Taking a closer look at foreclosures

The term foreclosure actually describes a process by which a lender takes title to a property on which a loan is in default. The two most common high-risk mistakes homeowners make that lead to foreclosure are

• Failing to make the mortgage payments as required: For example, homeowners who overstretched and bought their homes using up to 100 percent financing (they made little or even no down payment towards the home’s purchase price) and were, in effect, living on the edge.

• Borrowing too much when refinancing: Low interest rates combined with the tremendous increase in real estate values in most parts of the country in the early- to mid-2000s, led many homeowners to refinance their properties. Although there’s nothing wrong with refinancing, as long as you don’t borrow too much, some lenders promoted 110 to 120 percent loans that tempted homeowners to pull all of their equity — and more — out of their homes. Teaser rates (the initial interest rate is below market, but soon adjusts upwards) and no-documentation or stated-income loans also greatly contributed to the real estate mess of this period.

  The flawed theory was that real estate values only increased, so these folks were simply tapping their future equity. However, one slight stumble with a loss of a job or a reduced income, a serious illness, death, or divorce can lead to a missed mortgage payment or two and ultimately, foreclosure. That’s what happened to millions of property owners who were overextended with mortgage debt when the real estate market turned against them in the late 2000s and early 2010s. Although some folks couldn’t afford to keep up with their payments, others chose to walk away from properties worth less than their outstanding mortgage balance.

But properties can also be subject to foreclosure for other reasons:

• Owners fail to meet other loan requirements. Examples include not maintaining proper insurance coverage or not keeping the property in good physical condition.

• Absentee owners are unable to effectively manage the property. Good property managers regularly visit and inspect their properties. This level of involvement isn’t practical from a distance.

  This category of foreclosures is extremely prevalent in many of the most popular real estate investment markets for out-of-town speculators such as Las Vegas, Miami, and Phoenix. If you’re in these markets, you may be able to pick up some great bargains, but don’t make the same mistake that the earlier investors made when they purchased properties out of their comfort zone.

• Owners walk away from serious problems. Some properties fall into foreclosure because the property has serious and irreversible problems that are so bad that the current owner chooses to walk away rather than deal with them. Environmental hazards and serious physical problems where the cost of repair can exceed the value of the property (such as cracked slabs, landslides, or meth labs) often top the list. (In Chapter 14, we cover research you can perform to help avoid these types of problems.)

Many foreclosure properties also fall into this category because some real estate investors felt that the market was so strong that literally any property they bought would increase in value. Although this may have been true to a certain extent in some markets for a couple of years, the reality is that investors who bought properties without conducting proper due diligence often found that they had purchased white elephants, or properties that they couldn’t sell for what they paid for them (or even rent out to cover their carrying costs).

Before you pursue foreclosure properties, determine the type of foreclosure process commonly used in your state. Check with your favorite lender, real estate agent, real estate attorney, or title company representative to find this information. Your state falls under one of two categories:

• Deed of trust state: When a loan is placed in a deed of trust state, the property title is held in the name of a third party or trustee. If the loan payments aren’t made as promised or the loan is in default for another reason, the trustee can foreclose or take back the property. No court action is necessary, so a foreclosure in a deed of trust state can happen in 60 to 120 days. This process is referred to as nonjudicial foreclosure.

  Be sure to check that you have the latest information on federal, state, and even local efforts by legislators and courts that have been quite aggressive in extending the timelines to give borrowers more time to avoid foreclosure.

• Mortgage state: In a mortgage state, no trustee or third party is named. When a mortgage goes into default for nonpayment or other breach, the holder of the mortgage must go to court and seek legal remedies including judicial foreclosure, which can take much longer than a nonjudicial foreclosure.

Foreclosure properties aren’t that hard to find. Whether you’re in a deed of trust state or a mortgage state, the filing of a Notice of Default (NOD) or a judicial foreclosure lawsuit are matters of public record. An additional public notice announcing a pending foreclosure sale must be posted on the property, published multiple days or weeks in a local general circulation newspaper, or otherwise noted as required by state law. The timing of the publication prior to the sale varies by state. Many title companies and real estate firms track the Notices of Default and all the steps right through to the actual foreclosure. This information is public record and filed with the county recorder or equivalent, but subscribe to one of the local services offering this information via daily or weekly emails or faxes, because gathering this information on your own is time consuming.

