Distressed assets are the bread and butter of most real estate investment strategies. They offer the highest degree of upside and experienced investors know how to capitalize on the deal. But with this increased upside, we also see a significant increase in risk with the potential for many hidden costs, obstacles, and delays along the way. Foreclosures are one of the most common ways that a distressed property may become available.
It's relatively common to use the term 'foreclosure' in reference to a range of property types that may not have formally been foreclosed upon. The terms outlined below act as steps in the process, and each point may have costs and benefits for different buyers.
Steps in the Foreclosure Process:
Pre-foreclosure: This occurs when a property is in default and is troubled by being foreclosed upon, though it is not guaranteed.
Short Sale: Short sales can happen when a property owner is behind on their debt obligations and need to sell the property for less (short) than they owe.
Foreclosure Auction: Public auctions are where foreclosed upon properties are bought and sold. These are also known as sheriff's sales or trustee sales, but function essentially the same.
Real Estate Owned (REO): REOs occur when a foreclosure does not sell at auction and is repossessed by the lender who needs to offload the asset.
While all of these are variations on the common term, it's important to know the issues associated with each in order to find the properties that best suit your investment skillsets.
We know that homes in pre-foreclosure mean that the owner is behind on their payments, but we can't be sure to what degree. Different states have different criteria for pre-foreclosure but once they reach the threshold there is typically a notice that becomes public record. This is the first formal step in the foreclosure process and the fact that it is public record makes this information accessible to potential investors. Some listing platforms aggregate this information and publish it in easily searchable formats, but it is also possible to perform the research yourself.
It's important to note that the pre-foreclosure proceedings do not guarantee that the home will be foreclosed on and it certainly doesn't mean that the current owner is eager to sell. That said, it does offer valuable information that will allow you to stay ahead of competitor investors. Use the pre-foreclosure process as a notice to begin researching a property, creating comps, and putting together your financing options. In the event that it does become available, you will be ready to act.
It is also possible to reach out directly to the seller, though it is not necessarily advisable. The odds that a particular pre-foreclosure property will ultimately be repossessed is relatively low, and the current owner may not want to sell until they have to.
When a property owner does intend to sell, they often 'sell short', which means the property exchanges hands for less than what they own on their mortgage. While not ideal for the lender, they might allow this to forego the hassle of repossessing and selling the house themselves, or the hassle of going through a foreclosure process. Often the owners are underwater due to a rapid deterioration of the housing market, as happened in 2008. In these instances, they have no option but sell short as the value of the property simply doesn't match the outstanding loan balance.
Oftentimes you will find that short-sale properties are in relatively good condition. The circumstances that lead to the value drop may not be specific to the property, but rather the market at large. This presents a good opportunity to add properties to a longer-term portfolio in hopes that the value will appreciate down the road. Currently, there are few short sales available due to the high velocity of the real estate market. That said, these same high-value loans we see today may present opportunities for short sales in the future if the market experiences any volatility.
Foreclosure Auctions (Sheriff Sales)
These occur when the property has been formally foreclosed upon and is being put up for auction by the state to recoup the amount owed to the lender. This is one of the riskiest ways to acquire a distressed property because there is an immense amount of uncertainty surrounding the asset and the purchase requires cash in order to complete the transaction. Oftentimes the current lender will ultimately purchase the property (for the amount owed; a net-zero transaction to them) only to resell it on their own terms later on. This is also an area of focus for highly experienced investors who know what they are looking for and have the ability to deal with high degrees of risk in their investments.
New investors who want to try their hand at foreclosure auctions may not have the required capital to make their purchase, and traditional loans won't provide financing for such purchases. In a situation like this, many people turn to hard money loans. Hard money loans provide short-term financing (usually 6 months) that will allow you to acquire the property. From their investors perform a fix and flip or refinance under more traditional terms.
Real Estate Owned
Real estate owned properties, or REOs, are homes that have been repossessed by the original lender. Lenders are not in the business of property management and typically want to offload these as soon as possible as long as they recoup their costs. REOs follow a more conventional transaction approach that allows for home inspections, traditional financing approaches, and generally lower degrees of risk.
While the bank wants to recoup their costs, that is often their threshold for the sell price. This means that you have the ability to acquire the property below what would be market rates.
All that being said, properties usually only get to this point when there is an underlying issue meaning that these are some of the most distressed properties in the pool. The fact that they are in worse condition means higher upside, but sometimes they may be beyond repair.
The Bottom Line
Foreclosures are only one of the many ways that a property might become available, but they do present a great opportunity for the right kind of investor. Use these basic definitions to inform what kind of investor you want to be. It's good practice to explore opportunities in each category so that you're fully informed on the costs and benefits of each