Pre-Foreclosure - Winning the Race Against the Bank
We've all seen the late-night infomercials, back-dropped by a tropical paradise: "Make a Million Dollars in Your First Year" — just send us a check for a few hundred bucks and we'll teach you how to make your dreams come true — by selling items on eBay, installing Internet kiosks, or you guessed it, buying and selling foreclosures. Replete with monthly cash flow statistics, before-and-after photos, and a few "real-life" success stories, you begin to feel yourself being hooked, sucked towards the television screen, visions of your new yacht and umbrella drinks becoming more and more vivid. As you reach for your wallet and credit card, however, a thought crosses your mind, "Can it really be this easy? Why have I never met any of these folks?" Ah, your common sense is now leading you back to reality. Good. Because you'll need it should you choose to venture into the foreclosure business.
Getting rich overnight is rare, and when starting out, it will be better to implement the strategy of the tortoise rather than the hare. Utilizing your creativity, tenacity, and some good old-fashioned business sense will be your best path to profitability. Those who learn the system, adapt as necessary, and stick with a winning formula can often build healthy rental portfolios and/or make a good living flipping properties. That being said, with everyone looking to foreclosures as the "be all, end all" in property investment, how can you position yourself to beat the competition and avoid spending time and money chasing your tail? One answer is to begin looking for foreclosures before they become foreclosures.
Pre-foreclosure is a term property investors have coined to describe situations in which foreclosure proceedings have commenced due to one or more loans going into default, but before the property goes to auction. Homeowners default on loans for many reasons, including death, divorce, medical problems, and job loss. In recent years, foreclosure rates have also jumped due to some reckless and predatory lending practices by the banks. Whatever the cause, each situation has one thing in common: it usually takes months to as long as a year or more to actually foreclose on a property and sell it at auction. Meanwhile, all of the involved parties and associated financial issues go into a holding pattern, a legal purgatory of sorts, all waiting for that inevitable day of reckoning. Enter the knight in shining armor — the real estate investor with enough knowledge and professionalism to alleviate the collective pain this situation is causing, including the losses to the lender and other lienors who are probably not being paid at this point. Imagine sending the property owners on their way with badly-needed cash, and their credit relatively intact — you've made a handsome profit and the bank seems pleased to have been paid back. Sounds like a win-win for everyone involved, doesn't it? Well, in reality, not every scenario will leave all parties involved walking away completely happy, but if you do your homework right, then you should be able to take your winnings to the bank, literally and figuratively while still providing a valuable service to those in need of help.
The Race Is On
In a nutshell, investing in pre-foreclosures is a race against time, the foreclosing lender, and your competition. During each and every step of the process, you'll need to know your facts cold and reduce time-consuming tasks to a minimum. This is easier said than done, of course, but by breaking the process down into a series of repeatable steps, you can sift through the clutter and manage the blur-like speed in which these transactions often take place. The full lifecycle of executing a successful pre-foreclosure purchase will require the investor to follow a path similar to the following:
- Learn the local statutes regarding foreclosure
- Locate properties that are in pre-foreclosure
- Determine which deals are worth pursuing
- Contact the current owners of worthy properties and make an offer
- Contact and negotiate with the existing lenders and other lienholders affiliated with the property
- Develop and implement your strategy on how'll you finance each deal
- Purchase the property
After you've completed the purchase, you may decide to hold the property for a long-term investment, sell it immediately, or rehab the property and then sell it. But that's a decision you'll have to make based on factors such as the structure of the financing, the condition of the property, the health of the local real estate market, and your investing style.
A Walk Through the Lifecycle of the Deal
- Learn your Local Statutes
This is a MUST as a real estate investor – and we're not just referring to the foreclosure statutes. Becoming familiar with the various real estate regulations in your state can save you thousands of dollars in bad decisions later on.
- How long does the process take? The length of time between initiating foreclosure proceedings and selling the property at auction varies from as little as two months to a year or longer, depending on the state in which you live. Knowing how much time you have to work with is critical when dealing in pre-foreclosures.
- What steps are the foreclosing lenders required to take? Specifically, what types of documents are they mandated to file and where? Knowing this information will not only help you find prospective properties, but it can yield information such as payoff amounts, and enable you to track where the bank is at in the foreclosure process.
- What protections do the current owners have? This can be important in winning the trust of the owners, as they may not be aware of their rights; not to mention the fact that there may be ways to buy yourself more time to complete the deal should you need it.
