People talk a lot about short sales and foreclosures – and what amazing deals they can be. But, as is true with any great money making opportunity, it’s much easier said then done, and the process is full of uncertainties.
One thing that’s for sure is the more you understand how it works and what to look out for, the greater your chances of success.
For starters – what is a short sale or foreclosure?
These are the common terms you hear thrown around, but technically what we’re talking about is a larger category of properties called “distressed properties”. The name distressed refers both to the financial situation of the homeowner, and to the condition of the property. The stages of distressed properties are, (in this order):
1. pre-foreclosure/short sale
3. real-estate owed (REO)
The way it works is that if a homebuyer takes out a loan from a mortgage company (usually a bank) to buy a home, they are agreeing to pay back both the amount of the loan and interest, through monthly mortgage payments. In Florida, if the homeowner can’t make their payments for several months in a row and doesn’t work out a solution with their mortgage company, that company will begin the process to repossess the home by sending them an official default letter and working with the courts to file a lawsuit.
This is called pre-foreclosure and when short sales take place. A short sale is where the homeowner negotiates with their mortgage company and the mortgage company agrees to let them sell the property for less than what is owed on the loan.
Short sales can oftentimes be the best option for both the homeowner and the mortgage company because they are less harmful for the homeowner’s credit score than a foreclosure, and the mortgage company doesn’t have to deal with selling the home themselves. Short sale homes are usually in the best condition too.
If the homeowner doesn’t catch up on their payments, successfully contest the foreclosure in court, or work out a short sale in time, a court judge will grant the title to the mortgage company and set a date for the home to be sold.
Foreclosed homes can be bought 2 different ways, by auction or on the regular market. First the mortgage company puts the home up for auction at a minimum price of what is owed on the loan, plus interest, plus auction fees.
While you can potentially get a great price buying at an auction, it is very risky because you usually don’t have the right to inspect the home first. You have no idea what you’re getting into when it comes to repairs or home condition. It’s also hard to get a good deal because you are competing with investors who show up with cash in hand.
If no one bids, the home becomes the property of the mortgage company and is called real-estate owned (REO). The mortgage company will sell it on the regular real estate market through an agent, and can be found on listing websites like Zillow or Realtor.com.
The pro’s of buying distressed properties:
Great Deal: You can potentially get a great deal and live in a bigger, better house than you could otherwise afford. According to the National Association of Realtors, the average foreclosure sold for 18% below market value in July 2016, and short sales for 16% below market.
Sales Profit: You can potentially buy at an especially low price, renovate the property, and sell it for a profit; the “fix it and flip it” model.
Rental Investment: You can potentially buy at an especially low price, renovate the property, and rent it out, paying itself off and building you equity, which attracts many real estate investors.
(Notice all the potentially’s in the above, none of these are guaranteed. You can, however, take steps to protect yourself and more accurately predict their probability.)
The con’s of buying distressed properties:
Poor condition: Generally the properties are in really poor condition because if someone can’t keep up with their mortgage payments, it’s safe to say they haven’t been keeping up with general home maintenance either. A normal seller is required to disclose all known maintenance issues, but a bank doesn’t have this knowledge. Unless you’re buying at an auction (where you usually have to buy sight unseen), you should order a detailed home inspection which usually costs $300-$500, so you can accurately factor in the necessary repairs. And always build in a 10% buffer because, as you know if you’ve ever watched HGTV’s Flip or Flop, repairs are always more expensive than you think.
Complications: In addition to unexpected repairs, an easy way to lose money is if there are liens against the property from unpaid construction debts, property taxes, or homeowners associations, which you didn’t find until later. In general these deals are much more complicated than a regular deal so work with professionals who know what to look for and do your due diligence.
Competition: It can be tough to get a great deal because there are a lot of investors in this space who can pay cash and close quickly.
Time: Purchasing a distressed property will take longer than a regular sale. Since great deals are competitive, you may have to place several offers on different properties before one goes through and they have a much higher likelihood of falling apart because of all the bureaucracy and approvals required. Not to mention that for a short sale, the homeowner can become current on their payments at any time, cancelling the deal.
When it might be right for you
If you have a flexible timeline and aren’t in a rush, a distressed property might work for you. Remember, you’re submitting an offer to a bank, not a person, and there are many layers of approval so everything takes longer.
It may be right for you if you have the cash available to do the repairs and renovations that will be necessary to get the home in livable condition.
It also helps if you have an expert team of professionals experienced in handling these unique situations including a real estate agent, a lawyer, and a general contractor who can help you act quickly, but carefully.
In evaluating whether it’s a good deal, always look at how much is still owed on the home (so — how much the bank will want to make back), and the quality and condition of the property against your specific financial situation and goals.
Ultimately distressed properties have the potential to be great investments when done right and for someone in the right situation.
If this is something you’d like to talk more about, please reach out and I’m happy to teach you more about this process and introduce you to some of my trusted lenders, lawyers, accountants, and contractors.