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Getting Home Loans for Foreclosures and Distressed Properties

foreclosure sign outside a home
When people look to buy a home, they sometimes want to save money. This doesn’t mean that they buy a home that is too small for them. Rather, it means that they focus on options that will cost less money than alternatives.

One pair of options for homebuyers is to get a foreclosure or distressed property.

A foreclosure is a bank owned property. This means that the owner stopped paying the their monthly mortgage bill, and as a result the bank seized their home. “Foreclosure“ became a very familiar word during the height of the Great Recession when millions of people lost their jobs and subsequently couldn’t afford to pay their home loans.

A distressed property is a home whose owner is facing the possibility of foreclosure. The homeowner may be behind a few payments, or on a reduced payment plan with their home loan lender but they wish to sell the home, cut their losses, and avoid a foreclosure. Selling their home literally allows them to “get out from under” the home loan. This is an attractive option for people who are underwater on a home loan.

Banks, who are more interested in finance than real estate, tend to want to sell foreclosures both to make at least some money off the loss of the original home loan and to get the property off their hands. As a result, foreclosures are often more affordable than equally sized houses being sold by a private owner. This means that homebuyers looking for a deal often try to snag a foreclosure or distressed property.

Finance for Foreclosed or Distressed Properties

Since foreclosures and distressed properties are such low-priced options, the demand for them is high. Of course, most homebuyers can’t pay for the full price in cash, so they turn to getting a home loan.

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Rich Sharga, Executive Vice President of Auction.com, said that there really isn’t much difference between getting a home loan for a distressed property and a traditional property. Lenders still issue home loans based on the borrower’s creditworthiness and the property’s estimated value.

“Given the nature of properties, getting an accurate appraisal might be more complicated,” he said. “And sometimes negotiations on short sales can complicate the process, but the loans and the lending process are largely the same as what’s available to non-distressed property buyers.”

There is one special type of home loan that is specifically useful for anyone looking to buy a foreclosure: the FHA’s 203(k) loan.

This special home loan is for foreclosed homes in need of major repairs. 203(k)s can be vital to buyers since one of the most common mistakes is to underestimate repair costs.

As a result, many new homeowners can end up paying for extensive repairs that wipe out whatever savings they were hoping to get by purchasing a foreclosure or distressed property in the first place.

Deciding Between Foreclosures and Distressed Properties

If foreclosures and distressed properties are both more affordable than traditional home purchases, how do buyers decide which to buy? A home is almost always the most expensive purchase of someone’s life, so it is clearly an important decision and not one to be made lightly.

Sharga elaborated on how foreclosure auctions are generally better suited for investors since there is a certain amount of risk involved. Some of those risks include:

  • The inability to do an inspection
  • The possibility of pre-existing residents that will need to be evicted
  • Title insurance usually isn’t available
  • They normally require a cash purchase.
Even bank owned properties, which are often available at discount prices, tend to require significant repairs. Despite this, if homebuyers can find a bank owned property, the purchase will be similar to buying a traditional home.

Buying a short sale property is also a worthwhile option since the homeowner will typically keep the home in better condition than a bank owned property. Unfortunately, buying a short sale property takes longer since three parties (the bank, the owner, and the buyer) are involved.

Regardless, money doesn’t grow on trees and buyers should always keep their eyes out for a deal.

“Foreclosure and short sale properties can be discounted anywhere from 10-30 percent depending on what part of the country they’re in, what the local real estate market is like, and what kind of condition the property is in,” said Sharga. “This kind of savings makes it well worth the extra effort and time a first-time homebuyer might have to expend to find and buy one of these homes.”

Hunting for Homes

If one decides to seek out foreclosures and distressed properties, there are a number of ways to find them.

Several sites allow users to view foreclosure properties, property values, and property characteristics. Buyers can even find government-owned foreclosures at HomePath.com (under the auspicies of Fannie Mae) and HomeSteps.com (under the oversight of Freddie Mac).

Rob Berger, Founder and Managing Editor for The Dough Roller, is a house flipper primarily focused on hunting HUD foreclosures.