Technically, there are four steps, and thus four buying opportunities, for a property subject to the typical foreclosure process. Knowing these steps, which we outline in the following sections, and the techniques or negotiating points necessary at each step to motivate the owner or lender is essential to mastering one of the best strategies of buying real estate at below market or wholesale prices.

Examining lender REOs (real estate–owned)

Because titles to the majority of foreclosed properties end up with the lender, you may find that your next opportunity to purchase the property is from the lender’s real estate–owned (REO) department that specializes in handling foreclosed properties. Some investors have found that this is one of the best times to buy a property because they’re not dealing with an emotional or unreliable owner. Discovering the ins and outs of the lenders’ policies and procedures of disposing of these foreclosed properties can be invaluable to your goal of buying real estate at below market prices.

The days of stealing prime REO properties back in the early ’90s from the Resolution Trust Corporation (RTC) are gone. The RTC was a quasi-federal government entity established by Congress to dispose of the tremendous number of foreclosed assets of the major lenders during the real estate market downturn from 1989 through 1995. Due to the numbers of properties and the relative inexperience of and limited due diligence by the RTC in some areas of the country, a once-in-a-lifetime real estate investment opportunity did fall into the lap of savvy real estate investors who had large amounts of cash, could act quickly, and then had the financial horsepower to ride out the market downturn. Many real estate fortunes today started with bold investments in real estate during prior periods when the economic outlook to most observers and pundits looked dire. Remember that risk and return on investment are related.

Lender REOs remain one of the favorite strategies for the late-night infomercial gurus, but the reality is that today’s lenders are neither foolish nor benevolent. Although these nonperforming loans are a negative on their balance sheet, they’re not going to sell a property below its market value just to get it off their books.

The disposition specialists in the REO department are professionals who understand the real estate markets well and are usually wired into the best real estate brokers in the market. These real estate brokers are often compensated as a percentage of the sales price and thus also motivated to achieve the highest value as is reasonably possible.

The only angle a real estate investor usually has with an REO is financing and the continued operating losses that often occur because the lender is merely holding the property and isn’t willing to invest the time and money necessary to enhance the property physically and reposition it to perform better in the market.

Sales are as-is, and lenders are often exempt from the standard disclosure rules.

When lenders have an excessive number of REOs, they become more flexible, but they’re often limited by the Office of the Comptroller of the Currency (OCC), a government agency that oversees many savings banks and savings and loan associations and routinely audits their loan portfolio and their REOs. (Prior to the implementation in 2011 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Office of Thrift Supervision (OTS) had oversight of all federal- and state-chartered savings banks and savings and loans associations.)

The availability of foreclosure and REO properties has diminished with the improving economy, but your chances as an individual buyer have decreased as there has been a recent push by major Wall Street and institutional investors to buy pools of non-performing loans and REO portfolios. The institutional investors and major Wall Street financial behemoths saw an opportunity to buy low and sell high as the real estate market crashed in the late 2000s and early 2010s, but started to make a comeback in many areas of the country by the mid-2010s.

Recognizing seller benefits

With the advent of subprime and zero-down-payment loans in the mid-2000s, combined with the decline in home values, many owners found that they had negative equity in their homes in the late 2000s and early 2010s; they literally couldn’t afford to sell the properties because the sale proceeds wouldn’t cover the loan balance (a situation known as being upside down).

Some of these owners had other financial challenges and little savings to fall back on, so they were unlikely to be able or willing to continue making their debt service payments on the upside-down property. An owner in this situation is a prime candidate for a short sale.

