Foreclosed properties, also known as distressed properties, are often cheaper than homes of comparable value on the market. They can turn out to be profitable investments, especially if you’re willing to put in the work. However, there are certain risks associated with foreclosed properties that you need to take into consideration before buying one. Below, we explore what makes buying a foreclosed property risky and how you can lessen those risks.
The Truth About Buying a Foreclosed Home and Why Banks Sell Foreclosures for Cheap
Banks and other mortgage lenders foreclose on homes to recoup the remaining mortgage loan amount and associated foreclosure costs.
One of the things that makes buying a foreclosed home risky is that they can take a considerable amount of time to process, depending on the state. According to ATTOM, the average number of days for the foreclosure process is 815, although this number greatly differs from state to state.
There are five main types of foreclosure: pre-foreclosures, short sales, publicly auctioned properties, bank-owned real estate, and government-owned real estate.
When you buy a foreclosed property, you are essentially taking a gamble that the home will be worth much more later on (even after rehabbing costs have been deducted) than the price you paid for it initially.
Regardless of the type of foreclosure, owners are usually more motivated to get the property off their hands than to make a profit. Therefore, foreclosed properties tend to be sold for much less than other types of homes, either in the MLS or off-market. Realtor.com says these homes can sell for as much as 15% below their actual value.
Another reason foreclosures are priced lower than market value is that houses cost money to maintain and manage, and banks don’t want to bear that cost. They also cannot keep the excess proceeds from the foreclosure sale since they are legally required to return them to the original owner. This way, foreclosed homes can seem cheap since banks have no incentive to overprice them.
Despite this, lenders are not powerless in a foreclosure sale. They decide the opening bid price, and interested buyers must bid from that price. Foreclosed properties can sell for much higher than the opening bid price, especially if the market is competitive.
What Makes Buying a Foreclosed Property Risky? Top 8 Disadvantages to Know
Several reasons make buying a foreclosed property risky. Some are associated with the nature of the property itself (an investment that is no longer sustainable), while others are related to the foreclosure process. Let’s see what makes buying foreclosed property risky:
1. Hidden costs and expensive repairs
The truth about buying a foreclosed home is that the property is usually sold as-is. There will likely be one or two issues with it. Any damages or structural issues with the home are left to the buyer to handle. These problems may become more extensive and require much cash to repair. Also, there are bound to be hidden costs in the form of increased property taxes after rehabbing the foreclosed home.
2. Risky process
One of the biggest things that makes buying a foreclosed property risky is the buying process itself. Aside from the fact that the seller or bank is not liable for failure to disclose property defects, there’s no guarantee that the extensive repairs you’ll need to carry out will yield a commensurate return on investment when you sell the property. Also, if the owners have left the property vacant for a while, it might be occupied by homeless people or undesirable elements.
3. You may not be able to inspect the home’s interior
A home inspection is considered standard practice before paying for any rental property. But can you inspect a foreclosed home before buying? Yes, you can inspect the exterior. However, you may not be allowed to conduct a full home inspection before a foreclosure auction. You are only allowed to inspect from the outside. This puts you at risk of going over budget to make the home saleable.
4. Takes longer to complete the process
The rate at which a foreclosure moves between phases tends to vary from state to state. Generally, lenders must wait until the borrower is 120 months behind their mortgage payment before starting the foreclosure process.
Before the house is auctioned off, the lender has to file the case with the state court. If the state allows non-judicial foreclosure, the lender can schedule a date for the property sale immediately after filing the paperwork. However, if judicial foreclosures are the norm, they need to wait for court approval, lengthening the process considerably. Buying the property via a short sale instead of an auction can also make the process longer than usual.
5. You may assume previous liens and unpaid taxes
Winning a foreclosure auction might leave you with liens and unpaid taxes from the previous owner. Some liens get cleared in the foreclosure process. Others such as IRS taxes and property taxes become the responsibility of the new owner.
6. You might not get a traditional loan
Due to the high risk associated with this type of investment, a traditional loan might be challenging to obtain to finance a foreclosed property. You may have to pay all cash or secure a hard money loan.
7. Harder to secure insurance
Insurers might be unwilling to take the risk on a foreclosed property, especially if it’s not been maintained over the years and has fallen into disrepair. Insurance companies that provide coverage for these properties tend to charge high premiums.
8. Removing former tenants/occupants is your responsibility
Understandably, the previous residents of a foreclosed property won’t be too pleased with the turn of events. Consequentially, tenants are one of the biggest things that makes buying a foreclosed property risky. They might vandalize the property and cause further damages or even refuse to leave the premises.
You must send a notice of eviction to the residents and file an eviction case with the court. The entire process can take 30 days or more. In some tenant-friendly states, tenants must have a 90-day notice of foreclosure.
6 Tips for Buying Foreclosures and HUD Foreclosed Homes With Less Risk
Below are strategies you can employ to minimize the risks of buying foreclosed properties and HUD-foreclosed homes. HUD (Department of Housing and Urban Development) homes were purchased with FHA-insured loans and repossessed by the government.
