will help you know the best time to buy a foreclosure and how to find them. Understanding the process will also help you structure your deal and line up your financing.
There are 6 primary ways or times that you can purchase a foreclosure property.
The pre-foreclosure starts after the owner of the home has missed several payments on their loan and the lender demands that the loan is brought current. This is known as a demand notice or a notice of election and demand, also known as NED. This notice is sent to the homeowner and filed with the county where the property is located. It is done this way to make it public knowledge that the lender intends to foreclose. Making it public protects other creditors because it puts them on notice.
At this stage of the foreclosure process, you would need to purchase the home from the homeowner. Many times the homeowner acknowledges the situation and will try to sell the home. In those cases, you can find them by looking at for sale by owner ads or see if it is listed in the multiple listing service (MLS). Sometimes, however, the owner does not try to sell their home on the open market. This could be because they think they owe too much on the loan, they don’t want the hassle of selling it, or they are just embarrassed. In these cases, you would need to track down the owner and make contact with them.
The pre-foreclosure stage stops when the Trustee or court auctions the house to the public.
2. Short Sales
If the home cannot be sold for enough to pay off the loan, we consider that “under water”. This was a very common problem in 2008 when home values were sinking like a rock. In these cases, the only way the homeowner can sell the home is if the lender agrees to accept less than what is owed to release its lien. We call those short sales because the lender received an amount short of a full payoff to get the deal done.
This is an excellent way for real estate investors to purchase homes because it takes more work then most investors are willing to do. Eliminating your competition by doing what they are not willing to do opens the door to bigger profits and more opportunities. The process can be a little challenging and it takes some negotiating with the lender, but lenders will accept less than what is owed to avoid taking the house back. By negotiating a reduced payoff, you can create equity for yourself.
3. Sale Auctions
The next stage of the foreclosure process is the public auction. This is where the Trustee, or the county court, sells the house to the highest bidder and the money is used to pay the lender. The auction starts with an opening bid provided by the lender and can go up from there. The lender has some discretion here on what they want to bid. They can bid any amount up to what they are owed. Depending on the state, any amount owed over the lender’s bid, will still be owed by the borrower. This gives the lender the right to continue collections efforts for that deficiency amount. We call this a deficiency bid. If there are bidders, other than the lender, the lender would receive cash up to their bid amount. If there are no other bidders, they will get the house. Setting this opening bid can be tricky. Bid too little and the lender will not get the home and would receive less than they are owed in cash. Bid too much and they will end up with the house and no deficiency to try to collect down the road.
Savvy real estate investors like purchasing foreclosure homes at the auction because it is pretty straight forward. If you are the highest bidder, you get the house. It takes away the work of locating sellers in foreclosure and all the back and forth with negotiating with lenders, agents, and sellers.
There are some risks at the auction, however. If you don’t understand lien positions and bid on a home that is foreclosing from a junior position, you could get stuck with the home and would still need to pay off other loans that have a right to the property. You also do not get a chance to look inside, so you are buying the property without inspections.
Redemption rights vary greatly by state. A redemption is when the foreclosing lender is paid off in full after the auction. The property is in limbo during the redemption period because although the property sold at auction, the winning bidder will not receive a clean title until all redemption rights have expired. A property can be redeemed by the owner or another lien holder.
In Minnesota, where we do a lot of business, the owner has 6 months after the auction to redeem and keep the home. In Colorado, the owner has no redemption rights at all. In Colorado, each junior lien holder has 8 days to redeem in order based on priority. If a second mortgage holder redeems, they would get the house, unless there is another lien behind them who redeems. In that case, they would get their money.
Earlier this year I purchased a judgment lien that was recorded against a property I wanted. I did this for the redemption rights. I have also purchased a home from a junior lien holder by contracting on the property before they decided to redeem. I contacted them during their redemption period and negotiated the deal. They redeemed and then sold me the home.
There is very little competition using redemptions to purchase foreclosure properties, making this an attractive way to scoop up discounted deals.
5. Bank-Owned Properties
This is where most investors find foreclosure homes to purchase. After the auction, if the bank is the winning bidder, it goes to the real estate owned (REO) department for liquidation. A number of things are possible here but it is extremely common for the lender to remove the personal property, do a quick clean up, and then list the house for sale. This is normally done with a real estate agent and can then be found on the MLS.
This is the most common way to purchase foreclosures because it is the easiest and safest. Once you contract on a home, you have plenty of time to inspect it and you will get title insurance, so you know you are getting what you paid for. The downside is, it is extremely crowded. Since it is the most common way to purchase foreclosures, you will likely pay the highest price.
6. Government-Owned Properties
There is not much difference between government owned properties and bank owned properties. The only difference is it is owned by the government. There are two reasons the government will own a home. First is if they were the lender. Fannie Mae and Freddie Mac are the two largest buyers of mortgage loans. Fannie and Freddie owned homes will look almost identical to bank owned. They get cleaned up and listed in the MLS just like any other lender would do. They also list their homes on their website.
