REO 101

Like many investors, I used to attend the Commisioner’s Sale and buy homes at the foreclosure auction.  That was a great buying strategy until about 2 years ago when I began to see a definate shift in the types of homes being sold at the auction.  Fewer and fewer homes had sufficient equity to get an investor to make an offer, so the lenders were being forced to take the homes back. 

What I am now seeing, is a glut of bank owned (REO’s) properties listed for sale.  I am now buying from the banks and only going to the auction if I see something that really looks promising.  There are some secrets to buying an REO (this stands for Real Estate Owned- by a lender is implied).  The first item is to locate these properties.  Some are easy to find on HUD websites, but most are just listed on the local MLS system.  There are REALTOR “code” words that indicate a property is bank owned.  Some of these include “as is”, “proof of funds”, or “special deed”.  Since most lender owners will not do repairs, most REO’s are not going to qualify for FNMA or FHA type loans.  While there may be lots of deals out in the market right now, being able to capitalize on them requires some preparation.  Stay tuned for more!

Short Sales

Well, we just learned that Kentucky is rated 5th in the nation for foreclosures.  Our only consolation is that Indiana is rated 2nd.  None of this is good news for the lenders or for sellers.  Add the implosion of the sub prime lending market into the mix, and it becomes obvious that there are many more homes for sale than there are buyers.  Our market has never been one of high annual  appreciation.  We historically have just meandered along with home appreciation of 3-7% per year.  A few small areas have done better, maybe up to 10%, but those are rare.  Since we haven’t had much appreciation over the past few years, the homebuyers who got 100% loans with adjustable rates are really struggling.  We are seeing many more homebuyers whose loans are hitting the 3 year adjustment mark realizing they can’t afford a payment increase of  30-50%.  Loans with payments that are 30 or 60 days past due are increasing dramatically.  With this increase, many lenders are counseling the homeowners to try to sell the property and not go to foreclosure.  Since most of these homeowners are “upside down” in the loan the banks are negotiating a “short sale”.  A short sale simply means the lender will accept pay off funds “short” of the actual amount owed.  Short sales, both for the seller and the buyers, are not for everyone.  It takes a certain level of knowledge to negotiate with the lenders and to educate all parties to the specifics of the the transaction.  It is recommended that listing a home that may end up as a short sale only be done by REALTORS knowledgeable about the process.  The same applies to REALTORS working with a buyer who wants to purchase a “short sale”.  There are steps that need to be taken to protect the buyers if the lender decides not to accept a short sale, or it is determined that there are other issues to be worked out.

Foreclosures

Foreclosures 

Foreclosure is the legal process where a lender regains ownership for a piece of real property that has been pledged as collateral for a mortgage.  This is a multi step process where the lender files public notice of the default in the loan (lis pendens) and initiates the court proceedings necessary to regain title to the property.  Usually the final step is a court ordered auction by the sheriff or county commissioner.  Historically these sales were held in front of the county courthouse, hence the sayings “bought on the courthouse steps” or “courthouse sale”.

Foreclosures must have a significant amount of public notice in order to be sold.  This is to give plenty of notice for any parties who may have a claim on a property opportunity to contest the sale.  Foreclosure sales are usually advertised in the newspaper and by public postings in the courthouse.  Also, most counties have a web site which will show a list of auction dates and the address of properties that will auctioned.

Prior to the foreclosure auction, an appraisal is often done and posted publically.  In redemption states the auction sale price must meet a percentage of the appraised price to prevent the owners from coming back and redeeming (buying back) the property.

In

Kentucky, there is a one year right of redemption unless the property sells for more than 2/3rds of the appraised value.  If the property sells for less than this, the owner who was foreclosed upon can pay the purchase price paid by the new owner and regain the property within one year.  This means that the new owner will not get reimbursed for any repairs or upgrades made to the property before the redemption period ends.  Most investors either pay 67% of appraised value at the auction, or make no repairs or improvements until the redemption period has passed.

If you are interested in foreclosure sales, make a trip to your courthouse and find a helpful clerk to show you where the notices are posted and when and how the actual sale is done in that county.  Attend a few sales and watch to see how it works.  In my county, most of the properties are bought back by the banks because the loan values are so high. 

Leasing with an Option to buy

What is a Lease Option? 

