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Best Bets:  Fishing For Foreclosures

By Shelly K. Schwartz, |Special to CNBC.com
Monday, 15 Oct 2007 | 8:55 AM ET

Regina Peters smells profit.

The 58 year-old resident of Yonkers, N.Y. has been following the rise in mortgage foreclosures for more than a year and plans to purchase her first distressed property in early 2008.

“I have a lot of equity built up in my primary residence, so I’m going to use that to purchase a foreclosure, which I’ll move into and renovate,” she said. “I’ll then rent out the house I currently own.”

If all goes as planned, the new income stream will help supplement Peters’ living expenses during retirement, while rent will pay off the mortgage on her second home, which will continue to appreciate in value.

A home is advertised for sale at a foreclosure auction in Pasadena, California.
Reed Saxon
A home is advertised for sale at a foreclosure auction in Pasadena, California.

“I’m already looking, but I’m going to wait for prices to fall a little further, probably another three or four more months, before I buy,” she said.

Peters is not alone.

Sizing Up The Market

Foreclosed properties have long appealed to investors who are looking to build equity -- and aren’t afraid to roll up their sleeves.

In most cases, buyers can purchase such homes for 20 percent to 60 percent off their potential market value.

“This is a market where somebody who does their homework can save significant money on a home purchase and create a nice investment opportunity on a longer-term basis,” said Rick Sharga, spokesman for RealtyTrac.com, an online foreclosure marketplace.

Investors entering the market today, however, will have to employ a different strategy than those who came before.

“If you’re looking for something to buy and hold, investing in a foreclosure is a very reasonable thing to do right now,” said David Wyss, chief economist for Standard & Poor’s. “If you’re thinking about a quick flip, forget it.”

Sharga agrees.

“What’s fundamentally shifted about this market is that it used to be suited for investors who were looking to buy, renovate and sell,” he said. “Now, we’re looking at people who can afford to buy and hold, either with the notion of turning a property into a rental unit or sitting on the property until the market rights itself again."

Indeed, certain segments of the residential real estate market have taken a hit over the last three years as would-be buyers sit on the sidelines waiting for prices to bottom out, particularly in cities like Miami, Boston and Los Angeles that benefited most from the housing bubble.

Nationally, existing home sales are projected to fall 10.8 percent this year to 5.8 million, down from 6.5 million in 2006, according to the National Association of Realtors.

At the same time, the number of foreclosure filings – default notices, auction notices and bank repossessions – were up 99 percent in September over year-ago levels, reaching a total of 223,538 nationwide, RealtyTrac.com reports.

Many emanated from the subprime market, where borrowers with weak credit histories found themselves unable to keep up with rising monthly payments on their adjustable rate loans. (More: Mortgage Industry Meltdown)

For investors, a rocky residential market and a growing inventory of distressed homes could mean a bigger potential payoff down the road, said Sharga.

“If you combine a down market with the kind of discount you’d be looking at with the typical foreclosure, that doubles your opportunity for success when the market comes back,” he said.

A foreclosed home for sale.
David J. Phillip
A foreclosed home for sale.

Pitfalls

Yet, the process of purchasing foreclosed properties is also fraught with risk.

Without preemptive research, investors could end up buying homes with tax liens or other liens outstanding, which they would then assume.

“I’ve even heard about people going to auction and buying a second mortgage rather than the first and thinking they got a great deal on a house,” said Sharga.

Before making a buy, investors need to crunch their numbers carefully-- that means hiring a contractor, where possible, to complete a home inspection for big-ticket problems, like structural damage or costly mold.

Investors also need to secure as precise a figure as possible for how much renovations will likely set them back, a major drag on profit.

Finally, buyers should consult a real estate agent to learn about comparable home sales in the same neighborhood, which will help determine how much the house might eventually fetch in resale.

They should also take note of how long listed homes – both rental and resale – have been sitting on the market.

“Many foreclosure investors won’t purchase a property unless it is at least a 30 percent discount,” said Sharga. “That’s because you’ll typically need to do a rehabilitation to bring the property to back up the neighborhood standard, you’ll probably have to finance it for a short period of time and it’ll cost you some money to market the property.”

Buyer's Guide

How to buy

Buyers also should educate themselves on the three stages of foreclosure, as each has different rules.

The first phase is called preforeclosure, where investors buy directly from homeowners in the early stages of default – before the bank repossesses the property. (More: Winning a Home on a Short Sale)

“In an ideal scenario, there’s some equity left in the home so you are able to agree on a number that gives the homeowner a small profit and you a discounted purchase price,” said Sharga. “That’s a win-win situation.”

These days, however, with the advent of 100 percent financing, many homeowners in preforeclosure have no equity to speak of.

In those cases, the investor can potentially negotiate a short sale, in which the lender accepts less than what is due on the mortgage as full payment for the property.

The second phase of the process is where the lender, or bank, forecloses on the home and attempts to sell it at auction.

Typically, investors are unable to inspect the homes they bid on, leaving the condition of the property unknown.

They are also generally required to produce a 20 percent cash down payment the day of the auction, and pay the remaining balance on the home within 48 hours.

According to Andrew J. McLean, author of “Making Money on Foreclosures,” auctions are best left to professionals.

Average investors, he said, should focus instead on real estate owned, or REO, homes, the third stage of foreclosure.

“When the bank is unable to sell their foreclosures at auction they enter the REO stage, which is safer because you don’t have to deal with clearing the title, back taxes or any outstanding liens,” said McLean. “The bank has already done that for you.”

Buyers are also able to inspect the property in advance, which eliminates much of the risk.

And better yet, if buyers have good credit, the lender will often accept a lower 10 percent down payment, cover many of the closing costs and structure a loan with a favorable rate to help the investor renovate the property.

“Banks are anxious to get out from under these foreclosures,” said McLean. “They have to insure it and maintain it and it costs them money."

To find homes in any stage of foreclosure, buyers can visit their county courthouse, which maintains such documents as part of the public record.

Sites like RealtyTrac.com, foreclosuredeals.com and foreclosures.com also maintain a national database of foreclosure listings.

“This is a process that requires some work and requires some cash,” said Sharga. “It’s obviously not as easy as a traditional real estate transaction so buyers have to be diligent. It’s a numbers game at the end of the day.”

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