NEW YORK (MONEY Magazine) - Buying houses that have been seized by lenders is a popular way to invest in real estate. It can be profitable -- but it's not easy.
Dr. David Coffey remembers well what made him a convert to investing in foreclosures. It happened a few years back, when an elderly patient offered to sell him a commercial property at a great price, and he said no. Real estate was so far from Coffey's mind that the patient might as well have offered him a skunk at a discount.
|Investing in real estate
Later, though, the doctor started dreaming about how much the property he'd rejected might be worth someday. He was a changed man. He signed up for real estate seminars, he read books, he joined a local real estate club, and he decided that foreclosures were the way to go.
"I started thinking of them as a way to retire early," he says.
Coffey is one of a new breed of investor, burned by the stock market over the past few years, who have found real estate in general and foreclosures in particular to be a good place to put their money.
And for good reason. The average home price, according to Case Shiller Weiss, a real estate research firm, has shot up 42 percent over the past five years while interest rates have kept falling. Meanwhile, 1.8 million homeowners were behind on their mortgages and 167,550 houses entered foreclosure in the last quarter of 2003, according to the Mortgage Bankers Association.
The potential profits on the purchase and resale of a foreclosure can be tempting. Some experienced investors say such a deal should yield a profit of no less than 30 percent.
Such hefty margins are possible because nobody likes an empty house. Not the neighbors, not the community missing out on tax dollars, and certainly not the lenders forced to take back the property. Lenders want to get foreclosed houses off their books fast, and that means they're often willing to sell them cheap.
Buyers can profit either by doing a few repairs and reselling promptly -- a process known as "fix and flip" -- or by holding on to the property for some time and renting it out.
The latter choice has become more popular lately as a result of changes in the tax laws that scale back capital-gains taxes on assets owned for more than a year.
The basic equation is simple, but actually doing it right and making money isn't. The investors MONEY spoke to have profited from buying foreclosures, but usually only after a process of trial and error.
It's not as easy as the late-night TV, best-selling get-rich-in-real-estate gurus (Carleton Sheets, Robert G. Allen, "Rich Dad, Poor Dad's" Robert Kiyosaki and the like) make it sound. Potential deals are abundant, but good ones are few, and competition for them is intense.
Investors can and do get stuck with houses they can't sell. And to make the whole thing even more daunting, laws and procedures vary widely from state to state.
Still, it can be done if you're willing to take the time and do your homework. The first lesson is learning your way around the three basic types of foreclosure deals.
They are pre-foreclosures, in which the homeowner is in trouble with the lender but still has the house; auctions, in which the homeowner has defaulted and the house has been seized and put up for public sale; and REOs (real estate owned), in which a lender has wound up owning a house and is trying to sell it, either directly or through a real estate agent.
Each kind of deal has its own set of opportunities and problems, economic and otherwise. The experiences of Dr. Coffey and two other real estate investors, Chai Voraritskul and Toni Menchetti, provide a basic road map through the foreclosure landscape.
When homeowners default on their mortgage payments, generally after 90 days, lenders begin foreclosure. Notice of these proceedings is public information filed with county registrars or other authorities; in some places it's available online.
Some investors prefer to contact homeowners at this early stage, before the lender has seized the property and sent it to auction. One advantage is simply beating other bidders to a potentially good deal.
As Alan Smith, the communications director for Foreclosures.com, an online listing and advisory firm, puts it, "The longer the investor waits, the more likely someone else will get there before him."
People on the verge of eviction are not always thrilled to be contacted by a stranger offering to buy their house.
Debbi Smith, a Mesa, Ariz. foreclosure investor, goes in the front door -- literally. She says, "I don't look threatening or all professional. I go in casual clothes and I say, 'Hi, I'm Debbi. I'm an investor. Do you know anyone who's in trouble, behind in their payments?'"
Other would-be investors prefer to court homeowners via letters. Chai Voraritskul uses an even softer sell.
"I'm not pushy," he says. "I let people come to me." Voraritskul, 62, has been investing in real estate full time for almost two years. The retired Allstate insurance agent spends a lot of time driving around the Dallas/Fort Worth area in his pickup, looking for property. A sign on the tailgate reads WE TAKE OVER MORTGAGES. STOP FORECLOSURE. His phone number is posted on the doors and rear window.
"I get one or two calls a day," he says.
In February, for instance, Voraritskul got a phone call from a homeowner in the town of Wylie who had been unable to sell his three-bedroom house and was starting to have trouble keeping up with his mortgage. Voraritskul agreed to take over the monthly payments, allowing the man to walk away without the black mark of a foreclosure on his record.
Voraritskul thinks of himself as somebody who can help homeowners in trouble, not somebody who is just trying to benefit from their hardship.
"The people are in a very depressed state," says Voraritskul. "The owner knows he's in trouble, he knows others know he's in trouble, and he's very defensive."
In the case of the Wylie house, Voraritskul brought in a tenant under a lease-option agreement that gives the renter two years to buy the home. By the time the lease option runs out, the tenant will have built up $5,000 in equity toward the purchase price. (Such deals are attractive to people with bad credit who can't get mortgages initially.)
If the tenant chooses not to buy, Voraritskul will keep the $5,000 on top of the $235-a-month profit he's making on the rent.