He said that HUD sells foreclosures through online auctions. However, first they are made available to owner-occupants. Should the house fail to sell, then it is offered to investors.

Unlike HUD, Berger has found banks to be willing to hold onto properties for an extended period of time. Since banks don’t always prioritize upkeep on the properties they own, mold can often be found in the homes’ infrastructures. In order to expedite the process, rather than be overwhelmed with the steps to take, he advises getting outside help.

“Find a real estate agent who is an expert in foreclosures and rehabs,” he said. “They will have contacts for everything from financing to contractors. I’d look for a real estate agent who has bought at least 20 foreclosures for himself or herself.”

Investors Join the Housing Hunt

A sizable group of people with money to spare have entered the housing market and they are not seeking houses to live in. They are investors and their only goal is to make money off of buying houses now and selling them in the future for profit. Sometimes, they even sell the house immediately after purchase.

“Individual investors from around the block and around the world are looking for bargains, and recently we’ve seen large institutional investors in the mix as well, buying tens of thousands of properties,” said Sharga. “But Fannie Mae, Freddie Mac and HUD all have programs designed to give owner-occupants a “first look” at their foreclosure homes, and there are another 2-2.5 million distressed properties still coming to market before we get through this cycle, so there are opportunities for individual homebuyers too.”

Ian Aronovich, President and Co-Founder of GovernmentAuctions.org, said that to get started on investing into a foreclosure, people need to development a good understanding of the current market.

“Many factors are included, such as the region where the property’s located, the region’s property tax rates, the property’s quality (when was it built, if it needs repairs), the surrounding school districts, and many more,” he said. “One house in a tiny suburban town in the middle of Wisconsin will be drastically different in price had it been located at the edge of New York City.”

Aronovich advises buyers to look for real estate tax sales. These are when a property owner doesn’t pay the taxes owed to the government. Subsequently, the government sells the property unless the owner manages to pay their back taxes in time.

Even though they are in the hands of the government, these homes can still fall into disrepair.

“Many times there will be properties that are in need of repairs or properties that are small, vacant, and virtually overlooked,” he said. “These are the ones that many people invest in because they’re significantly cheaper than the rest.”

Aronovich also said that some buyers borrow small home loans in order to start out, yet end up with hundreds of thousands of dollars in profits. This is even more common when buyers purchase vacant land for a small base amount and then purchase building permits to simply sell later on to contractors and builders for a higher price.

Arthur V. Veal, a Managing Partner at We Buy Houses Home Services, said that large institutional cash buyers are gobbling up more and more of the distressed properties that come to market.

“The market is moving in this direction because banks are seeing that their bottom end distressed properties are being purchased quickly so they are trying to shore up the distressed property market by only releasing a small portion of properties at a time,” he said.

By releasing only a small portion of properties at a time, banks limit the supply, thus raising the price of properties. Had they simply flooded the market with all of their properties at once, values would fall and they would get very low offers.

In order to gain a better grasp on the actual flipping process, it is necessary to speak to an actual investor who has accomplished it.

Brandon Turner, Community Manager for Bigger Pockets, bought a foreclosure as his first home when he was 20 years old.

It was a 1970s ranch-style home that he renovated with the help of his friends. A year later he sold it for a modest profit which helped him pay for his dream wedding.

“The experience taught me not to be afraid of foreclosures or distressed homes, but to look at them as an opportunity,” he said.

Turner said that distressed property and foreclosure buyers should be careful about the type of home they purchase. This is because lenders don’t want to lend on a property that is unlivable. However, seemingly ugly homes are fine so buyers should seek out properties with cosmetic issues, not structural problems.

“Green, smelly carpet is great,” he said. “A giant hole in the roof, not so much.”

After buying a home, investors are faced with the decision to either hold onto it, hoping the value increases, or to flip it immediately for a profit. While flipping produces fast cash, buying and holding property can produce long-term wealth.

Bruce Ailion is a real estate agent for RE/MAX but he specializes in purchasing REO properties for a hedge fund. In the past 24 months, he’s bought 140 residential and commercial properties. 

“Hedge funds like no-lose high-return investments,” said Ailion, “Housing in 2011 and 2012 presented that opportunity.”

