The Guide to Investing in REO Properties

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​

When a property becomes real estate owned the bank or lender is at a disadvantage in terms of losing money on its investment. If an REO property proves to be too great of a liability the lender may be more disposed to sell it quickly to minimize losses. From an investment standpoint, that's a positive because the property is less likely to have an inflated price tag. Depending on the circumstances, it may even be possible to find one for less than market value.

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.)

The other option is renovating an REO property and then renting it out. Rather than getting all of the profits in a lump sum, you're able to generate a steady stream of income for as long as you own the property. In either scenario, the prospective returns may be higher with an REO property if you're able to lock in a lower purchase price. (For more on renting properties out, see Tips for the Prospective Landlord.)
 
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 tax liens or title issues associated with the property before attempting to sell it. That in itself can be a major time saver if you're hoping to move forward with a sale sooner rather than later.

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

For most investors, paying cash for a property isn't realistic, which makes a loan necessary. Before approaching a bank about buying one of their REO properties, you'll need to get a pre-qualification letter from a reputable lender. Banks prefer conventional mortgages to FHA or VA loans with distressed properties because there are fewer restrictions on the condition of the property.
 
In addition to getting pre-qualified for a loan, investors also need to have their down payment funds and earnest money prior to entering negotiations. With an REO property, the bank may ask for a larger down payment or an earnest deposit greater than the standard 1-2% which is something you need to be prepared for. Investors should also be prepared to anticipate the closing costs involved in finalizing the mortgage loan.
 
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.