The current owner or seller receives no proceeds from a short sale but will find it a quick exit strategy from a troubling situation, with the goal of minimizing damage to his credit (because he will likely want to be a homeowner again someday). Another benefit to the current owner is that the real estate investor is likely looking for a great tenant, and who would be a better tenant than the current occupant of the property (assuming he financially qualifies at the lower standards as a renter)? The current owner may no longer own the property, but he can at least continue to live there and not disrupt his life completely. Being able to remain in the property also avoids some of the stigma of losing the house. Plus, immediately having a tenant can help you get a loan for the property.

Comparing short sales to other properties

Many real estate investors find that buying foreclosures or REO properties can be challenging. With foreclosures, the public sale is published and readily known to all interested real estate investors, but there is limited information and rarely an adequate opportunity to conduct proper due diligence. For example, buyers usually can’t go inside the property to do inspections. Foreclosure properties can be full of surprises!

You often find that the best properties at the foreclosure auction attract the attention of other (often sophisticated) buyers who are prepared to pay more for the property than you are if they know they can make a good profit down the road. You also need to have 10 percent of the purchase price in cash and immediately have to find a loan for the balance within 30 days, whereas with the short sale you can usually negotiate for a sale closing date that gives you more time to find financing. A short sale also helps you avoid the complications of a borrower redemption possible with a judicial foreclosure.

Unless you subscribe to a service, tracking down the property information for REO properties can be challenging, and the lenders or their agents may not be cooperative with requests for inspections or details about the condition of the property. Though the reputation for REOs is that lenders are anxious to sell these properties at any price, the reality is that they often go for close to the full market value when discounted for the condition and quick sale terms that they require.

Find properties that are in preforeclosure — that is, properties where the owner is delinquent on her debt service payments — and make a deal to buy the property from the owner before she loses it anyway and ruins her credit. These situations became more common with the excessive use of highly leveraged financing where borrowers had loans that were equal to (or even greater than) the full value of the property when it was acquired. Some borrowers took out second loans, and the combined debt exceeded the value of the property.

Finding short-sale opportunities

The concept sounds much easier than it is to actually execute. The main problem is trying to identify the properties where the owner of the property is behind on payments but the lender hasn’t filed a Notice of Default.

With foreclosures, you can generally find lists available from real estate agents and even the lenders themselves, or you can drive through the neighborhoods that appeal to you and find signs that say bank owned. But with preforeclosure properties that are still owner-occupied and candidates for a short sale, there may not be an indication that anything is wrong. This is particularly true with many lenders now being asked to be extra patient with borrowers who are a little behind on their mortgage payments.

If you’re looking for these opportunities, you can find them in many ways. Some companies specialize in assisting homeowners who know they’ll have difficulty in making their mortgage payments; they work with the owners and the lenders to try and make loan modifications or alternative payment plans. These attempts may be successful, but many times they aren’t, and they provide one source for identifying owners who are short-sale candidates.

Another way to identify potential short-sale properties is when the mortgage holder sends a Notice of Default. But this document is public information, so many other real estate investors may be in contact with the owner seeking to arrange a short sale.

Just like in a regular foreclosure, you can find this information, and in the early days of the preforeclosure period many buyers may be willing to consider a short sale. Of course, you need to convince the lender and not just the current owner.

Note that lien holders may have purchased the underlying loan at a discount, and they may be more willing to negotiate with you to accept less money, which will enhance the prospects of a sale of the property. Your research will often reveal whether the loan that is in default has recently been sold; this is important information that can assist you with your negotiating strategy.

The concept of short sales often comes up if you have foreclosures in your area, but be careful: You need to check out the property just as thoroughly. You actually should have a better opportunity and better access to the property since the current owner is often living there. It’s not as bad as with foreclosure properties, but it has been our experience that short-sale properties can also be properties that the owner is willing to walk away from for a reason. So be very careful because what may seem like the deal of the century may actually be a money pit.

Convincing a lender to do a short sale

In addition to the difficulty inherent in finding an opportunity for a short sale, you may also have a difficult time convincing the lender to agree to a short sale. The recent trend by the federal government has been to require lenders to work with borrowers at an unprecedented level of patience and cooperation. Some lenders become overwhelmed with the large numbers of negative equity loans and the thousands of requests they receive to restructure financing. On one hand, lenders are motivated to consider short sales, but they’re also under pressure to formulate a workout strategy with the current borrower. This trend may actually reduce the motivation for lenders to cooperate with short sales.

