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House flippers often pursue foreclosed homes for fix & flip deals. In theory, these homes cost less than MLS and other off-market properties. As such, the new investors often ask: why are foreclosed homes so cheap?
Foreclosed homes tend to be cheaper than other properties because they often need some repairs. And if a bank won’t complete those repairs, they’ll sell the property “as-is” at a discount. But, currently, foreclosed homes aren’t cheap due to the moratorium on evictions for government-backed loans.
I’ll use the rest of this article to talk about foreclosed homes and considerations for buying them. Specifically, I’ll cover the following topics:
- What is a Foreclosed Home?
- Why Are Foreclosed Homes So Cheap?
- COVID-19 and Foreclosure Prices
- Buying Foreclosed Properties as an Investor
- Final Thoughts
What is a Foreclosed Home?
Before discussing foreclosure pricing, I need to explain the foreclosure process, in general. Understanding this process provides insight into why banks price these homes the way they do.
When you take out a mortgage loan, the home you purchase acts as collateral for that loan. Whether a primary residence or investment property loan, the property itself serves as a collateral. And the fact that home mortgages are secured loans (that is, loans backed by collateral) plays a huge role in why borrowers can get such low interest rates.
Simply put, collateral reduces risk to lenders, because if the borrower stops paying—or defaults on the loan—the bank can seize the collateral. They can then sell it on the open market and recoup all or a portion of the outstanding loan balance. On the other hand, take a look at the interest rate your credit card offers on a cash advance. This is a form of unsecured loan (that is, not backed by collateral). And you’ll likely see double digit interest rates due to the increased risk for lenders in providing these loans.
Banks call this process of seizing the collateral of a borrower who has stopped paying foreclosure. It typically follows these steps:
- Initial late fees and notice: When a borrower misses a mortgage payment, the bank will assess late fees. Then, banks will send multiple notices that the borrower owes payments. How many letters the bank sends depends on internal policy. But, generally speaking, the bank will move onto the next step after 90 days of missed payments.
- Notice of default: This serves as the formal, public notice that a borrower has defaulted on a loan. Lenders will prominently place one notice on the property door, and they’ll file one with the local courthouse. For many investors, this court filing offers the first opportunity to hear about a potential foreclosure.
- Notice of trustee’s sale: Following a notice of default, lenders generally provide borrowers an additional 90 days to pay their loan balance. If they fail to do so, the lender files a notice of trustee’s sale. This notice must be published somewhere (e.g. a local newspaper), and it lets potential buyers know that the property has been foreclosed upon and will be available at auction.
- Trustee’s sale: This is the technical name for a foreclosure auction. Banks conduct an analysis of the property’s pricing. They account for the outstanding loan balance, any liens, unpaid taxes, and the costs of the sale. Using this information, they’ll determine an opening bid for the auction. Potential buyers then bid on the property. Once sold, the buyer owns the property and is allowed to immediately take possession.
Why Are Foreclosed Homes So Cheap?
Now that I’ve explained how foreclosures work, I’ll explain why they can be very cheap. When most people—homeowner or investor—sell a home, they factor some sort of profit margin into the listing price. They may not always get this price, but profit typically plays a large role in pricing a home.
On the other hand, as I outlined above, banks tend to price opening bids in accordance with costs. They want to cover the outstanding loan balance, associated liens and back taxes, and the costs of the sale. The goal isn’t to make a profit. And if the sale does generate a profit—known as excess proceeds—the bank cannot keep those. They are mandated to return them to the original homeowner (unless another creditor has a claim). For this reason, banks simply have no incentive to price a home above the costs they need to recoup, which is why many foreclosed homes seem cheap.
Additionally, many homes that enter the foreclosure process need significant repairs. This, in theory, makes them ideal candidates for a house flipper. But they’ll factor those repairs into their rehab budget, meaning that they won’t purchase a distressed property above a certain price, as this would prevent them from profiting on the deal. As a result, even if a bank wanted to sell a foreclosed home at a high price, the market may not support it.
But, banks also only control the opening bid price. In a competitive auction, the final sales price on the foreclosed home may be significantly higher than the initial bid. This means that while foreclosed homes may be cheap, there’s no guarantee that they will be.
COVID-19 and Foreclosure Prices
I can’t discuss foreclosure pricing without also addressing the current “elephant in the room”—COVID-19. In response to the pandemic and associated economic issues, the federal government has imposed a moratorium on foreclosures of properties with government-backed loans. And, roughly 70% of the country’s outstanding mortgages fall under this moratorium.
Due to this moratorium, there just aren’t a lot of foreclosed properties available. And, for the ones that are for sale, tremendous demand exists. This demand has combined with skyrocketing home prices, in general, to drive up prices for foreclosed homes. Consequently, these properties aren’t that cheap right now.
Buying Foreclosed Properties as an Investor
The foreclosure moratorium will eventually end, and banks will hold plenty of foreclosure auctions. The question for investors then becomes, should I worry about buying foreclosed homes? A stigma generally exists around foreclosed homes. And, the fact that many of these properties need major repairs makes some investors unsure of pursuing this strategy.
Personally, I absolutely do not think investors should worry about buying foreclosed properties. I actually live in one right now, and I’ve bought multiple foreclosures in the past. But, you do need to conduct thorough due diligence before purchasing one of these properties. If you think a major issue exists (e.g. mold, structural damage, etc.), pay for a specialist to run tests. Yes, these specialists cost money. But, it’s better to pay these up-front costs than purchase a property that becomes an absolute money pit.
For example, a few potential buyers of my current home were scared off by neighborhood rumors that the property had mold issues. This can be a serious problem in homes, so I hired a specialist to conduct tests. The results showed that there were not any mold problems, giving me the confidence to move forward with the purchase (and I love the property!).
Due to the COVID-19 eviction moratorium, I recommend that, for the time being, investors use other strategies to find good deals. Yes, in normal times, foreclosed homes can be cheap. But, there’s simply not enough supply now, meaning the good deals just don’t exist. Instead, investors should pursue other strategies for finding off-market properties.