Ailion explained that real estate is an area of investment that average investors should look into. While the housing collapse is a marked exception, real estate can lead to massive wealth-increasing profits. Since prices are now deflated, they will only rise, along with the economic recovery.

Surprisingly, Ailion predicts that a new wave of homes will hit the market. This is because HUD is now the new subprime lender, allowing buyers with low credit score to get homes for low down payments — many of which are likely to default in the future.

If Ailion’s prediction holds true, then buyers looing for a new wave of homes and new investment opportunities may soon be in luck.

Housing Insiders’ Opinions and Advice

Adam Seligman, a real estate attorney at the law firm of Ward, Damon, Posner, Pheterson and Bleau, has closed over 1,000 short sales, foreclosures, and traditional purchases in the last eight years.

His experience has taught him that even though deals are easier with cash purchases, buyers using home loans should pay close attention to their contracts.

“Make sure your contract includes several contingencies to back out of the deal,” he said. “Some of these include clear title, no open code violations or open permits, no major repair work, appraisal of the property, etc.”

Seligman also urges buyers to look closely at themselves and make sure everything is in line prior to applying for a mortgage. This is because home loan lenders will call applicants’ places of work, review their bank statements, tax returns, and also check to ensure their credit score adequate.

Getting a real estate attorney can be a daunting task, especially for people overwhelmed with the process of buying their first home, but Seligman argues that the cost is actually relatively low.

“It varies depending on the type of service the clients want (only contract review, title review, lien searches, permit report, inspection report, and full service),” said Seligman. “But average would be $750-$1500.”

As far as buying a home goes, this price range is a drop in the bucket and a small price to pay for peace of mind.

Another cost that buyers confront when looking for a home is the appraisal and inspection to verify the quality and condition of the property. Depending on how nicely or poorly maintained a home’s condition, it may be a good purchase or a terrible one.

Despite how regulated home inspections are, they aren’t foolproof.

Deb Tomaro, a real estate agent for RE/MAX Acclaimed Properties, recalls one experience in which inspections couldn’t protect a homeowner.

She once helped a buyer purchase a bank owned property. While the initial inspection found no issues, even after other repairs were made to the house, the new tenants ended up discovering the septic system was bad. $15,000 in repairs later and the problem was solved.

“No amount of inspections would have found that, the house needed to be lived in,” she said.

Despite these lurking, yet potential, problems, she continues to see novice clients rush to foreclosures, albeit for a somewhat comedic reason.

“HGTV,” she said. “I don’t mean to sound snide, but HGTV Flip This House-type shows don’t show realistic pictures of profits, but what they do show is tempting and enticing.”

Just as buyers’ emotions can be manipulated by television shows, their feelings are equally affected by distressed property owners. These unfortunate individuals find themselves facing a terrible ordeal: losing their homes.

All is not lost though and in fact, buyers looking to purchase their homes can help.

John Fossetti, Founder of the House Flipping School, said that buyers can actually create a win-win scenario where a distressed property owner gets out of debt while also unloading the property at a fair price.

“As the homeowner is one the verge of losing their home and all of their hard earned money they have put into it, we could help them by purchasing the property fast,” he said.

Buyers can also improve neighborhoods by renovating the homes they buy as well as giving local tradesmen jobs. In fact, part of the reason houses can lose value is that their neighborhood has a large number of foreclosed and boarded up homes. When these properties are purchased, rehabilitated, then sold to a new family, the community gains a net profit, albeit not necessarily in dollar bills.

Risky Business

One expert doesn’t believe prospective buyers should be reading any of this advice. In fact, they shouldn’t even be seeking to buy a foreclosure or distressed property if they are looking to get a first home.

Aja De Los Santos, a Project Manager for Investcove Properties, said that for first-time home buyers, getting a foreclosure or distressed property is not the best idea, especially since getting a home is a stressful experience to begin with.

“Purchasing a foreclosure or distressed property as a first-time home buyer can amplify this already stressful situation,” she said. “I do not want to say whether it is or is not the right option because everyone’s situation is different and personal.”

