Buyer's Basic Guide to The Foreclosure Market and REOs

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I've written articles on when you can't make your mortgage payment and how to react if you see foreclosure coming in time to do something about it, and even on Short Payoffs, but all of those are owner (seller) oriented. This is intended as a basic buyer's guide to getting a bargain from people who bit off more than they could chew, with emphasis on the current local market but applicability anywhere.

There are essentially four phases in the foreclosure process. The first is pre-default. They've made late payments or none at all, and there's no way they can keep the payments up, but they won't do the intelligent thing, which is sell for what they can get. Many people who own properties headed for default are deep in Denial. Yes, this is often because something bad happened to them for reasons beyond their control. I'd be happier if those sorts of things didn't happen, but the amount of rescuing that's going to get done is minimal. There are very few White Knights running around, and the ones who claim to be White Knights are usually blackguards. Unless the seller knows of some factor that is going to change, this is the smart time to deal with the problem. Before the Notice of Default is recorded, nobody really knows but the owner and the bank. Once the Notice of Default hits, all the sharks come out because everyone knows the owner is in Dire Circumstances. Let's face it: most folks will make the payments on their home even if they let every other bill slide. When someone can't make their mortgage payment, and it's public information as a Notice of Default is, everybody and their pet rock knows that don't have any choice but to sell. They'll flood you with offers, but they won't be good offers.

Now if you're looking to buy at this stage, the thing to do is examine the Multiple Listing Service. "Motivated seller" and similar phrases are often code for "These people can't make their payments!", particularly in the current market with prices declining somewhat and many people who stretched beyond their means. It would be great to be able to get a list of properties that are sixty days or more delinquent, as this would include the folks in denial, but it just isn't going to happen. The only folks who know are the banks and the credit reporting agencies, and they are prohibited by privacy laws from disclosure. So at this point all you have to deal with are the people who are not in denial. Now when the market is rapidly appreciating, this is a good place to find a bargain, because once the Notice of Default hits, the sharks swarm, so if you can find these people before that, you're in a strong bargaining position if you correctly suspect they can't make their payments. The taxes being delinquent is often a good indicator of this, but there is no way to know for sure unless the people or their agent tell you, and the agent who tells you has just violated fiduciary duty. This can mean prospective buyers overplay their hands in negotiations, which is fine if you intend to move on if you can't get a "Manhattan for $24" type deal, but if it's a property you want and can make money on, overplaying your hand can poison the atmosphere. There aren't many "Manhattan for $24" type deals out there, because if you wait that long, someone else already has taken it. There are a lot more good opportunities for someone willing to pay a reasonable price and hold the property a while or make improvements. Deals so good that they instantly make oodles of money, someone will usually come along and offer the poor schmoe on the other end a better deal, and if the poor schmoe has a decent agent who's looking out for their interests, they can switch to the other offer. Buyers and escrow companies don't like it, but it can be done. It's extra work for the listing agent, so they may not want to, and they may not have done the best set-up, but it can usually be done anyway.

The reason it's smart for sellers to sell at this time is that this is when they are going to get the best deal. The mere act of entering Default is likely to cost thousands of dollars. Furthermore, this is the phase with the most opportunity to find a property at a better than usual price for buyers, because most of these don't get to actual default. Someone will come along and make an offer, and a listing agent who gets an offer on one of these is likely to advocate taking the first reasonable offer, reasonable being defined as "anything like the asking price".

The second stage of the foreclosure process is default. The Notice of Default has been filed, and because it is a matter of public record, the sharks instantly react to the blood in the water. The seller is going to get dozens to hundreds or even thousands of solicitations. Also, once the property is in default, the bank can require the owner bring the Note entirely current in order to get out of default. Whether or not the property is listed, they're going to have agents offering to sell it for them, individual buyers who want those Manhattan for $24 deals, and lawyers offering to "protect" them by declaring bankruptcy. By the way, I've never heard of anyone who came out better in the end by declaring bankruptcy, so you probably don't want to do it if you're in this position. I know it's your home, and you're likely extremely emotionally attached to it, but declaring bankruptcy doesn't mean you don't owe the money when it comes to a Trust Deed. Every single one of these folks, lawyer, agent, or prospective buyer, knows that you're in default. Some owners are still in denial at this point, but all denial means at this point is that such an owner is not likely to take the best offer they'll get. It's at this phase that most "subject to" deals happen, usually with highly appreciated properties with significant equity over and above the trust deed. If the owners owe anything approaching the value of the property, that's a silly situation to do a "subject to" purchase for buyers, and most of the prospective buyers (those with decent advisors or agents or experience) won't do it if the equity is less than a certain amount or proportion of the value.

The third phase of a foreclosure is the auction. This is typically a very short period. Five days before the auction date itself, the owner loses the legal right to redeem the property, although the bank will usually let them until the last possible instant. There is also a legal requirement to vacate the property before the auction. "Subject to" deals can still go through as long as the bank will accept redemption. Now the auction itself requires cash or an acceptable equivalent. You don't go to the auction and then get a loan later. At the very least you have to have the loan prearranged and a check for the proceeds in hand. This can mean that the rate is significantly higher, and it can be difficult to refinance within the first year.

The fourth phase is after the auction. In California, if the property does not get a bid for at least ninety percent of appraised value, it does not sell and becomes owned by the bank. The bank doesn't want it; they're not in the real estate business and in fact, they are legally required to dispose of it within a certain time. In the current market, this can be the best place to acquire a property. The bank knows they're taking a loss, and the longer it goes, the bigger the loss. Mind you, because the bank usually takes a loss, few properties go to this stage. The lenders will usually do anything reasonable in order to avoid auction, but once it goes to auction, they want to get rid of it. They usually require a substantial deposit, but the purchase price can be the best of all.

One thing to be wary of in foreclosures is they are often in less the ideal condition, to say the least. These people know they are losing the house, and often that they are going to come away with nothing in the best realistic case. They have no incentive to take care of the property, and many actively work to mess it up. This is cause for care in purchasing them, and inspections, because not all of the damage may be obvious. Furthermore, many of them may have been unable to afford proper maintenance for some time before they lost the property. Purchasing a foreclosure can mean you will need a large reservoir of cash in order to fix up the property to habitable condition.

Caveat Emptor

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This page contains a single entry by Dan Melson published on December 20, 2007 7:00 AM.

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