- Clients can reap substantial rewards when buying foreclosures directly at public auctions.
- There are great risks involved with buying foreclosures at public auction.
- Clients need to be educated as to how they can mitigate risk when purchasing foreclosures at public auction.
When investors purchase foreclosures through an MLS, they are usually able to gain access to the interior of the property before making an offer and know that they will be guaranteed clear title before they close.
But, with these two benefits comes the fact that numerous investors will be placing offers. And, more offers usually mean higher prices and less of a chance of getting a true bargain.
Therefore, some investors might consider purchasing foreclosures at public auctions, before they make it to the MLS system. Agents whose clients are contemplating such purchases should educate those clients as to the inherent risks involved.
These risks are:
- Knowing the priority of the mortgage being foreclosed.
- Being able to estimate the amount of rehab a property will need properly without gaining interior access.
- Determining whether there will be any certificate of occupancy (CO) issues.
- Determining whether a property is occupied or vacant and all that is entailed with a legal eviction.
- Properly estimating the resale of a property once the renovations have been completed.
Knowing the mortgage priority at a foreclosure sale
Many properties that are going to foreclosure have multiple mortgages on them. Speculators must do proper due diligence before each foreclosure auction to make sure they know whether they will be bidding on a first lien or a subordinate lien.
However, the fact is that usually less than half the properties that are scheduled to go to sale actually go off on any particular day. Thus, investors must do extensive research on numerous properties, all the while knowing that at least half their research will be for naught.
Even experienced investors have sometimes unknowingly placed bids on properties where the second or third lien is being foreclosed, only to find out that they have to pay off all the superior liens.
In such cases, what was thought to be a profitable deal quickly deteriorates into a substantial loss. But once a foreclosure sale has been completed and the down payment has been tendered to the court-appointed referee, there is no turning back.
Investors who bid on a subordinate lien without knowing what is owed on the superior lien or liens will lose their down payment should they not complete the purchase of the property. Foreclosing banks do not want to hear the words, “Please give me my money back. I made a mistake!”
In cases where a speculator does know that he or she is bidding on a subordinate mortgage, it is still nearly impossible to know the exact payoff of that lien.
Yes, many counties now have websites where investors can view a detailed list of mortgages and liens against a property. But just knowing the original amount of a superior lien does not tell one the current amount owed.
When a mortgage goes into default, the loan is accelerated, meaning the interest rate increases and the loan becomes fully due and payable. Thus, with accelerated interest now accruing on the entire outstanding balance, late fees, payments for insurance and taxes, attorney’s fees and so on, the amount due on a loan can easily double in just a few years.
Before the foreclosure sale, loan payoffs are only given to the mortgagor upon request, not investors interested in bidding at the auction. The best most speculators can do is to approximate the payoff amount.
Unfortunately, even the savviest investor will often find that his or her approximation of the amount currently due will be significantly off the mark once the loan payoff has been generated after the sale.
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Estimating the amount of rehab a property will need
It is illegal for a speculator to enter a vacant property before the foreclosure sale. Therefore, most investors will have to extrapolate interior condition from an exterior assessment.
Although it is true that a number of speculators will enter a vacant property prior to a foreclosure sale regardless of the legality of doing so in order to be able to gauge more accurately the repairs needed, the fact remains that it is extremely difficult to know just what lurks behind walls, under floors, in roof rafters and so on with only a quick view.
Thus, estimating the repair cost in advance of a property being foreclosed takes a great amount of skill and is often the difference between a deal being profitable or incurring a loss. Many speculators have lost significant amounts of money due to underestimating the repair cost of the foreclosure they purchased.
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Missing certificates of occupancy
Many homeowners build on to their homes without securing the proper certificates of occupancy (COs) from the town. What looks like a colonial could easily be a ranch with an added second floor where the homeowner has built onto the house without obtaining the proper permits and COs.
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Thus, speculators can many times find themselves in situations where they can’t resell a house because there are no COs in place. If a variance is needed from the town, the length of time an investor can be stuck in a deal could increase substantially.
Investors usually expect a deal length of four to six months. If a variance is needed, that deal length could easily double or triple.
Thus, with the added holding costs, permit costs, etc., a foreclosure deal can easily turn negative before one knows it.
One might ask the question, “Isn’t it incumbent upon one bidding at a foreclosure sale to research all the COs on a property?” The answer is, of course, yes. But, this is easier said than done.
Often this sort of information is only available through a Freedom of Information Act (FOIA) request at the town, which can take weeks to respond.
Also, keep in mind that only half the scheduled foreclosures go off, so it’s virtually impossible to research every potential property acquisition completely in advance of the sale. Thus, missing COs presents a significant risk to those speculating in foreclosure sales.
Dealing with occupied homes
Not every foreclosed property comes vacant. Many times the prior homeowner/occupant will remain in the house until he or she is legally evicted.
Some counties can process evictions in just a few weeks, and in other counties, the eviction process can take many months. Some states even have laws requiring that tenants be given 90 days notice before the eviction process can be initiated.
The time spent dealing with prior homeowners, tenants in possession or even squatters can quickly turn a profitable deal into a losing one.
Properly estimating the resale of a property before the foreclosure sale
Another area of risk associated with purchasing foreclosures at auction is the ability to properly determine the resale value of the property once it has been rehabbed. When there are identical houses on a block, and numerous recent sales in the public records, a speculator’s task of knowing what a property will sell for is not all that difficult.
The problem arises when there is no prior listing on a particular property to determine the room count and other pertinent attributes, or the neighborhood has many different house types on the same block or not enough comparable sales to determine value.
Let’s say an investor strikes down a house for $150,000 that he or she expects will need $50,000 worth of rehab. After the house is minted out, he or she expects it to sell for $250,000.
After factoring in title and legal fees at the purchase closing, insurance, real estate commissions, property taxes and other holding and resale costs, the investor expects to make a profit of $30,000, or 15 percent, on his money.
However, if he overestimated the resale value of the house and it only sells for $220,000, all his time, money and effort have been wasted on a break-even deal.
If the repair costs even increase by a mere 10 percent, the deal quickly turns negative.
Thus, properly estimating the resale of a property before striking it down at auction is imperative in determining the profitability (or lack of) of a foreclosure deal.
So there you have it. Although great bargains can be had, there are also great risks associated with purchasing foreclosures at public auction.
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Dino P. Ascari is a New York state licensed real estate broker with Island Properties Realty. Connect with him on LinkedIn.