De Los Santos offered a very logical strategy for purchasing a foreclosure or distressed property, provided they can handle the stress.

First, buyers should consider the current market value of the home and then deduct the cost of repairs and improvements when making an offer. For example, if nearby homes are $100,000 and the home a buyer selects needs $20,000 in repairs, then the buyer should offer $80,000 to the owner.

Following this, buyers need an inspection. It is pointless to purchase a home without a thorough inspection to detect any number of potential problems, such as a plumbing, electrical, or HVAC issues. On the bright side, even if a problem is detected it is ammunition for a buyer to use in order to reduce the price. This is a silver lining, especially if a contactor can give a low estimate on the needed repairs.

One North Florida realtor said that the state where a buyer purchases property really influences how the purchasing process works.

William Golightly, a Listing Agent at Poole Realty, cautions buyers to check their state laws because their state may be considered a “lien state.”

“In my state of Florida — because we are what is called a lien state — the property in default has to actually go through a court process (foreclosure), and then be ‘sold’ at a public sale, typically at the courthouse of the county in which the property resides,” he said.

Therefore, the assistance of a lawyer is a wise inclusion in any buyer’s strategy.

“I would always recommend any consumer, particularly inexperienced ones to consult with a real-estate attorney to discuss whatever questions they have,” he said. “Be especially diligent in understanding any additional disclosures a lender or seller may require you to sign for an REO purchase.”

Even if buyers select a house they want to buy and it is in seemingly excellent condition, that doesn’t mean that it is safe to live in, let alone a wise purchase.

Daniel Niemi, an Expert for Pillar To Post, said that whether someone buys a foreclosure or distressed property, they need to conduct a thorough inspection of the purchase.

As already discussed, many banks hold these properties for months or longer. Since they don’t always maintain the property decay and deterioration is inevitable.

“During the life of a structure, it may incur one or more issues, such as a seismic event,” he said. “If unchecked or overlooked and left unrepaired a seismic event can contribute to subsequent damages.”

Aside from the steady erosion caused by natural disasters, buyers should also keep an eye out for wood destroying insects and moisture damage. Since these problems can be hard to detect, seeking the help from a qualified professional home inspector is necessary. It just isn’t worth the risk to buy a home only to realize it has major damage.

“All buyers should have a professional home inspection to assure that the home of their dreams will not turn out to be a nightmare that they will not soon forget,” said Niemi.

Markets Past, Present, and Future

One investment firm executive believes that the distressed property market is shrinking.

Kurt Wannebo, CEO of San Diego Real Estate and Investments, says that in San Diego County, a real estate hotbed, distressed properties used to be 40 to 60 percent of the market. Now, they are about 9 percent of the market.

“This change has been due to the banks helping people out with loan modifications, principal reductions, and other workout programs,” he said. “Because the market for distressed properties dried up so quickly it essentially left an inventory shortage in our county that then propelled home prices upward along with the continued low interest rates for borrowers.”

Wannebo explained that when prices rose, homeowners regained equity so they were motivated to keep their homes or sell them as a traditional home purchase. Trends also reveal that home prices are stable, which means that distressed sales will stay low.

Overall though, the housing market is experiencing changes.

Kristin Palmisano, Owner of Prominent Properties, said that in the last ten years, the market has fluctuated dramatically.

“From 2009 through October 2012, sales were still on the rise until Hurricane Sandy hit our area, temporarily stifling any activity along the shoreline,” she said. “Currently we have seen a more consistent rise in sales. Home sales are still rising despite rising interest rates on mortgages, and as of August, we are up 11 percent from this time last year.”

Rising prices are good news for both investors and buyers looking to become owner-occupants. Investors get to buy foreclosed and distressed properties, then flip them around for a profit or rent them out. Owner-occupants get to buy homes that are increasing in value. For first-time buyers who are getting starter homes, this means that they will get even more money when it comes time to sell.

As the insiders stated though, foreclosures and distressed properties are not for everyone. The assistance of proper inspectors and skilled real estate attorneys are vital to making sure these seemingly bargain buys don’t end up becoming massive mistakes.