The Risks and Rewards of Buying Foreclosed Properties

forclosureNot a weekend goes by in these economic times when there is not an advertisement in our local paper concerning the auction of some piece of property that is being foreclosed. Everyone knows that you can usually purchase foreclosed property at a relatively cheap price to the regular fair market value, but not everyone realizes the risks that are also involved in this investment. Before going into the risks and rewards of buying foreclosed property, I think we should take a step back to learn about the different types of foreclosures. There are two types of foreclosures that take place in our Court system. The first is what is called a “Strict Foreclosure.” The second is what is known as a “Foreclosure by Sale.”

The Court will enter a Judgment of Strict Foreclosure in those cases where there is no equity in the property for the owners of the property. Because there is no equity, it is not practical to go through the expense and time of conducting a foreclosure by sale. In these cases, the Court assigns what is know as “law days.” These law days are assigned in inverse order to the interest that various parties may have in the property.

FOR EXAMPLE: Let’s take a situation where an owner has three mortgages or liens on his property and let us assume the following facts: The holder of the first mortgage has started a foreclosure action. The property is appraised to be worth $180,000.00. The first mortgage is in the amount of $150,000.00, the second mortgage is in the amount of 40,000.00, and there is a judgment lien attaching the property in the amount of $15,000.00. As you can see from this example, there is a total of $205,000.00 of debt on the property. With a total property value of $180,000.00 there is no equity for the owner of the property. In this case, the Court would order a Judgment of Strict Foreclosure. Let us further assume that the Court assigns the date of May 20th as the first law day. What this means is that, on May 20th, the owner of the property must “redeem” the property by 5:00 p.m. on that day.

To “redeem” the property owner must pay off the foreclosing mortgage on the property. If the owner does not redeem the property by the end of the day, the owner loses any legal interest he or she may have in the property. The next law day would go to the holder of the judgment lien in the third position. In the same way that lien older must “redeem” the property from the foreclosing mortgage. In our example here, that lienholder must come up with $190,000.00 to buy out the interest of the first and second mortgages. If they do this, then they become title owner of the property. If they do not do this by the end of that day, they lose any legal interest they may have in the property. And so it proceeds through the different mortgage holders, until we get to the first mortgage or the creditor who is foreclosing on the property. Their date is called a “reversion date,” because if no other party has acted to buy out their interest, then they become the title owner of the property on that date.

This system of strict foreclosure, creates an orderly way to transfer a property without having to go through the time and expense of a sale.

A Foreclosure by Sale will be ordered when either the owner has equity in the property in a sufficient amount that it exceeds the potential expense of the sale, or if a creditor has requested a sale of the property because they do not wish to redeem the property from an earlier mortgagee. When the Court orders a Foreclosure by Sale, it appoints an attorney who is called “the Committee” to oversee the sale of the property. At the time of judgment the Court makes many decisions regarding the sale of the property such as the sale date, where and when the property will be advertised in the newspaper, what day the sign will be placed on the property, and other details of the sale. The Court determines the amount of the debt that is owed to the foreclosing bank and establishes a fair market value for the property based on an appraisal that has already been submitted to the Court.

The Committee proceeds to follow the direction of the Court, placing advertisements in the appropriate newspapers, and putting signs on the property which would indicate the date and time of the sale. The Judgment also sets the amount of the deposit which is normally 10% of the appraised value of the property. A purchaser will have to provide this deposit by certified bank check to the Committee at the time of the sale. On the day of the auction, there normally is an inspection period that proceeds the actual sale. During this time potential purchasers may go about the premises to review the property and check out any problems they may foresee with the property. The actual sale of the premises is conducted like an auction with the Committee acting as auctioneer. There is no minimum bid (except the amount of the deposit) and the auction continues until the highest bid has been received from the bidders. The successful bidder then executes a document called a Bond for Deed with the Committee which acts as a purchase and sale agreement for the property. Following the sale, the Committee prepares a report which, together with the Bond for Deed, is forwarded to the Court.

The Court then schedules a hearing to review the report and approve the sale. Within thirty days after approval by the Court, the purchaser must close on the property. The only item that could arise following a closing on the property after the foreclosure sale would be if the U.S. Government has some potential interest in the property. Any U.S. Agency including the Internal Revenue Service has a four month window within which the U.S. Government may buy the property for the highest bid to the exclusion of the purchaser who bid at the auction.

Now that we have reviewed the types of foreclosures, it is a good time to explore the risks and rewards of purchasing this type of property. First, in dealing with a strict foreclosure you will have the opportunity to attempt to buy the property directly from the bank or financial institution. Normally these institutions do not want to hold the property and are eager to sell the property to someone else. The primary issue for the bank will be attempting to cover as much of their debt they possibly can. In those situations where the true value of the property is greater than the amount of the debt the bank is trying to cover, there is a true opportunity to obtain a “good deal”. The disadvantage of this type of purchase is that one has to negotiate with the financial institution to buy the property. In that sense it becomes a normal bidding process no different than if we were buying a property from any other individual. Additionally, we have the normal expenses of a closing upon the transfer of the property from the bank to you as a purchaser.

It is a foreclosure by sale that provides a potential purchaser with the best opportunity, however, they also have an equally large amount of risk. In these sales there is an opportunity to bid much lower than the fair market value of the property. Many times the bids equate to 60-70% of the fair market value of the property. It is also not unusual for the Court to approve the sale at those reduced price levels depending on what the activity was at the time of the sale.

But with every reward there is also risk. Property purchased at a foreclosure sale is purchased “AS IS”. There are no warrantees or representations concerning the property. Each purchaser is solely responsible for investigating the property and learning all that they can about the property. The Committee is not bound by any of the statements or representations that may be made. Many times in these sales, the potential purchasers are not even able to go inside the property. For one reason or another, they may be locked out or the property may be boarded up. In these instances the purchaser runs the high risk of not knowing what the structural or physical deficiencies the building may have.

Additionally, there can be no contingencies concerning the sale. Especially important here is the financing contingency. Since the closing must occur within 30 days after Court approval, any purchaser must make sure that they have all of their financing or their cash available. No extension will be allowed for the closing. If the purchaser is unable to close on that property within that 30 day time period they must forfeit their deposit. Moreover, the purchaser won’t really know until the time that the Court approves the sale whether or not they are truly going to own the property. Any party to the foreclosure could challenge that sale in Court if they feel that the purchase price was too low and it would be up to the Court to determine whether or not to approve the sale.

As with any investment foreclosed property has its risks and rewards. The main thing to remember is to do your homework – research the property at the Town Hall thoroughly, talk to your lender if you are financing, talk to your attorney about the title, then choose the price you are willingly to pay and be ready to walk away if others outbid you. This activity requires time and patience but there are some great opportunities available to those who are willing to go the distance.