Monday, April 07, 2008

Should You Invest In Foreclosures?

Periodically I hear from readers who want to make $1 million in real estate -- quickly and with no money down. Usually they want to know more about real estate foreclosures -- how to buy them and how to profit from such homes. I've participated in a couple of these deals, and I'm now working on my second million -- I gave up on the first.

Foreclosure properties can be a good place to invest for exponential growth (or loss). There are some deals out there for little or no money down, but potential investors should take precautions because foreclosed properties can involve significant risks.

There are various ways to invest in foreclosure properties. The first and probably most popular is to purchase a property, fix it up and then rent it out, hopefully creating a positive monthly cash flow. The investor then becomes a landlord, with all the responsibility of an investment property owner.

The second way to invest is to seek out foreclosures or "handyman" specials, buy them, invest more money to fix them up and then sell them, taking -- hopefully -- a profit once the house is sold.

A third approach is to purchase a foreclosure that is underpriced and selling it immediately at a higher value.

One way to sell homes for a higher value is to take back a mortgage. For example, let's say a house worth $100,000 is sold at a foreclosure to an investor for $50,000. The investor may put down 10 percent and assume or create a new mortgage for $45,000. The investor then advertises the property at a discount, say $80,000, offering 100-percent seller financing (remember, we're figuring that like houses are worth $100,000).

The owner hopes to create a sense of urgency by underpricing the house and pulling in buyers.
If successful, the investor takes a promissory note from the new purchaser for $80,000. He has now created a $35,000 note for himself (The difference between the $80,000 sale price and the original $45,000 mortgage). The new buyer makes payments to the investor for an $80,000 loan and the investor makes payments on the original loan for $45,000. In real numbers, here's what it would look like.

If the original loan is for $45,000 at 8 percent over 30 years, the principal and interest is $366.88. When the second buyer takes a note for $80,000, the investor may charge a bit higher interest since he's offering 100 percent financing.

Let's say he offers an $80,000 loan, 9.5 percent over 30 years. The monthly payment is $672.68, creating a positive cash flow of about $306 per month.

If the borrower stays in the house for 30 years, the investor will make $88,295 in interest and $30,000 in capital gains after he's paid his own interest on the first note for a total return of $118,295. Not a bad return on a $5,000 downpayment.

Keep in mind that not all mortgages allow an owner to "wrap" a second mortgage onto original loan. Most loans today contain a "due-on-sale" clause, meaning if the property is sold, the first trust must be paid off immediately. Wraparound financing is popular when investors purchase foreclosed Veterans Affairs (VA) properties as the VA allows wrap-around loans in such cases.
Before you go out, checkbook in hand and ready to bid away, take some advice first.
If you're deciding to invest in foreclosure properties with a spouse or with other investors, be sure that everyone understands this form of investing. You are about to enter a world of high finance, property management, calls in the night from tenants and other risks that regular homeowners never experience.

Second, get educated. Reading this column does not constitute preparing the first-time investor to start bidding on properties. There are plenty of real estate agents and auctioneers who do this on a daily basis and would be happy to educate you in the world of foreclosure properties. Also, visit the bookstore for guides by reputable authors who know investment intricacies.

  • Third, be realistic.
  • Not all foreclosures are good deals.
  • Not all foreclosed properties are available at discount.
  • If you take back a loan your buyer could default.
  • Most loans today prohibit wraparound financing.
  • Repairs might be far more than you expect.
  • Not all tenants pay their rent on time -- or at all.
  • Some renters damage property.
  • Changing interest rates could impact your bottom line.
  • It may not be possible to re-sell the property without extensive -- and costly -- repairs.
  • Not every deal yields a profit.
  • If you have a profit you may face taxes.
  • If you only look at foreclosures you may miss other investment opportunities.

The list of potential downers goes on...and on and on.... Think of it this way: If making money with foreclosures was both easy and a sure bet every time, no one would bother with IPOs -- or jobs.

Fourth, get professional help from brokers, lenders, attorneys, accountants, home inspectors, and others.