- What authority or agency handles the foreclosure and what process does it follow? There are a few different possibilities here, but to simplify it, most states either handle foreclosures through the county court system, leave the process to a third-party trustee, or use a combination of the two. This often comes down to whether or not your state uses a "mortgage" or "deed of trust" standard. The former, an agreement between the lender and borrower; the latter, a similar agreement, but with an intermediary known as a "trustee."
Many of the local statutes can be found online, but we also suggest paying a visit to a local real estate attorney before getting started to get the lowdown directly from an expert. It may be worth the money to have the attorney hold your hand through your first couple of deals as well.
2. Locating Properties
Locating properties that are in pre-foreclosure is relatively straightforward. Depending on the county you are working in, the process can be as simple as sitting at your desk and searching for properties online. By law, lenders must provide "constructive notice" to the public that a foreclosure process has commenced — typically, this is done by recording a "notice of default" or "lis pendens" (pending lawsuit) at the County Land Records Office. These notices are almost always published in a local newspaper as well, but most investors recommend using the land records office, as it is usually more current. Remember, you're working against time. This office may have a variety of different names, such as "clerk and recorder" or "registry of deeds," but essentially they all provide the same service: a repository for tracking all transactions related to real property.
Your next step is to determine whether you can access these records online. A favorite among professional land title abstractors is www.netronline.com, as it has links to every available county in the U.S. If you're unlucky enough to be working in a county still in the Stone Age, you'll get the distinct privilege of traveling to the physical office to do your searches.
Without going into the details of how to perform a full title search, which can be adventure in itself , you will need to spend some time decrypting the county's indexing system. Most likely their records will be indexed by name, but will also allow you to search by document type and date. If so, this is the trick of the trade! Try picking a date and search by either "lis pendens" or "notice of default," leaving all other fields blank. (Tip: When searching or sorting by document types, you may find that the name of these documents changes from state to state or even county to county — they may also use "codes" in the index instead of the full name). This should return all documents of that type for that day. Voilá, you now have a list of pending lawsuits and foreclosures. (Tip: Not all lis pendens will be related to foreclosures, so you'll need to examine those documents in more detail.) This process may require some experimentation to nail down, and each county will present a different set of challenges. If you're not able to successfully return a set of documents using this method, be sure to take that trip to the County Office and ask the staff for help. They will more than likely be familiar with the type of search you are trying to perform.
If the county system proves too cumbersome, there are online subscription services that can provide foreclosure lists and may be well worth the money. The beauty of these services is that they will supply a lot of the data "cleansing" and "filtering" for you. Performing the search yourself requires some examination of the documents to determine the property address and other pertinent information. The subscription services will often provide a useful summary that includes owners' names, property descriptions, and loan-to-value estimates. Try www.realtytrac.com or www.foreclosure.com for free trials.
3. Narrowing the Field — Assess Which Deals are Worth Pursuing
Once you've generated a list of properties, you'll most likely need to narrow the field to the deals that are worth your time – this can be done by performing some due diligence and preliminary analyses on the feasibility of each deal. Be sure to avoid properties mired in a legal struggle, such as divorce or bankruptcy (although as you gain experience, legal hurdles can actually become advantages) and look for those properties that either have equity or "potential" equity. Potential equity occurs when there is a chance to negotiate down payoff amounts and/or when rehabbing the property creates a significant increase in value.
Right out of the gate, eliminate the bankruptcy cases by performing a bankruptcy search on the owners. The easiest way to do this is to subscribe to PACER services, another online service well worth the money. Bankruptcy cases do not merit the hassle as there will be too many variables out of your control, and where there are foreclosures, there are often bankruptcies, so you'll want to be sure to take this step.
With the remaining list, you'll want to find equity where you can, and not necessarily total equity, but as a percentage of the total value. (If you have 20K in equity on a 200K house, you should pay attention to the 10% equity value rather than the 20K.) This is because many of the fees and costs you'll incur are based on the same formula, e.g. real estate commissions. There are a variety of schools of thought on where the cutoff lies, but Property Investor recommends a minimum of 25 percent equity after renovation costs. If you plan on keeping it as a rental, you may be able to justify the deal with much less than that — crunch the numbers with your accountant to determine your own comfort level.
The four major factors in determining equity are: the property's resale value (after rehab), the cost to renovate the property, the total amount still owed on the property, and the potential carrying costs of holding the property.