The viability of short sales is really a function of the lenders and their business strategies to minimize their losses. The lenders know that the payments aren’t being made and it’s inevitable that they’ll complete the foreclosure, have to hold the property for some period, and incur costs before they ultimately sell it.

If they have a large number of nonperforming loans on their books, they may be motivated to quickly make a few short-sale deals. However, our experience has been that some lenders with few delinquent loans are actually more willing to agree to a buyer proposing a short sale because they want to cut their losses quickly and not risk government intervention or negative publicity. Lenders that participate in short sales are always secretive about it too.

A legislative change, in effect for the past decade, that really helped owners of properties who wanted to work out a short sale was the Mortgage Forgiveness Act of 2007. Previously, mortgage debt that was forgiven or canceled by a lender had to be included on the borrower’s tax return as taxable income. Under this law, any loan that was used to buy, build, or substantially improve the borrower’s principal residence (not second homes or investment properties) qualified for the exemption from taxation as ordinary income. A refinance loan for the same purposes also qualified. The lender was required to report the debt cancellation to the IRS on Form 1099-C, and the borrower included Form 982 with his tax return.

This law was extended multiple times, including even retroactively with the Bipartisan Budget Act that was enacted on February 9, 2018, and renewed foreclosure-related debt forgiveness through the end of 2017. However, effective January 1, 2018, debt cancellation is once again taxable as ordinary income. While there is currently a stalemate of divided power in Washington, D.C., and the economy is getting stronger in most areas of the country, the White House and Congress could seek agreement on additional tax law changes that could include this issue, but that’s unlikely as long as we have divided government. So, be sure to seek the advice of your tax professional before agreeing to any short sale.

To earn this exemption, the taxpayer was required to send the lender a short sale package with the following information:

• A hardship letter or proof from the borrower that he is unable to continue to make mortgage payments.
• Copies of the borrower’s income tax returns.
• Information on the current condition of the property with contractor estimates or proposals to make any needed repairs.
• The estimated value of the property and your offer for the property.

The lender would verify current market conditions where the loan balance was greater than the current value of the property. They’d also obtain a Broker’s Price Opinion (BPO) of the property. This figure acts as the basis for their negotiations with you, with the goal of achieving as close as possible to the BPO.

Regardless of the taxable status of the debt forgiveness, the one common denominator to short sales with all lenders is that short sales require a lot of phone calls and investigative legwork to even find out whether the lender is open to receiving an offer for less than the current loan balance. Each lender has a different organizational structure for various individuals or departments that handle non-performing loans. Some lenders have automated phone systems that can be helpful and allow you to get right through to people you need; others are best described as “voice-mail jail.” Live operators are probably already familiar with what you’re looking for, and you just need to describe that the purpose of your call is to find someone in charge of loss mitigation or foreclosures. If all else fails, you should contact the customer service department and ask to speak to someone who is authorized to make sales on preforeclosure properties. Have the property address and the borrower name and loan number (if available).

These transactions aren’t likely and are a sure bet to take at least 30 to 90 days (or even more) because most lenders are now much more inclined to work with the current borrower if at all possible. Our advice is that short sales can be effective in limited circumstances and only if you have the ability to reach a decision-maker at a lender that is inclined to participate. The real estate investor looking for just one property may find that the effort exceeds the return and that there are better ways to locate and purchase rental properties.

Don’t forget that with short sales, you need to have some cash as well as be preapproved for loans or have lines of credit available so that you can make deals quickly. Lenders that are willing to agree to short sales are going to require all cash and won’t be willing to offer any sort of financing. Lenders that are likely to be sources of funds for your loan on a short sale are going to be selective about making loans on non-owner-occupied rental properties. Your creditworthiness and having an established banking relationship are helpful if you’re going to be successful with buying short sales.