1. Ensure your offer includes a home inspection contingency
You should only buy a foreclosed home if you have a home inspection contingency in place first. An inspection contingency allows you to conduct a professional home inspection in the timeframe before the contract becomes legally binding.
The inspection will check for structural issues and check major systems like HVAC, electrical, and plumbing to see if everything is in working order or if any repairs are needed. If you can afford it, you should hire a specialized home inspector to carry out inspections like pest, chimney, and water inspections. Note that homes sold “as-is” are not available for inspection.
2. Work with a Realtor who has experience working with foreclosed properties
You might think that skipping the agent and dealing directly with the seller might save you costs, but that hardly turns out to be the case, especially if you’re a first-time buyer. An experienced real estate agent can be indispensable when dealing with foreclosures for the first time. The agent will help you find foreclosures, walk you through the process, negotiate with the lender’s agent, make sure an inspection is carried out and present your offer.
Ultimately, a savvy real estate agent can help you avoid costly mistakes and save money in the long run. The Department of Housing and Urban Development requires you to work with a HUD-registered agent to submit a bid on one of their homes.
3. Get financing ready so you can act fast
You should consider getting pre-approved for a mortgage loan. A mortgage pre-approval letter allows you to compete with all-cash buyers. Remember that the letter is only effective for two to three months at most. Some financing options available for foreclosed properties are:
Conventional
Getting a conventional mortgage for a distressed property can be difficult but not impossible. As long as it is still habitable (i.e., no holes in the roof, functional kitchen, etc.), you should be able to find a lender for the home. You can consider getting pre-approved with the same lender or bank that sold the property as long as their rates are reasonable.
203(k) Loan
An FHA 203(k) loan is a government-insured loan that enables homebuyers and homeowners to finance the purchase and renovation of a house. Based on the extent of repairs, there are two different types of 203(k) loans: limited 203(k) loans and standard 203(k) loans.
As with other FHA loans, a 203(k) loan requires a 3.5% down payment and has a lower interest rate than other options. However, getting a 203(k) loan can take some time, and you are required to pay a mortgage insurance premium every month.
Fannie Mae HomeStyle Renovation Loan
The Federal National Mortgage Association (or Fannie Mae) offers a mortgage product known as the HomeStyle Renovation Loan that is perfect for financing foreclosed properties. This loan allows you to finance renovation costs and the purchase of a home with one mortgage. It comes at a much lower interest rate than personal loans. You may need to put in a bit of work to find a Fannie Mae HomeStyle lender.
Also, getting a HomeStyle Renovation loan requires a higher credit score than a 203(k) loan. However, the HomeStyle loan offers greater flexibility on the type of property you can use it for and the renovations you can make.
Hard Money Loan
This should be a last-resort option after you have exhausted every other alternative. Down payments can be as high as 30%, and interest rates can be quite exorbitant. Hard money loans are not advised if you are just starting out.
HUD homes can be challenging to finance because they often need extensive repairs. Also, most foreclosure auctions require cash, bank money orders, or checks for payment. So, you should consider the type of foreclosure you’re dealing with while selecting a financing option.
4. Do significant research on the property and the neighborhood
One of the simplest ways to buy a foreclosed property with less risk is to find out as much as possible about the previous owners and the circumstances surrounding the house. If possible, talk to the prior owner of the property. They may provide you with helpful information that is private only to them.
It is necessary to conduct a title search on the property to determine if there are any liens or claims against it. You should also find out information about the neighborhood such as crime rates, trends in property values, and available amenities to decide if the investment is worthwhile or not.
5. Go for short sales instead of auctions
In a short sale, the bank agrees to allow the sale in exchange for getting back what they can from selling the house at a discount. In this case, the homeowner has to show proof of financial distress. Short sales are generally easier to close, but the lender may take a long time to approve your offer.
Auctions allow you to get the home faster but offer less room for negotiation. Additionally, most auctions only accept cash payments. Ultimately, it is up to you to decide which one works for you. However, short sales do not affect a homeowner’s credit score, so the homeowner is motivated to sell.
6. Make sure you have enough money for renovation
Renovation costs can make buying a foreclosed property risky, especially if you don’t do your due diligence beforehand. Making the property livable can end up costing much more than you planned. Hence, it is wise to get an estimate from a contractor before buying so you have a budget in mind before moving forward with the purchase. When planning upgrades, you should ensure that they will have the desired impact on the property’s value. You should also have a good sense of how much work is too much. A foreclosed property that needs major remediation work may not be worth the hassle.
Final Thoughts
Foreclosed properties are not without benefits. They save you money and offer the potential of a huge return on investment. However, they are still a risky investment and are not advised for first-time investors. This article has shown you what makes buying a foreclosed property risky and how you can avoid the pitfalls.
If you’re looking to buy real estate in a less risky way, RealWealth can help! We work with turnkey property teams around the country that sell REAL Income properties™ with property management already in place. Join RealWealth today; membership is 100% free!
