Foreclosures seem like some sort of monkey’s paw deal, don’t they? On one hand, they seem like an incredible deal for investors of any experience level. But on the other hand, the deal can often be too good to be true. So is it right to be wary about investing in a foreclosed property? What is it exactly that makes buying a foreclosed property risky?
If you buy a foreclosed home in the right stage of its foreclosure cycle, there really is minimal risk thanks to things like title insurance which can protect you from hidden positions or unknown liens. The majority of the foreclosure cycle is relatively safe, but there is one specific time you need to steer clear (in my opinion, at least).
What is that time? Auction time. But let’s dive in so I can explain more and give you some tips for when the best time to strike is.
What is a Foreclosure?
Foreclosure is both a process and a singular event, so it can be a little confusing. Essentially, it’s a statement of no confidence a lender has for a homeowner and gives them the legal authority to remove ownership from the homeowner and hold the property or sell it at their discretion. The original homeowner receives none of the proceeds from this sale; it all goes to the bank.
What Does the Foreclosure Process Look Like?
How it typically works is that a homeowner who is down on their luck will start to get behind on their mortgage payments. After a few missed payments, they’ll receive what’s known as a “Late Notice” from the bank or lender.
This is the first stage before anything else happens where the bank is basically saying “You’re falling behind, what’s up? Do we need to talk?” If the homeowner begins to communicate with the bank, they can often work out a payment deal to avoid foreclosure and it ends there.
Before we continue, let me say that the bank most likely does not want to deal with a foreclosure process as it’s a whole thing that will incur them time, effort, and money. So the late notice is their way of tapping the homeowner on the shoulder to find out what’s going on and try to avoid the next stage if possible.
If arrangements can’t be agreed upon, the next letter that gets sent out is a Notice of Default. This is the stage where the actual foreclosure process begins. The lender has said to the homeowner “You’re too far underwater for this to be salvageable so we’re taking over the house and you’ll need to leave.”
After that, the bank acquires the title and either puts up the property for auction or holds onto it as they might see an upturn in the marketplace that could net them a better profit later on. If they don’t go the auction route they’ll put out what’s known as a Notice of Sale.
Once the Notice of Default has been released, eviction notices may be sent out if the original homeowner has not yet left the property. The day the property is sold is known as the Day of Sale. This is what’s commonly seen as the foreclosure event.
Depending on the state, the foreclosure event may need to be signed off by a judge, which can add to the timeline. Again, this isn’t set in stone and is dependent on which state the property is located. Be sure to check ahead of time to see if it applies to your potential investment property.
So to recap, foreclosure is both the process of a lender taking over ownership of a property and the sale of the property from the lender to a new buyer.
When is the Sweet Spot to Buy a Foreclosed Property?
For the most part, the entire foreclosure process is the “sweet spot” to invest, save for one event.
The reason why the majority of the foreclosure process is safe is thanks to title companies and title insurance but we’ll get into that in a minute.
There’s really no concerns to be had if you’re buying a property from a seller that has received a notice of default. Your safety net will be purchasing title insurance and closing with a title company.
During the notice of sales is also a great time to buy. During this phase, the bank may be eager to sell the property. The lender may also consider a short sale during this time, depending on the market. Again as long as you have title insurance there shouldn’t be a problem.
The problematic time is when the property gets put up for auction.
What Makes Buying a Foreclosed Property Risky?
On the surface an auction seems like a great time to buy, right? Maybe it won’t be a competitive auction and you’ll be able to swoop in and get an incredible deal. What could be the downside?
Well, a lot.
Auctions are run much differently than a traditional property sale is and there are some mitigating factors which can make your “great deal” turn into a money pit.
For one, auctions do not allow for inspections and you will not be able to enter the home to see the interior. It’s a big risk and might end up costing you a ton of money in repairs.
Another reason is that the lender putting up the home for auction is selling it as-is. I don’t mean “as-is” as in “what you see is what you get” but rather “we haven’t looked into anything and it’s your job to research the property ahead of time.”
This is the biggest reason I caution new investors about auctions. Too often they get in trouble because they don’t know what they’re buying. Like for instance, second mortgages go into a foreclosure auction. If there’s a second mortgage on the home that you didn’t know about, your great deal just turned into a world of hurt. You’d still be on the hook for the first mortgage that you’ve taken out in addition to the second mortgage before the property is transferred over to you.
Finally, auctions require cash at time of the sale. There’s no time to get a loan or seek financing. The auctioneers will want a down payment then, and then the balance wired over within 48 hours.
Weighing all of these reasons: the risk of not knowing what position you’re in, the inability to get title insurance, and not having time to secure financing makes auctions way too tricky for new investors.
What Does a Title Company Do?
I keep bringing up title insurance and title companies, so I just want to say a quick word about them to help clarify why they’re so important.
Title companies exist to do the hard research you don’t want to do. They research to ensure that no one else has claims on the property.
In addition, a title company will research to make sure that anything owed on the property is paid by the seller. Normally the outstanding balances are taken out of the proceeds on the sale. So if you’re buying a house for $100k and the seller owes $80k, the title company will do research to make sure only $80k is owed and that there aren’t additional liens (like for solar panels).
Title insurance is your guarantee that all of this research is legit and that you’ll be protected against any surprise claims that come up in the future.
To sum it up: foreclosures can be a great way to expand your real estate portfolio, but you’ll need to know ahead of time when to strike. Hopefully this gave you some insight into the right times, but feel free to ask questions in the comments below.