Error creating thumbnail
|This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it.|
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.
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:
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. Roughly 1 out of every 452 housing units in the U.S. received a foreclosure notice in October 2008.
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%.
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."
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. 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. 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.
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.
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.
The first step in foreclosure investment is to select target areas for potential investment. Key factors to analyze include:
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.
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:
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.
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:
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.
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:
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.
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.