How Buying A Distressed Property Actually Works

This is number five in our ongoing series on creating your own real estate investment business plan.

Today we’ll run through how buying a distressed property actually works in a nutshell. So here is what you can expect when you find a distressed property and you want to make an offer. To purchase a foreclosure auction home, you need cash. Realtors are not involved in foreclosure auctions because no one pays a commission to the Realtor. If you are new at bidding at foreclosure auctions, you might want to bring someone experienced with you such as another investor.

Auctions are generally for more seasoned investors who understand the risks associated with them such as no warranties, not being able to purchase title insurance and having to pay off liens and evict former tenants or owners. Foreclosure auctions are open to the public. The auctions are generally conducted by the sheriff or an auction company at the courthouse steps in the county where the property is located, at the property or at another designation. Check the notice of sale to find out the time and place. It is generally posted at the courthouse or on the property.

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Bids often come thick and fast, be prepared
The lender sets the opening bid price, which is typically the amount that is owed on the loan or market value. The highest bidder is typically awarded the property. Bidding goes quickly. You need to register, bring a cashier’s check generally for 10% of your bid price and a cashier’s check to pay for the home. Other people may be bidding on the home so you should set a maximum price you are willing to pay for the home before you bid so you don’t get caught up in the excitement of the bidding process and end up paying more for the home than you intended.

Many times the lender purchases the home back and it becomes a REO. Making an offer on a REO is similar to making an offer on a resale property owned by an individual owner except that with a REO, you must make the offer through a Realtor and the seller is the bank who owns the home. It may take a little longer to get a response. Sometimes the bank will pay your closing costs up to 3% or maximum 6% if you write it in your offer. You don’t need cash to purchase a REO.

Although making cash offer on a REO gives you an edge over other buyers as well as minimizing the number of contingencies in your offer. Have your financing set up and deliver a pre-qual or pre-approved letter with your offer so the seller knows you are qualified to buy the property. The closer to the asking price you offer and the least amount of contingencies as well as a quick closing are negotiating points that will win you the acceptance of your REO offer. Banks like quick clean deals.

Buying a short sale property
A short sale is a whole different game. The short sale is still owned by the seller, but they are upside down on their mortgage. This means they owe their lender more than the home is worth if they were to go and sell it on the retail market. The short sale may be listed with a Realtor or for sale by the owner. You will make your offer with a Realtor if the seller has the property listed with a Realtor. If not, then you can negotiate directly with the seller or the seller’s attorney.

Before you make an offer, be sure to ask the seller if they have spoken to their lender to make sure the property qualifies for a short sale so you are not wasting your time making an offer on a property that does not qualify. The seller has certain obligations that they must take care of such as providing the lender with their financial documentation to prove their financial distress. If the seller has assets, the lender may not approve the short sale and may require the seller to sell the assets to pay off their mortgage. If the seller does meet the lender’s financial hardship guidelines, the transaction will fall apart. The seller should also negotiate that the short sale process satisfies their mortgage debt so that the lender cannot go after them later for a deficiency judgment.

A short sale is contingent upon the seller’s lender approving the transaction because they are going to have to write off the loss between the sale proceeds and what the owner owes them on the loan. If the seller is not willing to provide their financial information or documentation that the lender requires, the whole deal can blow up. So the seller needs to be committed to the process as well. It is best if the seller is working with their attorney in negotiating the short sale because short sales are very complex.

Learn the ins and outs of short sales before bidding
Be sure to ask the seller or their Realtor if there is a short sale negotiator or attorney handling the short sale. This is important because most sellers do not know how to negotiate a short sale with their lender. If you are not familiar with the process, the chance of the short sale being successful is less. So if there is a short sale expert involved who knows how to handle the transaction, your offer has a better chance of getting accepted.

Lenders take short sale transactions more seriously if there is real estate professional or attorney involved. Otherwise, they tend to take advantage of the fact that the seller is not sophisticated about the process or the seller may omit an important piece of information, and the short sale might get rejected because of that.

Also it is recommended that you also do some research and educate yourself about the short sale process in case you have to end up negotiating the short sale if there is no attorney or negotiator. But again, in that situation, it might be smart for you to hire an attorney to help you if the seller cannot afford one or is not willing. You would need to get the seller’s permission to negotiate with their lender by having them sign an authorization letter.

With a short sale, you should also have a cash offer or have your funds lined up because the seller and the lender want to know that you are able to close the transaction quickly should the lender approve it. Again, the least amount of contingencies and a quick closing after the lender has approved the transaction are your best bet of getting the property. Be sure to negotiate that the short sale is contingent upon the approval of the seller’s lender and negotiate an out clause so you can get out of the contract if it takes too long to get a response from the seller’s lender.

Usually a 45 day out clause is sufficient. Keep your initial deposit small such as $1,000 because the contingencies do not start until the lender approves the transaction and you don’t want to tie up a large sum of money in an escrow account. You can always negotiate an additional deposit after the inspection contingency has been removed. Remember, all your contract contingencies start running after the seller’s lender has given their approval in writing. You may have to counter back and forth a few times with the lender until they accept the offer. Also be prepared that they might not accept the terms, and you might have to move on to another deal.

Buying a property – an example of how it’s done
To determine if the distressed property is a good deal, you want to run the numbers. Let’s say you find a three bedroom two bath distressed property in a hot neighborhood with good schools, and the asking price is $200,000.

You have a local Realtor provide you with a comparable market analysis and you discover that similar homes that are in better condition and are not distressed properties are selling for $250,000- $300,000. You know that the home will cost you approximately $10,000 to fix up and rehab. Taxes are approximately $4,000 a year and insurance is $1,200 a year and you pay away an extra $500 a month for repairs which is approximately $6,000. You already know that you have built in equity and appreciation, and the home is a good deal if you decide to rehab and turn around and sell it. Figure another 2% to 4% for your closing costs, and you are still ahead.

Income stream is also important. Having a regular income stream and cash flow keeps you in the black and out of the red. Cash flow is the difference between the income generated by the property and the property expenses. What the property will generate in steady cash flow is actually more important for investors than appreciation. Although having said that, appreciation is also a factor to consider.

Take for instance the above example. You can check market rental rates on our own or by asking your Realtor or a local property management company to provide you with a rental market analysis. So let’s say that you can rent out the above home for $1,500-$1,800 a month. You will generate rental income of approximately $18,000 at $1,500 a month.

Your expenses are approximately $4,000 for taxes, $6,000 for repairs, $1,200 for insurance and you might want to figure in a vacancy factor of two month’s rent so another $3,000. If you add all that up, you still have a positive cash flow for the year of approximately $3,800. If you buy at least 2-3 properties around the same price range, you can see how you can create quite a bit of positive cash flow with your rental properties.

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