Make $500,000 in one year! Buy houses for pennies on the dollar! The business of buying foreclosures and pre-foreclosures has never been hotter. The experts will guide you every step of the way to help you get rich quick. Just take a seminar or buy a book and you’ll be on easy street in no time.
With foreclosure filings reported on 291,000 U.S. properties in February, up 30% from a year ago, it’s easy to entertain visions of buying cheap houses and flipping them for quick profits.
The only trouble is, it’s not so simple. New realities are changing the foreclosure business, and the unwary investor can be left in the lurch.
Here’s what’s changed and what you might want to watch out for:
- There may be little or no equity on the table. Dana Mackey used to send 100 letters at a pop to distressed homeowners in the Agoura Hills, Calif., area. He would typically get about a 10% response. Of those, he would be able to work with several families either by carrying paper so they could stay in their homes or by purchasing the homes from them, and he’d make a good profit.
That doesn’t work anymore. Most of the houses in trouble in his area are now "underwater" — people owe more on their homes than the homes are worth. Many homes have $950,000 mortgages but are worth only $700,000 in today’s market.
"Before, I was able to help them," says Mackey, of Prosperity4Kids. "Now, they’re so far gone that there’s nothing you can do. The banks don’t want to negotiate. The banks don’t want the property back, but they don’t want to take the $250,000 hit right now either. And the market keeps dropping." Mackey has stopped sending the letters.
- Foreclosures are becoming more emotionally and politically charged. Groups such as the Moratorium Now! Coalition are working to stop foreclosures and evictions nationwide. Frustrated with rising unemployment and foreclosures, the coalition’s motto is "Bail out the people — not the banks." Reading a few stories of families sleeping in trucks after being foreclosed on could make Scrooge cry. Few topics raise people’s emotions as quickly as a classic battle between the haves and the have-nots.
You, as a buyer, may be an innocent bystander in this drama, but that might not keep you from having trouble taking possession of a home — or keeping it. A sheriff in Chicago, for example, has told his deputies to stop evicting people from foreclosed properties because he believes some people, especially renters, have been evicted without proper notice. In February, the Association of Community Organizations for Reform Now, also known as ACORN, announced a campaign of civil disobedience designed to help families resist eviction and remain in their homes after foreclosure. (See "When foreclosure doesn’t mean eviction.")
The homeowners likely won’t make it easy on buyers either. "What people don’t count on is the high emotional stakes involved with someone who is in the process of losing their home," says Craig Venezia, the author of "Buying a Second Home." They may have been fending off pre-foreclosure buyers, feel they were pushed into the loan or be emotionally drained by the prospect of losing so much. They don’t exactly welcome your contact; sometimes, they’re hostile.
You’ve got more competition than ever. Once a homeowner receives a notice of default, the foreclosure process is public. Some homeowners report being contacted by as many as 65 people offering to "help" during the pre-foreclosure period. At an auction, it’s no better. You register and get a bidder’s card or paddle, but so do as many as 2,000 other people. "People think, ‘If I get a foreclosure, I’ll be the only one,’" says Larry Loftis, the author of "Successful Real Estate Investing in a Boom or Bust Market." You could skip auctions and look for REOs, or real-estate-owned properties, where the bank has already foreclosed and owns the home. But those are put on the Multiple Listing Service rolls along with every other property. There’s really no way to get around the competition.
Even before the current foreclosure boom and its fallout, buying foreclosures had major downsides. Here are nine more good reasons you may want to steer clear in any market:
- Some pre-foreclosure tactics are sleazy. There’s a whole seminar market that teaches you how to find people who are about to lose their homes and pretend to be their white knight. The seminars teach you to pitch that, yes, Aunt Martha will lose the property, but she’ll save her credit. You use complicated contracts and high-pressure and scare tactics, and misrepresent what the homes are worth. What you’re hoping is that Aunt Martha has about 60 grand in equity. You take over her property, her loan — and her equity. Loftis says, "It’s deceitful and unethical, but that’s what they teach."