 

A lease option is a wonderful way to hold off the sale of a property for tax advantages.  If you hold a property for a year and a day, it will usually qualify for long term capital gain treatment.  However, you must verify this with your tax professional to make sure this method fits into your overall tax planning.

 

A lease option is exactly what it says.  It’s a formal lease and an option to purchase at a later date for a fee.  Always use two contracts, one for the lease and one for the purchase.  This will save you time and money down the road.

 

If I buy a property and fix it up, I may discover that Fannie Mae’s anti-flipping rules require I not sell it again for 180 days.  No problem, just lease option it.  Finding tenants who want to buy, but need some time to clear issues is not difficult.  I advertise on the sign in the yard and with any media advertising I do.

 

I use a standard lease and all of the screening tools I would use for any tenant.  If ever problems arise and you need to evict, having a separate lease agreement will make this easier in eviction court.  If you only use one form for the lease and the option, the judge may decide the tenant has what is called an “ownership interest” in the property and require you go through the foreclosure process.  You won’t like that, it’s tedious, costly, and takes a long time.

 

I also use a separate “Option to Purchase Agreement” and charge a non refundible 3% option fee.  This fee is used as the down payment for the optionee (tenant) at closing.  In the event the optionee does not purchase the property in the time agreed upon (failure to exercise the option), then the money is forfeited.   This means you get to keep it.  At this point you can decide to extend the option period for an additional fee, or notify the optionee of their failure to perform and non-renewal of the lease so you can sell the property or re-lease option it.

 

Before I accept a lease option, I take the optionee to a lender to determine that they can perform in the agreed upon time frame.  I never want to take someone’s money knowing they won’t be able to perform.  If their credit issues are such that they can’t purchase a home in one year, then I need to agree to extend the time frame until they can purchase, or recommend they rent until they are financially able to buy.

 

 Remember, a reputation for fairness will keep those referrals coming!

Words from the wise.

Terms and definitions

                                                       

Abstract of title- condensed history of a title to a specific piece of property consisting of a summary of the ownerships and conveyances and any liens or encumbrances affecting the poperty

ADA- American Disabilities Act which has specific duties for landlords.

Amortization- payment schedule of a loan which includes interest and principal required to pay the loan off over the contracted term.

Appreciation- increase in value of a property over time

ARM- Adjustable Rate Mortgage

Asbestos-a mineral once used in buildings which has been shown to cause respiratory ailments.  Federal law requires strict guidelines be followed to remove it from a property.

Assignment-the transfer in writing of an interest in a contractual agreement such as a purchase contract, mortgage, or lease.

Birddogging- hiring persons to look for properties to purchase and paying a fee for them.

Building code-local authority sets standards for occupancy that must be followed.

Capitalization rate- a mathematical formula to estimate the rate of return on investment a property will produce.

Closing-the finalization of a property purchase, usually done in an attorney’s office or title company, where deeds are given to the buyer and seller receives sales proceeds.

Collateral- real property of value pledged incase of default on a loan.

debt service- mortgage payments including both principal and interest.

Deed-a written instrument which conveys title to or an interest in real estate.

Default- nonperformance on an obligation or failure to meet an obligation when due.

Due diligence-checking the financial records, all inspections and other information gathering to make the most informed decision when buying investment property.

Earnest money (good faith deposit)-money deposited by the buyer to be forfeited if the buyer defaults, but credited to the buyer at closing.

Escrow- closing of a property through a third party, or use of a third party to hold funds for future payments such as taxes or insurance.

Eviction the legal process to forcibly remove persons from possession of real estate.

Fair Housing Act-federal law which prohibits discrimination based on any of the protected classes including race, religion, color, sex, handicap, familial status and national origin.

Foreclosure- the legal process where a property pledged as collateral is sold to satisfy the debt in the event of loan default.

Functional obsolescence- loss of value of property due to functional problems due to age, poor design, or changes in styles and trends.

HUD- Department of Housing and Urban Development, The federal agency that administers GNMA loans and the Fair Housing Act

Land contract (contract for deed or installment contract) seller financing where the purchaser has possession and use of the property, but the seller retains the deed until the payment terms are met.

Landlord -Tenant Act- local ordinances specifying the rights and responsibilities of landlords and tenants.

