What Does Pre-Foreclosure Mean Exactly?
When you hear the word foreclosure, do you think of opportunity? If you are like me, you are always on the hunt for money-making real estate deals. Foreclosure investing can be a fantastic way to find your next profitable deal. Foreclosure investing might sound simple, but it can be very complicated. To start, did you know there are three distinct stages in the foreclosure process? Did you know that each stage comes with significantly different strategies to both find and buy properties?
Pre-foreclosure starts when the lender files the demand notice letting the borrower, and the world, know their intent to foreclose. For some lenders, this can be after three or four months of missed payments, and some lenders start this process the same month as the first missed payment. This process could take anywhere from a couple of months to as long as a year. State rules very much 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.
What Are The Typical Causes of Foreclosures?
A foreclosure occurs when a borrower stops making their loan payments. Many different challenges can cause this. I believe it is good to understand some of the causes so you know what to look for when you are on the hunt for your next deal.
Rising Interest Rates
Looking back to the credit crisis, you will see that interest rates started rising long before the crash occurred. Most people do not talk about this because there are so many other factors that contributed to that massive economic collapse. Still, it all started when rates started increasing, and borrowers were over-leveraged.
If a borrower has an adjustable-rate loan, meaning the interest rates on their loan can move up and down, an increase in the market rates will cause an increase in their mortgage rate, thereby increasing their payments. If they are not ready for that, they may not be able to afford it.
I remember it was 2007 when I saw a spike in my vacancy rates on my rental portfolio. Each time I had a property turn over, I had to lower rents to get a new tenant. My rents were going down, and my interest rates were going up, forcing me to sell as I quickly found myself in a situation where I could no longer afford the mortgage payments. Many other property owners found themselves in similar situations. With many houses hitting the market in desperate situations, it drove down property values, sometimes to a point where you could no longer sell the house for enough to pay off the loan. Left with no other options, many investors started defaulting on their loans, and there was a wave of foreclosures. It all began with rising interest rates.
Death can be a very sensitive topic, and it is the area where I have found my best real estate deals. Probate can force some serious motivation with pressure from lenders or fighting siblings. These homes are often distressed from deferred maintenance, and the family needs to get the house sold. You, as an investor, can provide a much-needed service.
This service is even more important if the deceased was relied on as an income earner. Without that income, it may be difficult for a family to keep up on payments.
Divorce Of Owners
Anyone who has been through one knows the tremendous financial pressure a divorce can cause. Unfortunately, my former wife and I divorced. We had no attorneys and were almost perfectly aligned with our parenting goals. We co-parent fantastically and get along great! Some would say we have had a dream divorce, but I will still say that it was costly.
Not all divorces go as smoothly, and many times the costs of the attorneys alone are enough to bankrupt someone. Not to mention many households rely on two incomes. Neither party can enjoy the same lifestyle without the other, and many times neither can afford the house.
Credit Card Debt & Other Bills
Credit cards have to be the single biggest reason for personal financial stress. It is incredibly easy to spend money you don’t have when you use credit cards. If you cannot pay the card off each month, interest at a high rate starts to accrue. Suppose you continue with a similar spending habit, which most people do, and combine the interest. In that case, you are moving backward financially at an exponential rate, going into debt at a faster pace each month while your monthly payments go up more and more each month. Once you are in this spiral, it is very tough to get out.
Without a plan, or perhaps an inheritance, this will eventually lead to missed payments. It will likely start with the credit cards themselves, then maybe a car loan, and finally the house.
Being relocated is something I saw a lot when I lived in Colorado Springs. The military dominates that city. You have two major military bases, the Air Force Academy and Norad. In the military, people get moved around all the time. When you are forced to move, you could be forced into two house payments. If you cannot get your previous home sold quickly, it easily could end up in foreclosure.
There are many other reasons someone may need to move. I have purchased homes because people needed to move to take care of a parent, job transfers, and even acceptance into a school program.
Loss of income
There are many other reasons a homeowner may no longer be able to afford their home loan. It 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.
The Foreclosure Process
There are three distinct stages of the foreclosure process: Pre-foreclosure is everything leading to the sale. The sale itself is the second stage when the Trustee or the government auctions the house to pay the lender. If there are no bidders at the auction, the house is transferred to the lender. The final stage is real estate owned or REO when the lender now owns the home and often will sell it. There are buying opportunities at each stage.
Many investors will tell you this is the best stage to focus on. There is the least amount of competition and the best opportunities for great deals.
Some investors prefer to bid at the auctions. These auctions are open to the public, so anyone can attend and bid on any property. At times, these can be very competitive, and they always come with a fair amount of risk.
The post-foreclosure stage is by far the most common stage investors buy properties in because they are almost all listed on a multiple listing service (MLS) or other public sites. They are straightforward to find and safer to buy. Once under contract, you will have time to inspect the property and do your diligence.
Investing In A Pre-Foreclosure
Many times a house in the pre-foreclosure stage is not listed for sale. Because they are not listed, I believe it is the ideal stage for real estate investors. At this point in the process, the owner still owns the house. Assuming there is equity, you can negotiate great deals to help the owner avoid losing the property to foreclosure.
The Obvious Advantages & Disadvantages
There are both obvious and not so obvious advantages and disadvantages to buying in this stage of the process. Many times these houses are not listed for sale, meaning you will have much less competition. Less competition generally leads to a better price. The disadvantage of this, of course, is that you need to find them. The foreclosure is a public record, so you can get a list of owners and addresses, but then it is your job to make contact and negotiate a deal. Many investors do this by sending postcards and letters, which can be very effective, but some investors pick up the phone or knock on the door. You already know there is financial pressure, which should cause some motivation to sell; you just need to get them to talk about it.
Unlike the foreclosure auctions, you will have time to do inspections and see the property once you locate and negotiate a deal. That makes this a safer stage to be buying in.
Special Features of a Pre-Foreclosure
One fantastic feature of investing in pre-foreclosures is that you will have a ton of flexibility. Because you are buying from the owner, you can negotiate any deal that works for you both. For example, you can offer a little moving cash to take over their payments, and you can have them carry some of the 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.
Investing In Short Sale
There are times when the owner does not have enough equity to sell the home and pay off the loan. It is times like this that make it hard for the investor and the owner to complete a deal. One strategy that does work in these cases is a short sale. A short sale is when the lender accepts less than what is owed so the owner can sell the house. A short sale generally helps everyone involved because banks lose a lot of money on foreclosures. They would often rather take a loss now than go through the foreclosure process and lose money later.
Short sale investing takes a lot more time and effort because you first need to find the deal, then you need to negotiate with the owner, and finally the bank. These challenges keep many investors away, making this a prime area to focus on if you have the time and patience to negotiate them.
Pre Foreclosure 101
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 REO, but it is well worth it.