Foreclosures, Pre-Foreclosures and Short Sales

I have had an interesting week, working with a investor buyer who is trying to acquire a property that is in the foreclosure process. We weren't able to get the seller to bite on my buyer's bid, but nevertheless, it's been a very interesting few days.

When I very first got into real estate, I met a woman who worked for one of the big title companies who said to me something that at the time I thought was just a terrible thing to say, but now I realize was quite prescient. She said that I should be saving my money so as to be able to invest in the wave of foreclosures that she predicted was coming. Not being the kind of person who WANTS to profit from others' misfortunes I thought this was pretty heartless but in retrospect, I think she was right on the money.

Unfortunately, the last 4 or 5 years have seen lenders really lowering their standards as far as who they will lend money to. In one sense, it's good because it has allowed a lot of people to qualify to own their own homes who years ago would have been turned away. But it also means that a lot of people are in homes they can't afford, with 3 and 5 year ARM loans that are approaching the end of their fixed period. And, a lot of loans are what are called "no docs" loans, which means that people can claim a means of payment that may or may not exist, just to get into the house of their dreams. There are also negative amortization loans, which, rather than paying down interest and principal, actually ADD interest to the outstanding principal against the home. So, your interest rate is 2% as far as what you pay for now, but the extra interest (4% or more) is added to the principal, and counts against any equity in your home. So, when you sell it you end up owing money!

These loans suck. They prey on people who don't have a lot of income, have poor credit, and are not very financially savvy. Not surprisingly, the chickens are starting to come home to roost.

Back to my investor client. He was looking for a property that met a very specific, difficult to find set of criteria, and it so happened that I found a house that was a perfect fit. So we went out to take a look at it. Something about the house (perhaps it was the dirty diaper that greeted us at the bottom of the basement stairs, or the dead pet rabbit in the backyard? Don't believe anyone who tells you that real estate is a glamorous profession!!) made us feel that something about the place wasn't right. When you've been in enough houses, you start to get a feel for when a divorce, a death or financial problems are part of the picture. Anyway, we did some research and sure enough the house was subject to a pending Notice of Trustee's Sale. In other words, it was in foreclosure.

A search of the county records will usually tell you if a Notice of Sheriff's Sale, or a Notice of Trustee's Sale has been recorded against a property. Typically, if you haven't made a payment for 6 months, and you haven't made any arrangements with your lender to catch up on your payments, your lender will begin foreclosure proceedings. The first step is one of the two above Notices. I would explain the difference but that would get us into a discussion of different ways to hold title and it would probably be boring.

Anyway, these Notices are intended to inform the public that the house will be sold at auction unless the "arrearage" is "cured" or cleared up before a certain date. Here in Washington, that certain date is 11 days before the auction. Any money from the auction will go to pay off the creditors with a claim on the house. If the situation is bad enough, there won't be enough money to pay them all, and some of them will remain outstanding against the house, and the new owner can end up taking them on. This is a risk you take when you buy a house at a foreclosure sale. You also don't get to inspect the property.

A seller can stop the sale from happening if he is able to make arrangements with the lender, or if he is able to sell the house for enough money to pay off all outstanding debts recorded against the house before the cure date. If he gets an offer to purchase the house but it isn't enough to pay off all the debts, then he has to get his creditors to agree to a payoff that is less than they are owed. This is called a short sale.

If none of these things occur, the house will go to auction. The lender doesn't really want this to happen because the price they get at auction is often less than they are owed, plus, they aren't in the real estate business. They are in the lending business, which means what they really want is just to be paid back. But, if this is the only way they can get what they are owed they will do it.

From an investment perspective, buying a property at auction or on a short sale can be a good way to pick up a house for less than the market price. However, there are risks involved. For instance, you can get stuck with any outstanding liens against the house, or there can be problems with the house that are expensive to fix, such as needing a new roof. But if the price is right, a lot of investors are willing to take this risk in order to reap the profits on a flip. A lot of the time it works out pretty well.

Unfortunately, this particular house was also subject to more liens and judgements than the house itself was worth, and it was still the seller's right to accept or reject an offer to purchase the house. So, in order to obtain clear title, we needed to work with them as well as their lender to get them to accept our offer. The only way the sellers could pay off all their creditors and also pay closing costs would be if a buyer paid more than $50K over the fair market value of the house. My buyer wasn't going to do that.

So, we came in with a pretty low offer that was enough to pay off the first mortgage but not the home equity line, and we offered to pay closing costs. If we'd have gotten the sellers to agree it would have just been the beginning of the process. Sometimes it can take months to get a lender to agree to a short payoff. Doing so can be to their benefit--actually foreclosing on a property costs a lender quite a bit of money in terms of legal fees and so forth, so sometimes it makes more sense to cut their losses before it gets that far.

It can also be to a seller's advantage, because it reduces the damage to their credit rating of having a foreclosure recorded.

And it is obviously to a buyer's advantage, because they don't have to overpay for a property or take on the seller's debts.

But it's a complicated process and a lot can go wrong. Unfortunately, we didn't get out of the gate with this one. The seller didn't go for it--maybe they were not desperate enough yet! But it was a real eye-opener, and gave me something to talk about in ye olde blog. These sellers were a perfect example of WHY we will probably see a lot more of this kind of transaction in the years ahead. They had no way to make a payment (no verifiable income!) yet, they received a loan for a $400K house, then a 2nd home equity loan just 7 months later. They had a no down payment, negative amortization loan, and this wasn't even the first time they'd been in foreclosure!