Lease option an agreement to lease a property for a specified period of time with the right to purchase the property at a future date per a purchase agreement.

Lis pendens- a recorded legal document giving constructive notice that an action, such as foreclosure, has been initiated in court.

LLC- Limited Liability Company is a

form of business organization offering flexible management structures and limiting of personal liability.  Each state has varying rules for LLC formations and operation.

LTV- Loan to Value ratio used by lenders to determine the amount of a loan, usually offered as a percentage of the appraised value.

Marketable title- after title examination determines there are no liens or encumbrances on a property the title is deemed clean and marketable.

Mechanic’s lien a lien placed against a property for services provided by contractors, laborers and materialmen  in the building or repair of a property.

Notice of eviction ( seven day letter) notice to a tenant that eviction proceedings will initiated based on non performance of the tenant of duties per the lease agreement.

PITI Principal, Interest, Taxes and Insurance- the four parts of most mortgage payments

Plat map a map usually done by the developer and retained in the planning and zoning department showing information on home lots.

Promissory note a financing instrument which outlines the terms of the agreement and is signed by the maker and may be sold or transferred by the owner.

Quit claim deed a legal conveyance transferring interest in a property to another party without warranty or obligation. 

RESPA-Real Estate Settlement Procedures Act, a federal law requiring certain disclosures to consumers about mortgage loan settlements and prevents payment of kickbacks.

Sheriff’s sale or commissioner’s sale where properties in default either through foreclosure or non payment of taxes are sold to pay the debt.

Title search- the process of examination of the public records relating to a piece of real estate to determine the current state of the ownership and verify there are no liens or encumbrances.

Warranty deed- general warranty deed provides the greatest protection, where the deed is warranted for all owners and is fully insurable, a special warranty deed only warrants against title defects during the time the grantor held the deed and may not be fully insurable, or have a delay period for title insurance.

Let’s find a deal!

Getting started- Finding Properties 

 So you think you’d like to buy some investment property and make big bucks.  The opportunity to make money is certainly here with investment property, but it’s just not as easy as the infomercials say.  Let’s look at some realities.

Before you even start looking to buy properties do a financial analysis on yourself.  Do you have the financial means to get conventional financing, or do you need to find a “hard money lender”?  If you have a good credit history and income, there are several local banks that will lend money to investors at pretty good rates.  If you have some credit “issues”, then you need to find some investors who can evaluate the property and lend you money to get started.  These are “hard money” lenders and rates are much higher.  Make sure to include financing and any other holding costs in your property analysis.

Okay now to the good stuff.  First, finding the ideal property is not easy.  Even after 10 years of investing, the hardest part is still finding a property that makes financial sense to buy.  I may evaluate 15-20 properties for every one I buy.  I will say this though, because of all the foreclosures, right now it is easier to find a deal than anytime in the past 10 years.

Where do I look?  I look for homes in the area I want to buy in that are rough looking or possibly abandoned.  Then through the wonders of the internet I look to see who owns it, and if I can find the assessed value and amount of any liens against it.  If it appears the property is not severely over leveraged, and I can locate the owner, then I’ll evaluate it for profitability.  If the numbers look good, then I may try to buy it.  Often, the sad looking, neglected homes are owned by people in some financial distress and they need a way out. 

You can also use a REALTOR to help locate good deals.  It’s important to use a REALTOR that understands investment property and isn’t afraid to write and submit a “lowball” offer.  If your REALTOR says “that’s too low, you’ll insult the seller”, find another REALTOR.  The one you have doesn’t understand your financial goals.  Tip for you, don’t ever fall in love with the investment homes you look at, they are a business deal and need to meet the criteria to be profitable.  Find a REALTOR who is familiar with REO’s (bank owned properties that have been foreclosed on)and can help you through the process.  REO’s are usually sold “as is” with a special warranty deed, and rarely get conventional financing because of condition.

You can use the internet and search for HUD homes, but again a REALTOR who knows how to write HUD offers is helpful because the process is very tedious, and the rules are quite strict for investors.  However, this is a great source for homes that need a lot of work as owner occupied loans rarely allow the property to close unless repairs are done. 

So You Wanna be a landlord

Property management- or do I really want these people to know who I am? 

Once you have that first piece of property in your investment portfolio, you have to decide what to do with it.  There are really only a few strategies- each of which is covered in detail in another article.  This article covers two strategies- hold long enough for long term capital gain treatment, or long term hold for yourself.