The other reason the government would own a home is if they insured the loan. FHA loans are federally insured and if an FHA loan goes bad, the government could end up with that property. We call these HUD homes because they are owned by the Department of Housing and Urban Development. Again, these are not much different than any other type of lender owned property. There will be a first look period where they only sell to owner occupied users, no investors. After the first look period is over it is open to anyone to buy. Also, with HUD homes, if the property does not sell, they may donate it. Other than that it is the same as a bank owned home. You would make your offer through a real estate agent and have plenty of time for your inspections and diligence. Fannie Mae and Freddie Mac also have first look periods.
How To Find Foreclosed Homes
As you can see there are several different stages and ways you can buy foreclosures. Therefore, understand your strategy before you start spending time and money on locating opportunities. To find pre-foreclosures you will likely want to market yourself as a home buyer. You can get foreclosure lists and send them mail, call them, or even stop by and knock on their door. With these same lists, you can track properties through the process and bid on them at the auctions. Or you can simply wait and see what hits the open market with the help of your Realtor. For more detailed information on how to locate these opportunities check out our other posts here.
Why Homes In Foreclosure Are Cheaper?
Although it does not always work out this way, foreclosure properties are typically cheaper than other properties you might find. There are several reasons for this, but it really comes down to seller motivation. With a pre-foreclosure for example, there is a well-defined deadline. As that deadline gets closer, the seller is more motivated to take a smaller offer. Lenders are motivated to get their money back so they can loan it out again. They make money with loans, not owning houses, so foreclosures are considered “bad assets” on their books. They are motivated to get houses off the books and into performing loans.
It is also important to point out that most foreclosure properties will be sold as-is, and with some faults. Very few owners continue to take care of homes they are losing to foreclosure so you will have deferred maintenance and sometimes damage and vandalism.
Finally, if you are buying at the auction, you may find that there are assessments, taxes, or other liens that need to be paid. Investors will account for these other costs in the price they are willing to pay.
You may find that foreclosure homes are priced low to increase interest. In these cases, multiple buyers can drive the price up. This strategy has been effective for sellers so be careful not to get caught up in the emotion of competing for a property.
How To Purchase A Foreclosure
How you end up purchasing the foreclosure home will obviously depend greatly on which strategy you implement. Here are 5 steps to consider before you make your offer.
1. Determine Your Budget
The first step is to get a solid accounting of your resources. How much money do you have to invest in a project and what monthly payment are you comfortable with? Once you know these numbers you can start working with your lending professionals to guide you to the correct loan to meet your goal.
2. Get Preapproved For A Mortgage
Since there are several types of loans that will work, first talk to multiple lenders. For example, we make hard money loans for fix and flippers, but hard money is not the correct tool for all investors or for all situations. We work closely with banks and conventional lenders to complete the financing puzzle for real estate investors. I would suggest speaking with a few banks, a conventional mortgage banker or broker and at least one hard money lender. With their help you can come up with a financing plan and get your pre-approvals complete. Once you know you have some money behind you, it is time to find the deal.
3. Hire A Real Estate Agent
The easiest way to get started in foreclosure investing is to look for REOs (real estate owned by the lender). As mentioned, these are almost always found on the MLS. Although you can find them without the help of a professional, it is much easier to use one. They can set up filters and only send you deals that meet your criteria. You will also want them to make your offers, and in the case of a HUD home, you will need them to make an offer.
A good agent can do so much more for you though. They will help you pull comps so you can understand the true value, they can give you advice, let you in to see other homes on the market so you can see what other investors are doing, and help you sell the property if your plan is to flip it.
Even if you decide to buy at the auction, through redemptions, or market directly to sellers, you will want at least one great Realtor on your team.
Pay For An Inspection
Getting an inspection is especially important when you are starting out. This is another reason REOs are a great way to get started. When buying an REO, the seller expects you to get an inspection. This is not an option when buying at the auction so you will want your bid amount to reflect this risk.
You will want to inspect all the mechanicals, unless you plan to replace them, like the furnace, electrical and plumbing. You will also want to look for major repairs like roofs and foundations, and finally get a sewer scope. For less than $100 you can have a plumber run a camera down the sewer line and tell you if there are any issues. This is one item that is impossible for you to see and can be costly so even experienced investors that will be doing a full remodel will scope the sewer.
Resolve Any Liens
This is less important for you to worry about unless you are purchasing at the auction. The reason I say this is you should be getting title insurance when you purchase a home. Title insurance will guarantee that you get a clean title with no unpaid liens. If a lien does show up in the future, you can file a claim with the title insurance company to have it resolved. If you are getting a loan on the property, your lender will also be careful to insure you are getting a clean title to protect their interests. Unless you feel extremely confident in what you are doing, never buy a property without title insurance.
