Foreclosure

TOP CONTRIBUTORS

Justin Manger

Foreclosure is the process by which a lender legally disallows a borrower the right to continue paying equity into an investment, thus terminating the borrower's ownership of the property.

The process occurs in situations where a lender (mortgagee) agrees to finance a certain percentage of a property's given value. If the loan's borrower (mortgagor) is unable to make a certain number of scheduled repayments or otherwise violates one of the loan's terms, the mortgagee will eventually attempt to repossess the mortgagor's property through foreclosure.

Alternatives to Foreclosure

Foreclosure is typically the last resort a money-lender will turn to in attempting to settle a defaulted mortgage, as lenders usually lose money during foreclosure proceedings due to legal fees and other associated expenses. Some of the alternatives to property foreclosure include:

• Forbearance: The instance in which a lender puts a temporary hold on payment obligations (sometimes for up to a year) to give a lender time to make overdue payments. Student-loan debtors often receive forbearance.
• Mortgage Forbearance Agreement: A lender's agreement with a legally-defaulting borrower wherein the mortgagee agrees to not foreclose on the mortgagor's property, but instead restructure the currently in-place loan terms to bring the the borrower's equity quickly up to the minimum acceptable level. A short-term solution, these agreements are usually given to borrowers with otherwise-consistent payment histories who have happened to encounter temporary, unforeseen financial difficulties (i.e. ill-health or short-term unemployment).
• Loan Modification: A change made to the terms of a currently-existing mortgage by the lender in instances when the borrower has demonstrated a long-run inability to make the mortgage's required payments. The modification made is typically to either the interest rate or the length of the loan, although in certain situations altogether-new loans are issued. A lender will typically agree to a loan modification only if the cost of doing so is less than their estimate of the cost of foreclosure proceedings.
• Short Refinance: Occurrence in which the lender allows the defaulted borrower to restructure the terms of their debt, often with a portion of the balance being forgiven by the lender. This balance reduction is a calculated measure to avoid foreclosure proceedings that will end up costing more than the forgiven debt.

cash loans

• Workout Assumption: The assumption of the needed portion of a defaulted borrower's loan by an outside buyer in exchange for a percentage share of ownership in the investment.
• Deed in Lieu of Foreclosure: The borrower's willing relinquishment of the land and its improvements to the lender in exchange for immediate release from the mortgage's financial obligations. This occurs outside of a courtroom and poses substantial risk to the lender if all potential dangers (i.e. liens other creditors might hold on the property, unseen & unreported damage, etc.) are not foreseen and factored into the decision.

Types of Foreclosure

• Judicial Foreclosure: The most common method, judicial foreclosure occurs in instances when no power of sale clause is granted to the lender by the mortgage's terms. Once the mortgage is proven legally in-default, the court mandates and then oversees the sale of the property. The defaulted borrower must use the proceeds of the sale to pay back first the lender, then other creditors, and finally themselves if anything is left. If the sale does not generate enough money to pay off the debt, the remaining difference must be paid back, typically over an extended period of time and in fixed increments. Judicial foreclosure is required by many states, and legally prevents lenders from the selective leaking of debtor information (which can destroy the debtor's credit for decades).
• Foreclosure by Power of Sale: The court-unsupervised sale of a defaulted-on mortgage property by the lender, foreclosure by power of sale occurs much more quickly than judicial foreclosure. The proceeds from the sale pay back first the mortgage lender and then any other creditors the debtor many have. It can occur only if a power of sale clause is included in the mortgage contract or if a trust deed was used in lieu of a mortgage. In several states the line between a trust deed and mortgage is blurry, so make sure to research the specifics for the state in which you're planning to buy.
• Strict Foreclosure: Strict foreclosure begins when a defaulted borrower is taken to court by a lender. If the court rules in favor of the lender, the borrower is given a fixed amount of time to bring the loan up to its minimum-allowable equity margin. If this does not happen in the allotted time period, the lender receives ownership of the borrower's property without legal obligation to sell it. This is used only in a few states (as there is no protection for the equity the debtor has already paid into in the investment), and is usually reserved for situations in which the borrower's mortgage debt has become greater than the property's worth (is "under water").