Examining probate sales

Even more reliable than taxes, death creates opportunities for the purchase of good real estate at attractive prices. Every day someone in your area dies and leaves behind real estate that his heirs may not have any desire to retain. These properties are sold in probate sales by executors of the estate with the assistance of probate attorneys (or by the public administrator if the owner dies without a trust or will).

Know the laws and rules regarding probate sales in your area, because these transactions allow no contingencies and are all cash at closing. In most instances, there are waiting periods and even court confirmation may be required before the sale is finalized. Also, these sales are often subject to overbids. A potential buyer can use the overbid process to appeal directly to the court (before the court issues the order approving the probate sale) to outbid you and purchase the property for more than the current offer under consideration. Generally, the right to overbid requires an offer that exceeds the existing offer by at least 5 percent. Be aware that this possibility exists, and be prepared to raise your bid—and remember that you must have the cash in hand to pay the full price. Just be careful not to get caught up in a bidding war and overpay for a property. Set a maximum price for yourself before you begin bidding.

Robert has a friend who bought a one-of-a-kind beachfront property in San Diego at significantly below market value from the estate of an elderly gentleman who died and left the property to his son. Apparently, the son had no interest in living near the ocean because of the noise and traffic that accompany beachfront properties. So, the son contacted a real estate broker. He was anxious to sell the property, including the house and two rental units, for not much more than the value of the land alone. The real estate broker and Robert’s friend were surfing buddies, and because the broker owed Robert’s friend a favor, the broker was glad to give him the first shot at this once-in-a-lifetime opportunity!

Trying real estate auctions

Real estate auctions, in which companies claim to be selling prime real estate at below-market prices, have become one of the most popular ways for builders and investors to market their excessive inventory of properties in some areas. Don’t confuse these auctions with the foreclosure sales that are referred to as auctions in some regions. We’re talking about public auctions where antiques or collectibles may also be sold on the same afternoon. In strong real estate markets, even new home builders have turned to private auctions to sell their new homes in an attempt to generate interest and excitement in areas where demand is low.

Private individuals, government entities, and companies that specialize in auctions all use this method of selling real estate to the public. You can often find real estate auctioneers listed in your local yellow pages. Like any auction, the goal is to generate interest and competition among potential purchasers in order to drive up the sales price. Often a minimum or reserve price is set to protect the seller from giving the property away too cheaply.

These real estate auctions are promoted heavily in newspapers, on radio and television, and on the internet with sample prices that sound enticing. They claim to have all types of properties and usually promote a few irresistible-sounding properties — like ten acres of pristine land for only $5,000. Of course, who knows how far out into the boonies the property is located?

Our experience is that auctions are rarely great opportunities for investors, because too many people compete for the unusual, quality property. Plus, the reserve or minimum prices are set so close to the actual market value of the property that the buyer essentially pays retail under the illusion that she’s buying at wholesale. But some good opportunities do arise now and then, so check out these auctions to see if you can find anything worth pursuing.

If you do find a property of interest in an auction, follow the same thorough due diligence process that applies to foreclosures and REOs (see “Finding Foreclosures and REOs” earlier in this chapter).

Unfortunately, proper due diligence isn’t always possible due to the short time frame available before the sale or because the auctioneer doesn’t provide enough information. For example, the best way to minimize the possibility that the property contains some costly environmental hazards is to have a professional firm prepare a Phase I environmental report (see Chapter 14). But you’re unlikely to be able to afford one for every property that interests you at an auction. This is just one example of the dangers in buying properties without a thorough and exhaustive due diligence investigation, so don’t be rushed. Real estate is one investment that you can’t easily get out of if you make a mistake. Remember — you don’t want any surprises!

If you’re the lucky buyer, you must immediately produce a certified funds check for at least 10 percent of the purchase price. Your final closing date usually falls within the next 30 days.

The internet is the preferred method of promoting real estate auctions. As with many internet opportunities, great care should be taken to ensure that you’re dealing with a reputable firm. Never even consider buying any real estate sight unseen no matter how good the deal seems!