The Challenges of Investing in Foreclosures

Bank-owned bargains have become increasingly lucrative for real estate investors, but obstacles remain.

By SHARE

Stephanie and Jay Herbert briefly considered selling their Alpharetta, Ga., home to upgrade to a larger house in September 2009. But instead of selling, the Herberts stayed put, updated the exterior of their home, and used the money they set aside for a new house to buy two more houses, one a foreclosure. The Herberts now rent out the properties for extra income.

"It was always in the back of our mind that we wanted to buy a rental home and keep it long-term for retirement," says Stephanie, a 36-year old homemaker. "We just thought now was the time to take advantage of getting a good deal on a house."

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With home prices at historic lows and distressed properties selling at discounts of 35 percent or more in some parts of the country, scooping up bank-owned bargains has become increasingly lucrative for real estate investors. "If you have some money, the smart thing is to buy [foreclosures] as investments," says Jim Gillespie, CEO of Coldwell Banker Real Estate. "Once they hit the market, [they] sell pretty quickly because they're priced so strong."

While the demand for foreclosures continues to grow, real estate investors face a host of challenges when it comes to closing the deal on distressed properties.

Buying a foreclosure can be a long and arduous process, according to the Herberts, who waited three months for the keys to their foreclosure purchase. After the bank accepted their offer, the Herberts were told the bank didn't actually own the property and therefore couldn't sell the house. "We had sold our stock and had this chunk of money because we had to pay 20 percent down," she says. "Then, all of the sudden we were told the bank couldn't get the title because they didn't own the property. It was really disappointing." The Herberts learned this after paying for inspections and spending hours preparing to renovate the property. Eventually, the Herberts got the house, but not before plenty of back-and-forth between the bank and real estate agency. "It was just a big mess. Buying the foreclosure was the biggest pain," Herbert says. "It was a great price, but not a good experience."

Buyers can also run into problems when it comes to financing foreclosures. Qualifying for a loan is tough in this market, but it can be even harder if the mortgage is for a distressed property because lenders have higher standards for the homes they finance these days. "Your credentials need to be much stronger," says Keith Gumbinger, vice president of mortgage information website HSH.com. "Expect to put down 25 or 30 percent on the property and expect to pay higher fees to get your mortgage."

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Many lenders also expect real estate investors to demonstrate that a foreclosure purchase intended to be a rental is in line with market demands and comparable rental properties. "You might have to come in with some market analysis of what supported rents are for comparable properties," Gumbinger says.

The valuation of a property can also derail would-be buyers. If a house's list price is higher than its appraised value—for example, if the purchase price of a home is $200,000, but it only appraises at $180,000—many lenders won't pony up for the extra cash. If negotiation with the seller isn't possible, buyers may have to come up with a larger down payment.

"Valuation really does matter," Gumbinger says. "If you think the property is worth 'n' and the seller is selling the property for 'n' and you think you can rent it out for 'n,' you may have to demonstrate both of those things. The burden of proof may end up being upon [the buyer]."

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The foreclosure market might be a bargain hunter's dream, but while distressed properties may be cheap, many aren't turnkey and need significant improvements to be rentable. "We had to totally gut the foreclosure we bought and completely start over," Stephanie says. "There were no appliances, no light fixtures, no blinds. We had to replace flooring."