Tips for Buyers of Distressed Properties

The number and variety of distressed properties on the market (foreclosures, short sales, bank-owned and others) now make this type of property attractive for the first time home buyer or investor. Many are listed and sold at under-market prices.

However, purchasing a foreclosure is not for everyone. There are some characteristics of purchasing a foreclosure property, which make it different from purchasing a “normal” property. Buyers need to be cognizant of these characteristics to avoid some of the pitfalls of purchasing a foreclosure.

Note: these comments are directed to buyers purchasing REO and other bank-owned properties, which are listed by a realtor and which have already been through the foreclosure process. Some of these statements may also apply to purchasing a property on the courthouse steps, but buyers of that type of property need to do their own due diligence.

1. Have the money before you shop. Buyers of REO properties must be pre-approved by a lender and have an approval letter that can be attached to the offer. If a buyer will be paying cash, proof of funds should accompany the offer or it may not be accepted.

2. Delayed closings and red tape are normal. The buyer may have to wait for some time to close and may have to maintain the mortgage commitment even through fluctuating interest rates. Another issue may be that a delayed closing may mean that they could be without a home for a time, especially if they are purchasing the home to be their primary residence. On the other hand, an offer which includes a quick settlement (i.e. within 30 days) is more likely to succeed than one which requires an extended settlement date.

3. Foreclosed and REO properties are sold “as-is.” They may be a really good deal, but they may need significant work to make them livable. If the buyer doesn’t have funds to do that, they either need to consider a type of loan which will give them money to do that or search for a home which doesn’t need such work. 

     a. There are a couple of types of mortgage loans which may help in this regard: the FHA 203K loan will give funds to complete work that needs to be done to bring the home to livable standards. The buyer gets estimates for the work that needs to be done, the appraiser values the home as if the work has been done, and the loan functions much like a construction loan where the buyer does “draws” for the construction. Buyers should be careful in the selection of their lender, however, since many loan originators and banks do not have experience with this type of loan.

     b. For Fannie Mae-owned properties, Fannie Mae has “HomePath” Financing which works in a similar manner. But this loan is only applicable to Fannie Mae-owned properties. Freddie Mac also has loan programs for the purchase of their properties, called Homesteps.

     c. When the buyer is looking at the home, even for the first time, he or she may wish to take a home inspector with them to determine the approximate cost of repairs or the cost of bringing the home up to code. This may help determine what price to offer for the home.

     d. Buyers also need to be aware of environmental issues which could exist in the home, including mold, pest infestation, septic/sewer, etc. A home inspector can often test for mold. And as part of the offer, the buyer can ask for a termite inspection and termite policy. For potential septic issues on a rural property, a sanitarian can do a septic inspection.

4. The buyer may want to hire the services of an attorney, although in Arkansas an attorney is not usually necessary (most “normal” closings occur at title companies and most sales do not have an attorney involved). Realtors use forms developed by the Arkansas Realtors Association, but the banks and other entities who own these foreclosed properties generally have their own forms which they use. In some cases these contradict the ARA forms, and if there is a contradiction the bank forms prevail. If the buyer doesn’t understand all of what the bank forms say, they should have an attorney view them and explain what they say and what the buyer is being asked to do. Some of these forms also allow the lender to sell the property to another buyer prior to their closing if it is in their best interest to do so, even though the buyer is under contract with them.

5. Buyers need to assure that the lender who owns the property has clear title to the property and that there are no outstanding liens on the property. Foreclosed properties are generally purchased with what is called a “Special” Warranty Deed not a General Warranty Deed. The General Warranty Deed normally assures clear title to the property. The Special Warranty Deed only assures clear title from the time that the lending institution took possession of the property. Thus there could be previous outstanding liens which a buyer may end up having to pay.

There are a number of steps that a buyer can take to guard against that.

     a. Have his attorney do a title search on the property to make sure there are no existing liens on it, especially if the property is a new-construction home. In that case, there may be mechanics liens on the property if the contractor has not paid his subcontractors. Other types of liens on any property may include Tax Liens (IRS).

     b. Close at a title company of the buyer’s choosing. RESPA rules dictate that the buyer may choose the title company at which the closing will occur. On a “normal” sale, it is often convenient and more cost-effective to close at the title company selected by the seller. However, in a foreclosure situation, having your own title company do a title search and provide a title insurance policy may safeguard against existing liens on the property and be better protection to get a clear title on the property. The buyer may also want to obtain an “enhanced” title insurance policy on a new-construction home which may cover mechanics liens filed after closing.

6. Buyers may want to think about reselling the property even as they are buying it, especially if there are a lot of foreclosures in the neighborhood. If they were to be in a position where they needed to sell quickly, they need to be aware of how many other foreclosures in the neighborhood may be competing with their home.

7. Be ready to act when you find the property you want. The best chance of getting what you want and at the price you want to pay is when you are not competing with another offer. Foreclosures are usually being listed below market value, so the chances of there being another buyer who wants the same property are greater than for a “normal” property, even in this buyer’s market.

Related to this is that if you have to sell a home to purchase another, a foreclosure is probably not for you. Lending institutions do not accept contingency offers (i.e. offers contingent on the sale of the buyer’s current home).

See also Buyer Tips for purchasing Short Sales.