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Buying foreclosed—or real estate owned (REO)—properties can be a great strategy for real estate investors. But, availability of these properties tends to vary with economic cycles. As such, a few people have asked me recently: Ryan, is it a good time to buy REO properties?
Unfortunately, now is not a good time to buy REO properties. In response to COVID-19, the federal government has imposed a foreclosure moratorium on all properties with government-backed mortgages. This means supply is extremely low while demand remains high, driving up REO prices and competition.
I’ll use this article to cover some more considerations about buying REO properties—now and in the future. Specifically, I’ll dive into the following topics:
- What are REO Properties?
- Potential Benefits of Buying REO Properties
- Is It a Good Time to Buy REO Properties?
- REOs in the Future
- Final Thoughts
What are REO Properties?
To understand REO properties, investors need to first understand the bank foreclosure process.
When a bank issues a mortgage, the associated property serves as collateral for the loan. This provides lenders protection in case of default. In other words, if a borrower stops repaying a mortgage, the bank can seize (foreclose) the property. The bank can then sell this property to recoup its outstanding loan balance. This is one part of the reason why mortgage interest rates tend to be so much lower than other credit. Real estate tends to appreciate in value—or at least retain its value. As a result, banks face less lending risk. They know there’s a good chance that, if a borrower stops paying, they’ll recoup the outstanding loan balance via foreclosure and resale.
Once a bank has foreclosed on a property, that property becomes an asset on the bank’s books. But if the bank plans on immediately selling the property, it will be classified as a real estate owned, or REO, property. This lets people reviewing a lender’s accounting records clearly differentiate between A) the property held for investment purposes, and B) foreclosed upon properties intended for immediate sale. dr
Potential Benefits of Buying REO Properties
Many real estate investors—and particularly house flippers—try to buy REO properties from lenders. In theory, banks want to sell these properties quickly, clearing their books and paying off as much of an outstanding loan balance as possible. As a result, investors see finding and buying REO properties as a great strategy for fix & flip deals. Why pay retail on MLS properties or spend time seeking off-market deals when you can just go to a fire sale?
In reality, many REO properties do not offer investors outstanding deals. Most of these properties, when foreclosed upon, require significant repairs. Some lenders will complete these repairs themselves. But if they do, they’ll likely list the property at retail—negating any value in an REO purchase. Or, if not repaired, the amount of work—and competition for these properties—may prevent investors from getting what, at face value, looks like it could be a great deal.
Bottom line, yes, REO properties can provide investors great deals. But this is certainly not a guarantee.
Is It a Good Time to Buy REO Properties?
Unfortunately, no, now is not a good time to buy REO properties. And the reasons for this bad timing come down to both supply and demand factors.
On the supply side, COVID-related restrictions have significantly limited the number of REO properties on the market. At the federal level, the government has imposed a moratorium on foreclosures on all government-backed loans (i.e. FHA, USDA, and VA loans—as well as the loans purchased and rolled into securities by Fannie Mae and Freddie Mac). These are loans that the government insures, providing A) protection to lenders, and B) easier access to financing for American homebuyers.
Due to this lender protection, the government also has significant say over how lenders behave. And, as a result of the massive economic impact COVID-19 has had, the government has used this say to prevent lenders from foreclosing on properties. Essentially, the government doesn’t want to punish homeowners (or exacerbate a pandemic) for a catastrophe largely outside their control. And as nearly 70% of homeowners’ mortgages are somehow backed by the government, a large number of people who normally would be foreclosed upon remain in their homes, significantly limiting the supply of REO properties on the market.
On the demand side, tremendous competition exists for the REO properties that do end up on the market. Part of this demand comes down to the somewhat counterintuitive effect that COVID-19 has had on home prices. Due to a combination of low interest rates and limited supply, home prices have skyrocketed across much of the country in the last year, even as the broader economy took a hit. For house flippers who analyze their deals based on after-repair values, or ARVs, these valuations mean a ton of profit potential for flips.
This reality has dramatically increased competition among house flippers for potential deals. As a result, when an REO property does come up for sale, you’ll face a ton of competition to actually purchase it. And, if banks list via an auction service, this competition will likely drive purchase prices to a level negating the benefits of an REO purchase in the first place.
REOs in the Future
Eventually, the federal government’s moratorium on foreclosures will end. This will potentially result in a tidal wave of foreclosures, with plenty of opportunities for investors to purchase REO properties.
To find these deals before foreclosure—and thus gain an advantage—investors should look for notices of default (sometimes called pre-foreclosure notices). When a mortgage borrower stops paying, lenders will typically send a series of past-due notices. Eventually, lenders complete a notice of default, which is a public notice filed with the local court declaring that a borrower has defaulted on a loan. Most lenders consider this filing as the first formal step in the foreclosure process.
And as a public notice, savvy investors can research the public records looking for this information. When they find a notice of foreclosure, buyers can position themselves to A) make the purchase upon foreclosure, or B) purchase the home before foreclosure, thus avoiding the whole process for lender and homeowner.
Often, buying REO properties can provide investors a great way to find deals. But, COVID-19 has changed this calculus for the time being. Due to the federal government’s foreclosure moratorium and increased demand for residential real estate, in general, good REO deals simply don’t currently exist.
Instead, I highly recommend investors pursue other strategies to find off-market properties. Plenty of homeowners have equity in their properties and reasons to sell, but they haven’t actually listed their properties. It’s worth the effort to find these deals for two main reasons. One, an off-market property inherently won’t have competition, as other buyers won’t know about it. And two, related to this lack of competition, investors generally purchase off-market properties at deep discounts—frequently better than REO deals.
If interested in finding these sorts of off-market deals, check out our Investor’s Edge software. We’ve poured all of our collective real estate investing experience into building this outstanding program for finding great deals. Investors can use this software to search through over 160 million potential deals, filtering by preferences and saving potential deals. REO deals may make sense in the future. But in the meantime, other off-market strategies just make more sense!