The Current Foreclosure Crisis

In The United States of America

Due primarily to severely relaxed government-encouraged subprime lending practices in the U.S. for the preceding 15 years, current U.S. foreclosure rates are reaching levels higher than they have in decades. RealtyTrac reported 279,561 foreclosures in the U.S. in October 2008 alone, a figure representing a 5% increase from September 2008, and a 25% increase from October 2007.^[1] Roughly 1 out of every 452 housing units in the U.S. received a foreclosure notice in October 2008.^[1]

Judicial States

The foreclosure crisis has been prolonged in judicial foreclosure states due to government interference and regulation while non-judicial states are almost emptied of foreclosure listings. Currently, the median year-over-year percentage change of listing prices in judicial states are lagging non-judicial by nearly 2%.^[2]

Government interference has been so much more pronounced in judicial states that in October 2011 "non-judicial foreclosure inventory percentages [are] less than half that of judicial states. This is largely a result of the fact that foreclosure sale rates in non-judicial states have been proceeding at four to five times that of judicial. Non-judicial foreclosure states made up the entirety of the top 10 states with the largest year-over-year decline in non-current loans percentages."^[3]

Florida, Nevada and Arizona Suffer Nation's Highest Foreclosure Rates

Nevada reported a total of 14,483 foreclosure filings in October 2008, This is a 11% increase from September 2008, an almost-119% increase from the year-ago period in October 2007. Nevada's foreclosure rate is over 7 times higher than any other state's, with 1 out of every 74 homes receiving a foreclosure notice in October 2008, marking it as the 22nd consecutive month in which Nevada had the nation's highest foreclosure rate.^[1] Arizona posted the nation's second-highest foreclosure rate, with a total 17,507 foreclosures posted in October 2008. This represents 1 out of every 149 housing units in the state, a 35% increase from September 2008, and a 176% increase from October 2007.^[1] Florida came in third, with a total of 54,324 foreclosures reported in October 2008, representing 1 in every 157 housing units in the state. This is a 13% increase from September 2008, and close to a 80% increase from October 2007.^[1]

California Posts Highest Foreclosure Total Despite Drop in Foreclosure Rate

In October 2008 California posted a total of 56,954 foreclosure filings, representing a substantial decrease from its August 2008 number of over 100,000. Still, the October 2008 figure is a 13% increase from October 2007, and the legislation recently signed into effect by the California State government calling for legally-enforced delays on foreclosure proceedings will merely delay future spikes in California's foreclosure numbers.^[1]

Investing in Foreclosed Property

Appearance vs. Practical Reality

The underlying logic of foreclosure investment is simple: get a good deal on a property the current owner must sell immediately at discount to stem additional financial losses, and then "flip" or sell later the said property for a higher price to make a profit. Because of this simplicity, foreclosure investment attracts more than enough of a supply of potential buyers to make finding a profitable deal a fiercely competitive affair. It is also the subject of widespread late-night infomercials and many get-rich-quick schemes. In stable economies, however, average discounts on foreclosed properties usually range between 3% - 15%, which means that successful foreclosure investors do many deals and thus tend to have either large sums of their own money or investors who finance their purchases. Large amounts of accessible cash are necessary for property maintenance & upgrades, city & county fees, legal fees, marketing and loss absorption, meaning that the buy/revamp/flip process becomes much more profitable when a buyer does not have to make monthly interest payments on borrowed cash. That said, many who have careers outside of foreclosure investment which afford them large sums of money spend most of their time and energy on that career, which makes them paying adequate attention to all of the many variables involved in a foreclosure purchase much less likely. Outside investors ensure you're not paying interest on debt, but each additional investor will also directly translate to increased pressure-to-profit and decreased personal profit. If you decide to use them know exactly what you are and are not willing to psychologically and economically tolerate before committing.