There are a number of ways to determine resale value, starting with the quickest and easiest method — checking free online sites such as www.zillow.com or www.myhousevalue.com. You can usually get the county's assessed value online as well, although this information is not always up-to-date or overly accurate in terms of square footage, etc. If you are looking for a quick snapshot analysis of value, these resources should serve as a starting point, but as you further refine your search and move closer to actually investing in a deal, you will definitely want to hire an appraiser, or at a minimum, begin working with a real estate professional that can provide you quick feedback on comps, average time on market, and other important market information. Also, be sure to base your value analysis on the condition of the property after the improvements you plan to make.
This previous sentence is important to remember, because using industry-standard "percent return on investment" formulas, such as, 98.5 percent return on the cost to remodel kitchen, can be extraordinarily inaccurate when working with foreclosures, and rehabs in particular. For example, you may find that replacing a carpet or improving the curb appeal provides you a well over a 100 percent return, especially if the costs of holding the property are taken into consideration. This is especially true anytime you can do the work yourself. The bottom line is to be conservative when estimating resale value and your costs to rehab the property, but don't underestimate the importance of repairing or replacing something that will prove to be a major obstacle in reselling the property.
The last step in determining your equity is to locate and assess all of the liens, judgments, mortgages and taxes owed against the property or by the owners. To do this, you'll need to perform a full-blown title search. The rules from state to state are so different that entire books have been written on the subject, but to break it down to its simplest level, you'll need to search all relevant public records for this information by the owner's name and by the property itself when possible. For example, in Colorado, this can be done in two offices — the Clerk and Recorder and the County Treasurer, whereas in other states, you may need to perform searches in as many as four or five different offices. This all depends on how the local system was established many years ago. Some states require that liens and judgments be recorded at the county court level, while mortgages and deeds are recorded elsewhere. Adding to the complexity, there are different statutes of limitations for different types of liens and they vary from state to state. The bottom line is, you'll probably need some help from a local title company or real estate attorney to verify your work on your first few deals, but the most important factor is to be sure that you find everything!
As you'll soon discover, finding equity can be difficult, but either through rehabbing the property or negotiating short sales and payoffs with lenders and lienholders, you can "create" equity. (Short sales are discussed further in Step 5.) You'll also find that properties with large amounts of equity will create a lot of competition. Do not be tempted to get into a bidding war over these properties. Generally, if you pay more than 50 cents on the dollar for equity, you are probably paying too much.
4. Contact the Owner
You've done your research and you've narrowed the field to properties that appear to be worth pursuing. Now it's time to try and make contact with the owners. (A word of caution here. Some states have strict requirements on how and when you may contact the owners. Be sure to check your local statutes.) Unlike purchasing foreclosures at auction, pre-foreclosure deals require the cooperation of the owners on a few levels. First and foremost, you'll want to get a signed affidavit permitting you to speak with their lender(s) about the terms of their loan. The reason for this is two-fold — you'd like to get the lowdown on how much is actually owed, and you'll want the ability to work out potential compromises with the lender.
Making contact with a property owner can be tricky. As an investor, you need to remember to be sensitive to the owner's current situation. You'll want to be discreet, yet available; helpful, but not condescending. You'll be part investor, part therapist. Most important to a successful relationship with the owner is to recognize what his motivations are. There are those who want to walk away with some cash, those who only want to save their credit, and those who just need some handholding with the details of extracting themselves from their current bind. You may be able to help with all three.
The most effective way to make initial contact is by mailing a letter, stressing these points. We don't recommend that you cold-call or drop in unannounced on the owner, which tends to be less effective, since the owner is caught off-guard, and sometimes reacts by going on the defensive. However, if you don't have any luck via mail, you may be forced into making a personal visit.
Once you have established contact, try to get permission to inspect the property and contact their lender. You'll also want to try and extract as much information as possible from the homeowners on everything from the condition of the property to estimated value to additional liens, etc. You won't necessarily take anything they say as "fact," but they may offer up some information that can be quite helpful and perhaps save you some time.
It is vital that during the entire process, you earn and keep the confidence of the homeowner by being professional and respectful. Once you've lost the owner's cooperation, you might as well move on to the next property.
5. Contact the Existing Lenders and Lienholders
This is probably the most frustrating portion of any pre-foreclosure deal. One would think that lenders who are in the process of trying to collect on a loan would be cooperative when contacted by a potential investor, but this is not necessarily the case. Unfortunately, there are a couple of problems you'll run into during this phase: first, getting to the right person that can make the decision; and second, getting the bank to be cooperative with negotiating a payoff can be a real challenge.
