The Fundamentals of Foreclosures and Distressed Properties
Distressed properties can be a great opportunity for homebuyers with many potential financial benefits, as well as negative aspects. A foreclosure occurs when a homeowner defaults on loan payments and the lender takes steps to sell the property so that the loan may be repaid. There are three main types of Distressed Properties; Short Sales (pre-foreclosure); Auction Foreclosures; and REOs (lender-owned properties).
Short Sales (Pre-Foreclosure)
If the property owner misses 90 days of mortgage payments, the lender initiates the pre-foreclosure process by filing a public Notice Of Default. The borrower then has 60 days to either repay the loan in full or come to an agreement with the lender to avoid foreclosure. The lender may allow a Short Sale, where the distressed property can be sold for less than the loan balance on the open market. A lender will only allow a short sale if the property owner can prove financial hardship.
Auction Foreclosures
If no agreement is reached and there is no short sale, the lender forces the foreclosure auction of the property. There are two types of foreclosure auctions; non-judicial, and judicial. In Hawaii, non-judicial foreclosures are the norm. When this happens, the lender will publish a Notice of Trustee Sale for three subsequent weeks in a daily newspaper and schedule the foreclosure auction for two weeks after the last published Notice.
The auction typically takes place on courthouse steps and is open to any qualified bidder. If there is no qualified bid higher than the amount of the defaulted loan, then the lender will take ownership of the property with the intention of re-selling it again.
REO (Real Estate Owned or Lender sale)
If it does not sell at the auction, the lender will take ownership of the property and it becomes an REO (Real Estate Owned). REOs can be good for buyers in that the lender will want to sell the property quickly rather than carry the unoccupied home on their books. It can result in the bank selling the REO property below market value to encourage a quick sale.
Potential buyers of an REO property work directly with the property owner/bank throughout the sale, as opposed to a short sale in which the buyer has to deal with both the home seller and the lender. Working directly with the property owner/bank tends to eliminate the significant time lags that are frequently seen in short sales, and tends to promote a more smooth and trouble free closing.
Negative Aspects of Distressed Properties:
Foreclosures
No disclosure statement from seller (bank): In a normal property purchase, the seller always prepares a property disclosure statement detailing any problems/issues with the property that the seller is aware of. In a foreclosure purchase, the buyer purchases the property directly from the bank, and because no one from the bank has actually lived in the property, there is no disclosure statement provided to the buyer. This can be detrimental to the buyer because there can be any number of unforeseen problems with the property, which may not become apparent until after the property is under contract.
Property is purchased "as is": It is also worth noting that in every foreclosure sale the property is purchased "As Is," meaning that the seller will not pay for any repairs that are needed. Essentially, what you see is what you get, so buyers need to be very diligent in assessing potential damage to the property, and in determining a realistic value for the property. Utilizing a seasoned and knowledgeable real estate agent can be a huge benefit and is often essential in determining a realistic offer price.
Contract Verbiage: Another potential issue for buyers is that the verbiage of a foreclosure sales contract tends to be worded in a manner that minimizes the liability to the bank and prevents recourse from the buyer should any issues come up with the property after closing. Again, using an experienced real estate agent is critical to protecting your interests.
What are the disadvantages compared to other property types?
Your rights as a buyer are very limited when dealing with a short sale property: Even if the seller accepts your offer and signs the contract, the lender provides the final approval for the transaction. We have seen short sales in which the lender has cancelled the transaction on the same day that it was set to close. This can be very disappointing and costly because buyers have no recourse, and are unable to recoup any of the costs incurred during the escrow period such as home inspections and appraisals which can end up costing the buyer thousands of dollars.
You need to be flexible on when you close. The short sale transaction process is anything but short. We have seen short sales in which it has taken up to 6 months to process and close the transaction. This time lag can be especially detrimental in today's buying environment, where interest rates can change at any time. An increase in interest rate during the escrow period can adversely affect your mortgage payment amount by several hundred dollars per month, which can result in the property becoming unaffordable for you.
Short sale sellers try to secure as many offers as possible--even after they have an accepted contract--which keeps buyers in limbo: In regard to non-short sale transactions, when a seller accepts an offer, the status of the listing is normally changed from "Active" to "Pending." The difference with short sales is that in most cases, the seller will keep the property marked as "Active" after accepting an offer, with the intent of attracting more buyers so that they can get an offer that is higher than the one they initially accepted from you. If they do receive an offer higher than yours, the bank is extremely likely to accept that higher offer, and you would essentially be out of luck. We have seen short sale transactions in which up to 3 buyers have all had accepted offers from the same seller, and all 3 buyers had to wait months to hear back from the lender as to which of the offers the lender would accepted.
You will need to bring additional funds to the closing table to pay for the seller's closing costs: In a normal real estate transaction the seller pays their own closing costs, which include costs such as termite reports, title fees, recording fees, and pro-rated property taxes. These closing costs are normally paid using the seller’s proceeds from the transaction. In a short sale however, the buyer may need to pay for most or all of the seller's closing costs because there is no equity for the seller to use to pay for their closing costs.
You will need to do a lot of follow-up: It is essential to monitor the lender during a short sale to make sure that there has been a stay placed on the foreclosure action. This information can be difficult to attain, and if the property isn’t monitored effectively, it could go into foreclosure, and be taken off the market--even if the seller has accepted your offer.
Your closing must be completed quickly: Though approval from the lender can take several months to receive, once the lender accepts your offer, you must close the transaction within 14-21 days. If closing does not occur in that time frame, a fee of $150 per day paid can be assessed to you, the buyer.
The Seller is not likely to make repairs, replacements, or even clean the property: In a short sale transaction, the real seller is the lender. If the short sale property has defects and needs repair, the lender may be unwilling to pay for them. To put this into perspective, once you finally get into escrow with the property, you find out through the home inspection that the home needs a new roof and has foundation damage. You will have to pay for these repairs if you want to close the transaction. As a buyer, you have the option to cancel the transaction based on the home inspection, but if you want the property, the cost of any repairs falls on you.
There is also potential for title issues relating to how the foreclosure was initially recorded. As a result, buyers of REO, lender sale and foreclosure properties should always consult with a seasoned real estate agent to make sure that their needs and best interests are being represented.