Though the discount on foreclosed properties is not as large as it once was, being able to have access to discounted properties of any kind is still quite tempting for many real estate investors. During the mortgage crisis of 2007-2010, foreclosed properties were sold with an average discount of about 25%. Today, the figure is around 16% which still represents a significant discount.
But before anyone gets too excited about the prospect of investing in foreclosed properties, it is important to recognize the amount of effort that is actually involved. We take a look at the dynamics of the foreclosure investment market, its risks, and its obvious potential to yield above-average returns on your investment.
What is Foreclosure Investing?
A property is foreclosed when the owners of the mortgage have violated their mortgage’s specific terms and agreements. Usually, foreclosure is a consequence of people failing to make their mortgage payments, but depending on the terms of the mortgage, there may be other events that can trigger a foreclosure (such as abandonment, tax issues, etc.).
Once a property has been foreclosed, the bank (or another mortgage provider) becomes the full owner of the mortgage. Banks usually prefer to have a relatively liquid asset portfolio and will often try to sell the foreclosed mortgage in a short amount of time. However, there is still a significant portion of foreclosed mortgages that never actually make it onto the market. If sold, the foreclosed mortgage will be sold at one of several different types of auction venues for a price that is usually well below the market value.
The individuals acquiring these properties at auction are referred to as foreclosure investors. In the ideal situation, the foreclosure investor will be able to put the property on the market themselves and earn more than they paid for it. However, as the real estate industry has demonstrated time and time again, there is no such thing as a risk-free investment. Being able to quickly flip a foreclosed property into cash should never be assumed as a guarantee.
Determining the Value of the Property
Before entering the foreclosure investment market, it is important to try to determine the objective value of the property you are considering buying. Without a firm understanding of what a property is actually worth, it will be impossible to know the amount of discount you are getting or if you are even getting a discount at all.
Ideally, you will be able to inspect the property before making an actual investment (or at least hire a professional to inspect the property for you). This is really the only sure way you can avoid the horror stories that deter many people from even entering the foreclosure market. There are many different components of the property valuation (appraisal) process. The foundation, infrastructure, and utilities of the home are among the most common sources of unwanted “surprises.” The typical inspection checklist may have upwards of 100 different things that will be worth looking into.
Though being able to take a look at the home before investing would obviously be ideal, many foreclosed homes are sold blindly at an auction. There may be pictures or reports available at these auctions describing the status of the home, but this information is something you should almost always take with a grain of salt. In general, if you are trying to do a rough valuation of a property you are considering buying blindly, looking at the prices of recently sold homes in the neighborhood can help you at least begin to estimate what a “fair” deal might be.
Asking the Important Questions
The primary risks associated with investing in a foreclosed property are deception, liquidity issues, and having to put in an unexpected amount of work in preparing the property for resale. While the average time on the market varies by location, foreclosed properties usually require a longer amount of time to be resold.
Before investing in a foreclosed property, there are many important questions you should take the time to try to answer.
- How long can I go without being able to sell this home?
- What is the lowest rate of return I would be willing to accept on this investment?
- What are the current conditions of the real estate market in general? Is it currently a buyer’s market or a seller’s market?
- How long have other foreclosed homes in this area typically stayed on the market before selling?
- How much work am I willing to do in order to make this home sellable?
If, even after answering these questions, you still believe that the home you are considering buying is worth the risk, then investing in foreclosed properties isn’t something you should outright dismiss. But it is very important to note that foreclosure investing should never be considered to be risk-free.
Earning a Return on Your Investment
Foreclosed properties can provide lucrative returns on your investment if they are sold and if the market conditions are right. Buying something for $80,000 and selling it for $100,000 can be a financially justifiable decision, even if you believe there will be $10,000 worth of work involved. But one part of the foreclosure investment industry that is frequently overlooked is the time value of money.
Part of the utility of money is its unique ability to be immediately exchanged for something else (liquidity). But if this money is not something you will be able to access until later, this utility naturally decreases. If someone could be guaranteed to sell an $80,000 property for $100,000 later today, they would have no reason not to invest. But there is no guarantee that this sale will even take place and even if it does, the amount of time between now and then will cause this apparent $20,000 profit to be worth much less.
There are some things you can do to increase your return on your investment such as converting the property into a temporary (or permanent) rental property. Continually doing work to improve the conditions of the property can also make it easier to get off the market, but there are still no guarantees in this recognizably fluctuating industry. Whether foreclosure investing is worth the effort will depend on your personal level of risk acceptance, your patience, and your willingness to put in some work. But as is the case with almost all large financial markets, it is important to recognize that there is very rarely such a thing as easy money.