Investing In Foreclosures Not A Get-Rich-Quick Venture
Investing in the foreclosure market 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 foreclosure investing. Used car dealers - people who have knowledge of all the makes and models as well as their common defects and the way to change them to create value - take significantly less risk than the average Joe who attends the auction with the goal of buying a vehicle at a price significantly lower than its value. In the worst situation, when the dealer obtains a car with a defect that cannot be cured, the loss will be averaged into the many successful purchases made. In the same situation, the buyer seeking that one special purchase ends up with a lemon - a total loss. The situation is the same for the part-time real estate investor who, with very little knowledge, obtains a property with no implicit warranties and a significant risk of losing a large amount of capital.
Many foreclosure buyers go to the auction at the courthouse steps with the hope of creating profit between the auction price and the property's intrinsic value, but without any real knowledge of the investment and without any risk mitigation strategies. Many investors well-seasoned in the residential foreclosure market will tell you 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 the rest of the properties in the neighborhood or local market or that present some opportunity to create value.
Investors in any real property investment should have a specific strategy that includes the goals and manner for acquiring the property, holding the investment and disposing of the investment. 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 or is the result of a trend that may affect the market in which the property is located. (For more on foreclosures, read Subprime Mortgage Meltdown.)
Investors also need to do a significant amount of research on the local markets that are targeted for acquisition. The demand for properties, which is a function of population growth, job growth, disposable income growth and demographic changes, will greatly affect pricing as well as the ability to sell properties at the end of the investment period. The probability for infrastructure development, such as roads, schools and community projects, the support of local and state government for a certain locale and its business growth, and plans to fix any particular issues, such as traffic, air quality, crime and taxes must be researched, as all of these items will make an area more desirable and increase the value of properties within it. (For some common dos and don'ts regarding foreclosures, see 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 one's chances of closing as well as provide an opportunity to fully understand and analyze the property before taking title.
For example, let's say an investor gains access to properties by using his or her contacts in the marketplace and knowledge of residential lending to help struggling homeowners negotiate with their lenders and work out their loans. In the event that the loans are worked out, not only does the investor increase his or her reputation with both the owners and the lenders, the investor may also get referrals and access to others with problem loans. For the many loans that cannot be worked out, the investor is the first in line to acquire the property because he or she has gained the owners' trust. Investors can also make an informed decision about whether to buy the property because through work, they've learned about the property's drawbacks and benefits.
Another strategy example 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, often these institutions will 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 much larger capital outlay than buying individual properties at auction. The point here 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 very sure of what tactics to employ once the asset is acquired. One major question to be answered is whether the property will be "flipped" back into the market or whether it will 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, thus making it more marketable and more valuable. The improvements that provide the greatest bang for the buck include adding bedrooms and bathrooms, remodeling kitchens and finishing basements or other unused spaces. (To read more about renovations, see 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 pricing is too high relative to 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, the strategy of buying distressed properties at a discount and converting them to rental property is one that has been used to create significant wealth. The ability to obtain 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. (For further reading, see 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. As previously mentioned, 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. (To learn about investing in all types of property, see Investing in Real Estate.)
Not having thought through an exit strategy is the big mistake that new investors in the foreclosure market 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. In actuality, 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. Whatever it is, it 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 than usual 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, such as mortgage payments, taxes, insurance and maintenance during a protracted marketing and sales period. Many buyers of foreclosures that choose the wrong property or the wrong market will see their estimated profit severely reduced or eliminated by the inability to sell the property within some reasonable amount of time. One of the ways to avoid this pitfall is by being well informed about sales trends in the target area and by having a disciplined sales strategy. Setting a time limit in which to sell a property and then discounting the price until the property sells is another 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 in the long run.
Investing in nonperforming real estate assets to build wealth is a viable strategy, but it's not a way to get rich quick. Success in this field seems to be a byproduct of carefully crafted and executed acquisition, and operating and exit strategies designed to achieve specific investment goals. For every rags-to-riches story, there are many more who have lost their capital because they did not keep abreast of changes in market trends or have a plan to mitigate the risks inherent to foreclosure investing.