Investing in real estate owned (REO) properties can be profitable for flippers and would-be landlords alike but it's not without its fair share of challenges. Before venturing into REO territory, it's helpful to understand the ins and outs of how these properties work and what to expect as an investor. (For more, see the tutorial Exploring Real Estate Investments.)

Defining Real Estate Owned Property

A real estate owned property is one whose ownership has reverted to the bank or mortgage lender. If the borrower associated with a commercial or residential property defaults on the mortgage, the lender can pursue a foreclosure action to repossess the property. The next step is to try and sell the property at auction. If the property fails to sell or if the lender is the highest bidder, the property is deemed real estate owned. The lender can then list it for sale.

Why Invest in REO Properties

Investing in real estate offers multiple advantages regarding the ability to diversify your portfolio and generate higher returns. With distressed properties, investors are in a position to enjoy even greater benefits in several key areas.

Cost​

Returns

There are two ways to realize a profit through REO investments. The first is to renovate a distressed property and then resell it for more than the initial purchase price, plus the amount you've invested in fixing it up. Flipping properties is risky if the house doesn't sell right away but if done right, it's possible to net a sizable return. (For more on how to execute a flip successfully, see 5 Mistakes That Make House Flipping a Flop.)

Fewer buying obstacles   Buying a property that's bank-owned is not the same as buying a property from the owner but that's not necessarily a bad thing. One of the most important differences is the fact that the lender will typically take steps to clear any

Buying an REO Property

Having a game plan can make buying a bank-owned property easier. Here are some of the most important things investors need to be concerned with.

Financing

Making an Offer   One thing that can kill the purchase of a bank-owned property faster than anything is getting the offer wrong. While these properties are often priced right at market value or slightly above, you don't want to make the mistake of going in too low. Working with a real estate agent who's experienced in buying and selling REO properties can help you to formulate an offer that's agreeable to both sides.  
Inspection and Appraisal

Contingencies are usually negotiated once an offer is in place and two of the most important ones center on the inspection and appraisal. Investors need to schedule an inspection to check for structural problems as well as a separate pest inspection. A professional appraisal ensures that the property's value matches with the amount the bank is willing to lend you to complete the deal. It's beneficial to have the inspection and appraisal done as soon as you can in case either one results in an issue that needs to be resolved.

Beware of the Pitfalls

Bank-owned properties aren't without certain drawbacks. Lenders will often sell them as is, which can affect turn-around time if extensive repairs are needed. Investors who are working on a limited budget may see their returns negatively impacted if they're required to spend more than they anticipated to get the property rental or resale ready.

REO properties can also be problematic if a problem with the title arises after the sale is complete. Investors would need to purchase a separate owner's title insurance policy in addition to a lender's policy to sidestep any problems; however, this would add to the cost of owning the property.

The Bottom Line

Real estate investing is not risk-free. Taking a gamble on an REO property can pay off big but it can also backfire if you're not able to find a buyer or a reliable renter. Taking the time to carefully research properties and the larger real estate market in your area is a must for ensuring the success of your investment.