You can pay too much. Auctions are designed to create a buying frenzy. It’s easy to get caught up and spend more than you’d planned. "People should not be misguided into thinking that the lenders just take a loss. Sometimes they do," says Venezia. "What I’ve seen is that more short-selling is happening, but it’s still more of the exception than the rule." Remember, when a house sells for far less than both the market price and the mortgage, it makes the news exactly because that’s not how it usually works.
- You don’t get much time to do your research. Foreclosure auctions are a quick process, so when you find out a property is coming up for auction, you don’t have much time to research it. If a property sells at auction, all liens are wiped clean, but you are liable for any property taxes. That could wipe out any savings. "You’re going to know less about the property," says Venezia. There’s no home inspection. Some of the houses are sold sight unseen. And if you’re the winning bidder, it’s yours — there’s no going back.
Your profit can disappear in the time it takes to rehab and sell a home. Even if you get a property at what you think is a good value, you have to factor in all your costs. It’s not just labor and materials. It’s the time you hold the property. It could take months to fix up one property and find a buyer for it, and all that time you’re paying mortgage interest, utilities, property tax, insurance and more. You really have to do the math.
Say you manage to pay $200,000 for a house worth $250,000. You plan to put in $10,000 worth of carpet and paint before clearing a nice profit. Not so fast. There’s always more that needs to be done than you had expected, so say the rehab actually costs you $15,000. Closing costs add $12,500. Then, say it takes you six months to fix the house and find a buyer — and each month you’re paying $3,000 in expenses.
The cost of flipping
Selling price, once fixed:
6 months of taxes, interest, etc.:
That’s a pretty slim profit margin — one that’s completely wiped out if the previous owners trash the place. Or if there are any unknown major defects, such as a leaking roof, a severely cracked foundation or mold. Or if it takes longer than you think to rehab the house in your free time. Or if selling the house takes longer than you anticipated. Not to mention that it could take two to three times longer to complete than a traditional sale, tying up your time and money.
That’s a lot of risk, and it could turn out even worse. There are other ways to invest in real estate without exposing yourself to so much risk.
The owners or tenants may still live there. If you buy property at a foreclosure auction, you may have to be the one to evict the tenants. Do you have the stomach for that?
Vacant properties are a huge financial drain. Most foreclosures involve single-family homes. These homes feel like safer buys because they’re what we know. But you’re better off buying multifamily homes, with renters to cover the mortgage payments, taxes and utilities. "If you buy a quad, even if someone moves out, the other tenants cover your expenses," author Loftis says. "You rehab one unit at a time. You never have a property sitting empty that eats your lunch."
The neighborhood may have underlying problems. You need to ask, "Why is this house in foreclosure?" If the owner lost his job, that’s one thing. But if many jobs are being lost in the area, causing a glut of homes on the market, stay away.
Financing a foreclosure can be complicated. At an auction, you have to bring a cashier’s check for a down payment, and then you might have 24 hours to come up with the rest of the cash. Getting a traditional mortgage on a foreclosure would be extremely difficult. You would need to have different sources — your own cash, access to trusts or hard-money lenders (which can charge exorbitant interest rates).
You can get great deals now — without buying foreclosures. One of the best reasons not to buy foreclosures: It’s a buyer’s market. Loftis recommends that you look for properties that have been on the market six months or longer. You’ll find sellers who are willing to give you a good price.
Still, buying a foreclosure might make sense.
If you’re thinking of buying a foreclosure or pre-foreclosure for your own residence, it’s an entirely different scenario. If you do your research, avoid occupied houses and never buy sight unseen, it could be worth the trouble. Georg Finder, an independent credit evaluator in Fullerton, Calif., bought a fixer-upper that way. He paid about half as much for his house as his neighbors had paid for theirs, and he used some of the savings to make cosmetic fixes. For Finder, the positives outweighed the negatives. He still lives there, 20 years later.