With the record-high numbers of foreclosures in recent years, lenders will probably cooperate in the area of pushing out the sale date. Lenders are often willing to make time extensions or other arrangements so that the owner can work out some type of financial arrangement. If the bank senses that the owner may be able to sell the property, but needs more time, it may be worth it to them to wait a bit longer rather than take the chance that they will be stuck with the property. The last thing a large national lender wants to deal with is the hassle and overhead involved in maintaining and selling local properties. The reality is that lenders have more of these (known as REOs) than they know what to do with. This will probably be your strongest leverage point with the bank. As the sale date gets closer, compromise becomes more and more appealing. At a minimum, they may be willing to push out the sale date, and if you play your cards right, they may be willing to take a "short" payoff — short sales are when the lender will accept less than is owed.
In order to negotiate such a deal, you'll need to contact the "workout" or "loss mitigation" department (there are number of different names for this department) and speak with a real decision maker. It may take a few tries to work your way past their first line of defense, so be sure to have all of the ammunition and information you've gathered organized and ready to go. At a minimum, you'll need:
- Hardship letter describing how the borrower got into his current situation;
- Financial statements;
- Market analysis include overall local market conditions and comps;
- Detailed description of the property and its condition;
- Signed purchase agreement;
- Proof of funds from the investor.
In addition to negotiating with the first mortgage holder, you will also want to contact any additional lenders and lienholders. As a general rule, the further down the food chain the lienor is — a third mortgagor is in a much weaker position than the first mortgage holder — the more they will be willing to discount their lien amount. This is because they risk losing everything once the property goes to auction.
6. Financing Options
There are essentially four categories you will fall into when deciding how best to finance the purchase of a foreclosure.
- Assume the existing loan
This is probably the quickest way to take title without the concern of down-payments or expensive financing fees. With an assumable loan, the lender will allow, usually with credit and income checks, a new owner to take over the payments on the loan. Only a small percentage of FHA, VA, and owner-financed loans are assumable without lender consent so you'll probably need to pursue other options if you discover you're working with a conventional loan.
- Take title to the property subject to the existing loan
This is a risky and somewhat precarious method of acquiring title. Essentially, you'll continue to make payments to the existing lender (after you've reinstated the loan by paying all back payments, penalties, and interest), hoping to buy yourself time to either sell or refinance the property. The risk in this transaction is that if the loan has a due on sale clause, then the bank can default the loan if the owner has transferred the property, even if the payments are up to date. Some states allow land contracts as a creative way to take over the ownership of a property and keep the existing loan in place for a period of time. The due on sale clause in the existing loan documents will tell you if a particular loan needs to be assumed or refinanced in this case.
- Make an outright purchase of the property using a new loan
The upside here is the "cleanliness" of the financing. No concern over "due on sale" clauses or the like. The downside is that it may take an inordinate amount of time to run through the process of a conventional loan application, appraisal, title commitment, etc. The fees to accelerate the process can be expensive, and the more leveraged you are, the less likely you'll receive terms that seem acceptable.
- Pay cash
If you can do this, hooray! Keep in mind, if the cash is proceeds from another real estate sale, the IRS may even allow you to perform a1031 exchange and avoid the tax consequences of the sale by reinvesting in the new property.
7. Closing the Deal
If the deal looks good, you'll want to get a contract to purchase signed as soon as possible. It will take time to get title insurance and a closing set up, and you'll also want to eliminate the heat from the competition sooner rather than later. There's nothing worse than losing a deal at the last minute to someone else after you've done all of the legwork.
This is more than enough information to get you started, but stay tuned for future articles that will cover each of these steps in more detail. Until then, good luck!
Some Important Tips to Remember!
- Learn your local statutes. This point can't be emphasized enough, as you can dig yourself a deep hole if you don't have a basic understanding of the rules in your state.
- When searching or sorting by document types, you may find that the name of these documents changes from state to state or even county to county — they may also use "codes" in the index instead of the full name. For instance "MTG" for "Mortgage." Ask the county staff for help if you need it.
- Search by document type and date to find lis pendens and notice of default documents. Entering the most recent dates or date range will give you the "freshest" prospects.
- Not all lis pendens will be related to foreclosures, so you'll need to examine those documents in more detail.
- Pay close attention to your equity situation, and don't let your emotion sway you into a deal in which you are destined to lose money.
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