Strategy

Evaluate Geographies

The first step in foreclosure investment is to select target areas for potential investment. Key factors to analyze include:

1. Area Demographics: How profitable (or unprofitable) a property will be is directly correlated to the area in which the unit is located. Assessing a locale's population growth, job availability, and average level of disposable income as well as the trending of each of these is key in determining potential profitability of a given investment. The higher each of these respective numbers is, the more profitable the foreclosed property will be. Other key factors which contribute to a locale's average property valuation include weather, road-building, air quality, crime levels and taxes.
2. The Market Values of Surrounding Properties: Since the price at which a foreclosed home can be sold ultimately drives all other decisions regarding the property, using sales "comparables" to find the values of surrounding properties in the area is an essential part of the research process: it ensures that you get the highest price possible for your home. Also, since they are somewhat historical in nature (with the pricing information being taken from the last transaction of the property), studying comps can often give you insight into how property values in those areas are trending, and thus if you're finding the foreclosure because its truly a good buy or because it's one of many homes about to go on the market in the area.
3. Applicable County/State Housing Law: Foreclosure and home purchase laws vary state-by-state, so it's important to know what is and is not legal in the area in which you will be attempting to do business. Legal technicalities can and often do nullify the profit in what would have otherwise been a lucrative purchase.

Auctions are how a great many of foreclosed-on properties are sold, and both local newspapers and county recorders' offices will have information about both when & where auctions will be held as well as lists of properties to be sold there. There are also a number of paid services which track and then send relevant property information to a potential investor. Experienced foreclosure investors also frequently look at pre-foreclosures (properties with a Notice of Default or Lis Pendens, depending on the state) in their target price range and areas, and will attempt to deal with the defaulting owner directly in efforts to find a better arbitrage opportunity than might be available at the well-attended police auctions.

Evaluate the Property

The most common method of acquiring foreclosed properties is through police auction. Most of the time properties at foreclosure auctions are sold sight-unseen, with no warranties or sell-back options if further inspection reveals "hidden" property de-valuers (wood rot, leaking pipes, etc.).

If no other options are available to you, a decent way to give yourself the initial information advantage needed to hedge against these unpleasant surprises is to carefully study whatever sources (newspapers, county recorder's documents, etc.) you use to find what's going up for auction in your target area. Pre-select the foreclosures in which you are interested, and then make contact with the current owner(s) ahead of time to ask questions and find out more out about why the property is being foreclosed on. Essential questions that should be asked include:

1. Does the property have tax liens? How many and for how much?
2. Is the foreclosed home on leased land (this makes a foreclosure purchase infinitely more time-consuming, and consequently money-draining)?
3. Are there unpaid property taxes?
4. Is all the information you saw listed when first scouting the property accurate?
5. Partial Interests - is there more than just the 1 defaulting property owner?
6. What are the issues on the property that need fixing? [Ask this one delicately: an owner knows he/she is going to have to list a couple of the property's flaws, so they will usually disclose the more minor repair work needed while often euphemistically skirting over some of the more serious (and usually less-obvious) problems. The better the rapport you build with the current owner, the more likely you are to find out the most complete version of the truth.]

Auction Alternatives

While this approach is better than just showing up at an auction, the most effective way of maximizing your chances of finding a profitable property and ensuring its closing is either by using your own business connections or by acquiring the foreclosure through less well-known methods.

If starting out with no connections, the simplest way to make them is through experience. Make an effort to meet, make good impressions on and build rapport with as many people in the business as possible as you're going through your initial phone calls and auctions. Provided they know their stuff, these people often can give you kernels of wisdom specific to your target area that you may not be able to find anywhere else (or maybe they'll end up becoming aware of a property they don't want but you will). Personal contacts are the starting point for how many successful foreclosure investors beat their competition to the punch.

Once you have some knowledge of residential mortgage lending and connections in the field, you can use both to help lenders and borrowers with loan workouts. A potential workout will require you to do much of the normal research about a property you would do if attempting to purchase it yourself. This is a win-win social business opportunity: if you are able to help bring the loan back to acceptable equity levels, you now have a partial equity stake in a new property and have gained the lender and home-owner as respecting business contacts (and usually access to their business contacts as well) by your enabling of them to avoid foreclosure litigation. If the loan cannot be worked out, it's highly likely that you, being the investor who attempted to facilitate the workout, will be given the first opportunity to buy the distressed property (and will have enough first-hand knowledge from the attempted workout to know whether or not the property is a good investment).

