Every real estate investor knows there are some great deals to be had with foreclosures; they're generally cheaper to buy than homes not in foreclosure. But investors also understand what else comes with great deals: risk.
There's no doubt that buying foreclosed property is risky business. That's not to say you shouldn't do it. But if you do want to dabble in buying foreclosures, it's good business practice to first understand what makes buying a foreclosed property risky.
Why foreclosures are cheaper
When a property has been foreclosed, it means the bank has repossessed the home from the homeowner, who stopped paying the mortgage loan. Banks are not in the real estate business; they're in the money business, and with a foreclosure situation, banks typically just want to recoup their money.
Banks usually put foreclosed homes up for auction. There, the home goes to the highest bidder. If the home doesn't sell at a foreclosure auction, banks might charge only what they are owed for the home to get it sold, which is usually less than market price.
Six risks of buying a foreclosed property -- and five ways to combat them
There's no question that there are risks involved with buying a foreclosed property -- thus the great potential for deals. Knowing there are risks can actually be a good thing: The difference between knowing what your risks are and not knowing could be the difference in whether you make or lose money on the transaction. Once you know the risks and have plans in place to adequately deal with worst possible scenarios, you have a better chance of making, not losing, money. It's better to know what those risks are than to be blindsided.
1. The house is in bad shape
Foreclosed homes are sold "as is," meaning that if repairs are needed, they haven't been done. If homeowners are in such dire financial straits that they can't pay the mortgage note, they're probably not keeping up with repairs and maintenance, either.
Of course, the house might not be in bad shape, but if you buy at auction, you probably won't be able to know for sure, since many auctions don't allow buyers to inspect the home first. If you buy from the bank, you might have a better chance of inspecting and previewing the home before you buy, depending on the deal.
But, unlike a traditional home sale from a seller where you can ask for seller concessions or for the seller to make the repairs, with a bank-owned property (REO), you'll be responsible for any needed repairs.
Possible issues with buying a foreclosed home that could prove to be big expenses include:
2. The house has been vulnerable from being vacant
A foreclosed home has probably been sitting vacant for quite some time. And that isn't good for many reasons. Vacant homes are subject to vandalism, theft, squatters, and water and fire damage. The longer the home you're interested in buying has been sitting vacant, the more likely it will be for damage to have occurred.
3. You could pay too much
If you only consider the price of the home and not the repairs involved, you could easily lose money on the deal. Investors need to consider the after-repair value (ARV) of the home as well as the acquisition cost. (More on that below.)
4. The buying process can be difficult
It can take longer to buy a foreclosed home. Instead of dealing with just the seller (and perhaps their agent), you are now dealing with a bank. Sometimes banks can drag the process on longer than a typical closing from the homeowner.
Homeowners who can't pay their mortgage might have had other issues regarding home expenses. They might not have paid contractors, resulting in a mechanic's lien being put on the home, which you will likely need to pay if you buy the home. You also might need to pay property taxes or homeowners association (HOA) dues if those are outstanding.
6. Others are interested
Whenever there is a great deal, you can bet that you won't be the only investor interested. You will likely be competing with experienced or institutional real estate investors for a good deal.
Five ways to combat risks
1. Hire a real estate agent
Ideally, you'd hire an agent who specializes in buying foreclosures for their clients. Look for agents with a designation that signifies specialized training and experience in the area, such as the Short Sales and Foreclosure Resource (SFR) designation. A trained agent can help you avoid possible minefields.
2. Have funds in reserve
No matter how much you crunched the numbers, you might wind up with a scenario you didn't plan for. If you have enough in reserves, you're still in the game. Try to have six months' worth of holding costs in the bank.
3. Don't pay too much
Look at what comparable homes have recently sold for, and plan to offer 70% of that price minus what you figure it will cost to renovate and repair. If you pay much more than that, you might have a difficult time making money on the deal.
4. Know your local laws
Some states or jurisdictions limit how much you need to pay on outstanding liens when you buy a foreclosed property. Look up the laws for your state to determine whether your local laws will help you mitigate that damage.
5. Understand your competition
Be prepared before you get in the game. You'll likely need to have cash (or at least a preapproval letter) to finance the deal in order to compete with more experienced investors.
The importance of factoring in after-repair value (ARV)
Many real estate investors buy foreclosed homes with the intent of flipping them. If that's your plan, don't forget to calculate the after-repair value (ARV), an important metric when buying distressed homes that can help you pick the good deals from the bad.
Getting a foreclosure at a discount price is great, but unless you know the market value of comparable homes that aren't in foreclosure, you won't have the complete picture. ARV measures what the foreclosed property should be worth after it's been fixed up.
Look at what homes comparable to the home you wish to buy have recently sold for. Aim to look at between three and six comparable homes. Take the average amount, and use that figure as your ARV number.
Let's say comparable homes are selling for around $235,000. Investors typically don't want to pay more than 70% of the ARV for a home, which in this case would be $164,500. But then, investors subtract the estimated cost of repairs and renovations. Note that this can be difficult to figure out on homes you can't inspect.
But for the sake of argument, say the cost of repairs will be $40,000. You would then subtract $40,000 from $164,500 to get $124,500, the maximum you should pay for the home to help ensure you will make, not lose, money on the deal. The catch is getting the numbers you use in your calculations to be as accurate as possible.
Another aspect to consider when buying a foreclosure is how long the repairs and renovations will likely take to complete. Time is money in this game. The longer the project takes to finish, the more money you stand to lose in carrying costs: loan payment, utilities, property taxes, insurance, and possibly HOA dues.
The bottom line
Many real estate investors are in the foreclosure business because of the potential to make a lot of money, and that can happen. There are many risks to buying foreclosures, however, so this type of investing takes a certain amount of skill, knowledge, and often help from a team of experts, like a real estate agent, appraiser, real estate attorney, general contractor, subcontractors, and a handyman.