Investing in the foreclosure market is a strategy that requires a level of sophistication and diligence that is far beyond what most people realize. It can have big potential, but it takes real effort to cash in. As such, it should be approached as any significant investment, requiring focus, diligence and careful research into local property, economic and demographic trends. It also requires the formation of a strategy for acquiring properties and for eventually selling them.
Buying used cars at auction is similar to investing in foreclosed properties. Used car dealers are people who know all the makes and models as well as their common defects and the way to change them to create value. They take significantly less risk than the average person who attends the auction just to buy a car at a discount.
Many foreclosure buyers go to the auction at the courthouse steps with the hope of grabbing a bargain – the disparity between the auction price and the property's intrinsic value. But they may not have any real knowledge of the investment or any risk-mitigation strategies. Investors well-seasoned in the residential foreclosure market know that relying on price differential as the main source of investment income is a recipe for disaster.
The correct method for obtaining a foreclosure property is not the shotgun approach, but selecting properties that are in a locale that is destined for redevelopment or improvement. The property needs to have unique qualities that make it stand out from others in the neighborhood or local market or that present some opportunity to create value.
Any investor in real estate should have a specific strategy that includes the goals and manner for acquiring the property, for holding it and eventually for disposing of it. This strategy is even more critical when investing in the foreclosure market. You must determine whether the foreclosure occurred as a result of some unique circumstance related to the former owner, or is the result of a broader trend that may affect the local market.
Investors need to do a significant amount of research on the local real estate market. The demand for properties is a function of population growth, job growth, disposable income growth and demographic changes. It will greatly affect pricing as well as the ability to sell properties at the end of the investment period.
Research upcoming infrastructure development, such as roads, schools and community projects. Also learn how the local and state government supports business growth and plans to fix any particular issues, such as traffic, air quality, crime and taxes. All of these items will make an area more desirable and increase the value of properties within it. (See also: Foreclosure Opens Doors For Investors.)
Most investors have been taught to scour publications that list assets going to auction and to correspond with owners about their intent to purchase the property before it goes on the auction block. Although deals can be obtained on the courthouse steps, finding alternative ways to secure distressed properties will greatly improve your chances of closing. It can also provide an opportunity to fully understand and analyze the property.
For example, let's say an investor gains access to properties by using his contacts in the marketplace and knowledge of residential lending to help struggling homeowners negotiate with their lenders. If the loan problems are worked out, not only does the investor increase his reputation with both the owners and the lenders, the investor may also get referrals and access to others with problem loans. And if the situation can't be worked out, the investor is the first in line to acquire the property – because they have gained the owners' trust. Investors can also make an informed decision about whether to buy the property because through their efforts, they've learned about the property's drawbacks and benefits.
Another strategy is purchasing the distressed loans at a discount from the lenders. Banks and other lending institutions do not like acquiring foreclosures. To avoid taking on real estate owned (REO) properties, these institutions will often sell several non-performing loans at a significant discount to par.
Investors can be more flexible than the lenders in working out a non-performing loan, sometimes turning it back into a performing loan that will command a much higher return, thanks to the investor's lower basis in the investment.
After seasoning the loans, investors can either hold them or sell them at a premium once they have been performing for some time. In the event that they cannot be worked out, the investor can foreclose on the property and take title without having to compete with any other parties. The only downside to this approach is that buying a pool of loans requires a larger capital outlay than buying individual properties at auction. The point is that there are creative ways to reduce the competition in acquiring a non-performing asset.
Holding Period and Exit Strategies
Investors should also be sure of what to do once the asset is acquired.
Will the property be "flipped" back into the market or will it be held and seasoned awaiting a market change before sale? Investors considering buying foreclosures and then remarketing them shortly after purchase should find ways to improve the property. The improvements that provide the greatest bang for the buck include adding bedrooms and bathrooms, remodeling kitchens and finishing basements or other unused spaces. (See also: Fix It And Flip It: The Value of Remodeling.)
Since property transaction information is public knowledge, some prospective buyers will be wary of paying a premium for a property immediately after a foreclosure sale even if its price is in line with other properties in the area. Creating value through redevelopment helps provide rationale for the higher resale price and can reduce the risk of long marketing periods. However, investors should be wary of not improving the property so much that its price is much higher than neighboring properties.
Another strategy is to hold assets as rental properties until something happens in the marketplace to enhance property values. Once again, investors must be aware of the rental market to ensure that there is an adequate amount of demand for rental space. And that the property purchased will command enough rent to cover the cost of maintaining the property.
For those who can handle the additional time and effort it requires to be a landlord, buying distressed properties at a discount and converting them to rental property can create significant wealth. The ability to get attractive financing, such as interest-only loans in concert with the deductibility of mortgage interest from income taxes, provides a great way to create cash flow while waiting for the right time to sell. (See also: The Mortgage Interest Tax Deduction.)
Although residential real estate is not as volatile as other asset classes, it is characterized by long periods of low returns and then a "pop" in value corresponding to some major change in demand that explains a significant portion of return. Again, this is the impetus for ongoing research and a holding period strategy that will help estimate the timing of the value jump and create a plan for the asset in preparation for sale. (See also: Investing in Real Estate.)
Not having thought through an exit strategy is a big mistake that new investors commonly make. Many are under the false impression that the best time to invest in foreclosure properties is when there is an abundance of them available. Actually, a significant increase in homes for sale and foreclosure properties underscores some problem that is preventing people from paying their loans or making them unwilling to keep their homes. This could be due to the loss of jobs in the area or some infrastructure problem that makes the area undesirable. Those trends will have a positive impact of the supply of available homes for sale or foreclosures and a negative impact on demand. This means that it will be more difficult to sell the property until the market fundamentals improve.
A common mistake made by investors that rely solely on the pricing differential for their profit is that they fail to realize the negative impact of carrying costs. Expenses can include mortgage payments, taxes, insurance and maintenance during a protracted marketing and sales period.
Setting a deadline to sell a property and then discounting the price until the property sells is one way to avoid excess carrying costs. It is much better to sell at a small-to-zero profit than to continue to market a property for a price that will ensure a long marketing period and thus high carrying costs that can lead to losses.
The Bottom Line
Investing in nonperforming real estate assets to build wealth is a viable strategy, but it's not a way to get rich quick. For every rags-to-riches story, there are 10 more of people have lost their capital because they did not keep abreast of changes in market trends.
Those who succeed in the foreclosure market have studied the strategies and tactics of other successful investors. They have put the time and resources into making the appropriate market contacts needed to create a competitive advantage over others. But pouring time and energy into getting to know the local real estate market is only one of several strategies that investors can use to get a leg up on the competition. Success comes from carefully crafted and executed acquisition as well as smart exit strategies.