4. Make A Competitive Offer
There are many tricks to making your offer competitive but with very little exception, nothing beats price. Obviously, sellers want as much money as they can get.
Outside of price, you can make your offer stronger by reducing your timelines and eliminating contingencies. This is one of the reasons hard money is attractive. You can close in days or weeks instead of a month or more. If your price is lower but you are closing in a week or two, the seller just might accept your offer.
Limit your contingency to an inspection only makes your offer look stronger than other offers. A contingency is a way for you to back out of the deal without losing any money. Your earnest money is returned as long as you follow the contingency requirements in the contract. A standard contract is loaded with contingencies making it risky for sellers to accept them. Things like appraisals and loan contingencies should not be needed. If you are confident you are approved for a loan, you just need a little time to inspect the home and make sure all the numbers work.
5. Purchase & Prepare To Settle In
Once your offer is accepted, quickly put together all the documents needed for the lender. This could include your scope of work and repair budget (click here to see a sample SOW), tax returns, bank statement, and anything else needed. Give your lender as much time as you possibly can in case any issues arise. You want to have everything lined up before the end of your inspection period to protect your earnest money.
Your lender and/or real estate agent will help walk you through the closing process. They will work with the seller, insurance agents, title company and anyone else involved. Stay on top of them and respond to any requests for a smooth closing.
Different Ways To Pay
There are many ways to fund your foreclosure which is why it is so important to make connections with great lenders who understand the real estate investing space. Here are the top 5 ways investors fund their foreclosure purchases.
This is a loan that will be sold to Fannie Mae or Freddie Mac. This is the most simple loan because there is a clearly defined box you must fit into to qualify. Assuming you qualify, this is also the cheapest money with the best terms. It is likely you can lock in an interest rate for 30 years if you use a conventional lender. Conventional lenders will require significant down payments and they do not fund repairs. You should expect 25% of the purchase price needed as a down payment and to fund all needed repairs out of pocket. It is also important to understand that these loans are best for long term hold. If your goal is to keep the foreclosure purchase as a rental, this would be a great option to explore. They do not like, however, quick payoffs. In fact, it could cost your lender money if you flip the house and pay off the loan in a short period of time. It’s best to be transparent of your plans with your lender.
A renovation loan is meant to purchase and repair the property. Most hard money lenders offer renovation or rehab loans but so do local commercial banks. A bank is able to do this because they do not sell these loans. They keep them in their portfolio which gives them greater flexibility. They will often loan 75% of the purchase, much like a conventional loan, and 75% of the rehab. Using this loan is typically a better option if your plan is to flip it because they are ok with the shorter loan term and can loan you more of your project costs.
This is a fantastic and often overlooked method to finance foreclosure purchases. If you have equity in another property, your bank or credit union may give you a line of credit secured by your property. The line of credit gives you access to the cash but you only pay interest on it when you use it. It also acts like cash when buying houses so you can offer all cash by using the line of credit. Once you own the home you can refinance it, and pay back most or all of the money you accessed from your line so you can use it again.
This is also a great option to fund down payments, so it is feasible that you combine this financing method with another one to accomplish your goals.
Hard Money Loans
Hard money is an excellent source of money for your real estate investing business. Many hard money lenders, including Pine Financial Group, will fund your entire purchase and repairs. Obviously, the numbers on the deal need to work, but this is true no money down financing for foreclosure purchases. When you work with a hard money lender, you are working with someone who understands the real estate investing game. Most hard money lenders work exclusively with investors, so this is just one more set of experienced eyes looking over your deal.
Hard money is not always the best option, however. It is very expensive, reducing your profit per deal. If you are only wanting to do one deal at a time and you have plenty of reserves, hard money is not a great fit. If you want to do multiple deals or limit your cash exposure to any one deal, using hard money is a fantastic alternative. Hard money lenders also understand rehab lending so if a house is so destressed that someone could not live there, it is not financeable for most banks. Hard money lenders understand properties in distress, in fact they look for that. They can also close much quicker than conventional lenders or banks so when you need to close fast, call your hard money lender.
This might be the most obvious, but it is certainly worth a mention. If you have cash or access to cash, you can always just use that. Many investors do. Paying cash increases profits because you don’t have the cost of money. It is also extremely helpful in a competitive situation as you can make your offer stand out.
Cash is required when buying at the auction.
Take Your Time
This is a game with consequences, or maybe I should say this is not a game at all. There are risks when buying foreclosure homes so it is important to take your time and make smart buying decisions. Educate yourself but don’t let the fear of a mistake stop you. There is a lot of money to be made in foreclosures.
It is possible you won’t see all the risks which is why it is advisable to work with lenders and agents that understand foreclosures and real estate investing. Let them help you and advise you and work together so everyone wins. When it comes to foreclosure investing, take your time, make some money, and have some fun!