Another way to give yourself access to foreclosure opportunities most investors will never see is by purchasing a distressed loan. Investors looking at pre-foreclosures will likely (at some point) come across a property they know they would like buy. Banks dislike having to deal with foreclosed homes, as the properties they end up holding on to almost always have less value than the debt their debtor owes on the defaulted loan (which is why the home didn't get purchased at auction). To avoid having to hold these properties, banks will sell the defaulted loan with many of their assigned liens and various other default penalties removed, deeply discounting the loan and sometimes even bringing it to its par value.

The key here is making sure you're giving yourself access to opportunities your competition does not have.

To Flip or To Hold

Flipping Strategy

Property "flipping" occurs when an investor purchases a devalued property at a discount rate with the intention of re-selling it for profit in a relatively short time frame (ideally immediately, although realistically-speaking it usually takes a few months). The key with flipping strategies is to know which remodeling projects to execute to get the greatest return. When trying to decide which remodels are key, focus on the following:

1. Evaluate the Essentials - A non-leaking roof, solid floors, working gutters, decent furnace, etc. are all things essential in convincing someone to buy a recently foreclosed property. People don't want a house that can't provide basic human shelter, and all the value-increasing repairs on Earth won't help your bottom line if you can't sell the property fast.
2. Appearance - Although a green lawn, nice coat of pain, ornately decorated yard and new carpets don't have a significant affect on property value, they will all help put a prospective buyer in an emotional and psychological state conducive to buying. If the buyer can see (and more to the point feel) the property as a real home, two-thirds of your selling work is done.
3. Focused Remodeling - The key in foreclosure flipping is to take as-minimal an amount of time as possible to make a few key high-value-returning remodels. Focal remodels for experienced foreclosure flippers usually include updates to frequently-used living spaces (namely bedrooms, bathrooms and the kitchen), siding, new windows and the addition of decks. Pools are often added to increase property sale prices, though savvy buyers know that in the long-run their upkeep costs typically outweigh the value they add to the property.

The longer it takes to move your property, the more your resale profit is eroded by maintenance, interest (if using lender-borrowed money) and marketing expenses.

Holding Strategy

If your initial research and preparation allowed you to find a residential area with uncommonly high or increasing property value builders (i.e. a rapidly growing population, growing disposable income, substantial road building, gentrification, etc.), you'll probably want to take your time refurbishing your recently-purchased foreclosed property before you sell it. Areas in which foreclosed homes are a good idea to hold on to have:

1. Things to do nearby - People don't want to live in a neighborhood where there is little or nothing to do within a 5-15 minute driving distance.
2. Good neighbors - Good neighbors are pleasant to be around and take care of a neighborhood. A lack of "problem" neighbors, big & full trees, home add-ons like decks/pools/patios, well-maintained landscapes, fresh coats of paint and general cleanliness are all almost always reliable indicators that the property values in the area either are or will shortly be increasing.

In holding situations, the most common practice is to rent out the recently-purchased property until one or more value-spiking shifts occur in the neighborhood that make selling the property a profitable prospect. The key here is making sure your property can command enough rent to cover all insurance/maintenance/interest expenses with enough left over to generate a cash flow for you.

Exit Strategy

Even with careful preparation, sometimes an owner will simply select the wrong property, the wrong area, or both. Carrying costs on property (insurance, interest payments, marketing expenses) can create a "black hole" style investment that eats away at profit until the house is sold. Know the sales trends in the areas in which you're looking to invest, and set a time limit as to how long you will give yourself to move the property. If you're not seeing any real interest in the property, reduce the price. While many foreclosure investors initially balk at this, remember that it's better to walk away from the house with no profit as opposed to sunk losses.

References

1. ↑ ^{1.0 1.1 1.2 1.3 1.4 1.5} "FORECLOSURE ACTIVITY INCREASES 5% IN OCTOBER."
2. ↑ "October 2011 Real Estate Data"
3. ↑ "LPS' Mortgage Monitor Report Shows Delinquencies Down Nearly 30 Percent from Peak"