"I'll either put it back on the market," he says, "or I'll use it as a rental. I have two years to think about it."
When a homeowner actually defaults on his mortgage, the lender gets the right to sell the house at a public auction. (The timing and exact procedure for this vary by state.)
Not all auctions are created equal, however. If the loan was guaranteed by the U.S. Department of Housing and Urban Development (HUD), then the department takes ownership of the home and either sells it through a real estate agent or auctions it on the Internet.
These properties are not the bargains some potential investors think they are. For one thing, there's a lot of competition; in February the department put 3,250 houses up for auction and got 22,000 bids. For another, HUD's Web site states that it "sells homes at market value" and that bidders who intend to move in get preference over investors.
As for auctions of homes owned by banks or other private lenders, investors should not show up without preparation. All investors should know the state's laws and the particulars of the property they wish to bid on.
They should also be ready to put down a cash deposit of 10 to 20 percent of the sale price on the spot should they win the bidding. The balance will most likely be due in less than 30 days -- in many cases in as little as 24 hours.
Toni Menchetti bought her first three foreclosures at a single auction in 2000.
"I was terrified," she admits. "You get into this auction mode, this ego thing. You're bidding and people are bidding against you and you think, 'I'm going to get this.' It's dangerous."
Menchetti, 42, a single mother who decided to pursue real estate investing for extra income after her divorce six years ago, bought the three foreclosed properties having seen only slides of them.
"I knew the towns and the average comps [the sales price of neighboring homes]," says the North Haven, Conn. resident, "and these were about 40 percent less."
Menchetti bid roughly $25,000 for each of the houses. She paid her 10 percent deposits and then went to inspect what she'd bought.
"One was a complete mess," she recalls. What's worse, the houses were appraised at only $23,000 apiece. "I didn't realize," she says, "that the banks wouldn't give me a mortgage for anything lower than $25,000, and they wouldn't combine. I gave [the houses] back because they were all contingent on financing."
Menchetti was lucky. Some auctioneers, including HUD, will not return deposits for any reason.
Today, Menchetti says, she makes sure her financing is in place before the auction. She's bought and sold four foreclosures for a total profit of $162,500.
Financing is not the only obstacle for buyers at a foreclosure auction. The homes may still be occupied by the delinquent owners, and it is up to the high bidder to deal with the messy question of eviction. In some states, the former owners have up to a year after the sale to buy back their home for the amount they owe plus foreclosure costs.
Also, don't expect a clean title search or title insurance to accompany an auctioned property. It is not uncommon for a winning bidder to be unpleasantly surprised by an unpaid $6,000 bill from a roofer or a claim by a third cousin who has an interest in the property.
And while some auctions take place in a house's front yard, allowing you to actually look the place over, just as many are sold online or "on the steps," meaning at the county courthouse. Good luck locating someone with a key to let you in for an inspection beforehand.
Here's the investor's last chance. If the foreclosure didn't sell at auction, it has nowhere else to go but back to the lender, where it takes on a new name: real estate owned.
Lenders hate REOs. An empty house is a nonperforming asset on their books. The longer a house sits unoccupied, the more its value depreciates. Meanwhile, the lender is spending money for its upkeep -- or not, in which case it faces the possibility of a thorough trashing and an "as is" sale price.
Most large lending institutions won't deal with investors directly, preferring to hand over properties to real estate agents. But smaller banks, eager to save on the commission, may want to talk.
Dr. David Coffey's first purchase was a three-bedroom REO in fairly good condition in the Cincinnati area. He found it with the help of a childhood friend who had become a real estate agent.
The duo negotiated $5,000 off the $83,000 price tag; Coffey paid in cash and then refinanced the property. He used the refi money to buy another house he found, again through his agent friend.
"It was a major repo," Coffey, 42, recalls of the first house. "The previous owners had busted up the toilets, busted through walls, and the basement had eight inches of water. But I thought I could make money on it. I figured no retail buyer was going to touch it."
Coffey says he's made more than $170,000 total on all his foreclosures to date. He follows a 70 percent rule -- he buys only when he calculates that he can sell a place for 30 percent more than he put into it, including any renovations.
His first foreclosure was a textbook example of the 70 percent rule: Purchase price: $78,000. Cosmetic work (painting and a new carpet): $2,000. Sale price one year later: $115,000.
When in doubt, don't
Every homeowner knows stories of houses in his town being "fixed and flipped" for quick profits. In fact, for a lot of would-be investors, the word "foreclosure" is practically synonymous with this technique, and a lot of no-money-down real estate gurus base their teachings on it.
But Coffey has held on to four of his five purchases, and Voraritskul has done the same with his properties. This is partly because capital gains on sales of assets held a year or less are taxed as regular income, while gains on assets held longer than a year are taxed at a top rate of 15 percent.
The other reason investors like Coffey and Voraritskul hold on to the buildings they purchase, despite the burdens of being a landlord, is that profitable foreclosures are hard to find. Menchetti looks at a minimum of 10 properties for every one she bids on. Voraritskul says he acts on one out of 100 calls.
And Coffey disciplines himself with this rule: Don't fall in love with a house. "If you get desperate and think you have to buy today," he advises, "you might just get hosed."