I evaluate each property and decide what my strategy will be when I do my due diligence prior to purchase.  Once I decide to buy a property I plan my primary exit strategy as well as a back up plan.  Most of my properties I hold for “a year and a day” for long term capital gain treatment.  This means I have to make a management decision, either I deal with the tenants and all the issues, or I hire a property manager.

This article covers self management, we will cover picking a property manager at another time.  The cardinal rule of property management is to pick your tenants wisely.  If you screen tenants properly, 90% of your tenant problems never arise.  Cardinal rule number 2 is: Never let your cash flow problems convince you to take a bad tenant.  A bad tenant almost always costs more than an extra month’s vacancy.

But Anne, how do I find good tenants?  Well,

Virginia, two things come to mind.  First, be a good landlord.  Have your property clean and in better shape than similar ones.  This already makes the better tenants want to rent from you.  Before I rent a unit I do a basic inspection.  I check light fixtures, put in new bulbs, check toilets and sinks for leaks, make sure the plumbing fixtures work.  In fact when I get a new property, I usually replace the faucets unless they are obviously new.  It’s actually cheaper to do this, than have a leak later that causes damage under the sink or to the flooring.  I service my HVAC units at the end of every summer.  This lets us check both heating and air- if you wait until it’s cold they can’t service the AC.

The second way to find good tenants is to screen them.  Have an application form that asks for current and previous address, employment history, SSN, vehicles owned and license numbers, DOB, and a photo copy of their driver’s license as well as a recent pay stub.  Then I check them out through the National Tenant Network- it’s easy to join and has a quick turn around time.  I also search the

Jefferson

County sheriff’s website for any outstanding warrants or notice of eviction.  I tell them at application that I will do these screens, and ask if there is anything they might want to explain beforehand.   Sometimes the prospective tenant will mumble they really didn’t need a place after all and leave. 

I always charge a fee for application.  The fee depends on what my cost is to run the credit check (currently about $25/ person) and what I need for the paperwork.  Most landlords charge about $50, but some are higher.  Your bad tenants don’t want to pay the fee, and they always want to negotiate the damage deposit.  I have found that a tenant rarely has the financial fortitude to actually pay you an extra $100 a month for the next 6 months, so be prepared.  You can’t evict for non payment of a security deposit either- your just stuck with a tenant who now has no real motivation to take care of your property. 

Okay, you’ve taken the application, and the tenant checks out.  Yahoo, you are already ahead of the game.  Now, download a copy of the Landlord Tenant Act so you are doing everything you are required to do.  You’ll need to make sure you have the 10 year sealed lithium battery smoke detectors installed per the

Jefferson

County fire code.  I also have CO detectors in any unit with gas heat or gas hot water heater.  It’s not required, but having one probably saved the life of one of my tenants so I’m a firm believer.  You also need a good Move In/ Move Out checklist.  If you don’t have one and get it signed you can’t keep the damage deposit, no matter how much damage the tenant may do.

A good lease is the final step in the process.  Make sure it covers as many potential problems as possible, that it covers who responsible for maintenance, lawn care, and snow removal, and tenant caused problems like clogged plumbing.  Make sure the terms are clear- length of the lease, how it’s renewed, amount of notice required for termination, rent amount, when and where to pay, and any late fees or charges.  If you allow pets, that needs to be addressed, as well.  I put in the lease that the tenant is required to carry personal property insurance ( a Renter’s Policy) and that the owner is not responsible for their belonging.  If the tenant has a dog, they must provide proof of a renter’s policy that includes liability coverage for the pet.

Now you’ve got a lease, your damage deposit and the first month’s rent, what’s next?  Well first of all, make sure the damage deposit is in a separate account just for security deposits.  If you mix them up in your other account you automatically lose the ability to keep it if there are damages.    I never admit to my tenants that I am the owner- I am always the “Property Manager” and I often defer decisions to “the owner”.  This helps keep the tenants from taking out their frustrations on me.  It also makes it easier for me to tell them no, without them taking it personally.  It’s certainly easier to tell someone “Oh, I’m sorry, the owner won’t let me waive the late fee,” than to say “I realize your baby has been sick, but I won’t waive your late fee.”

I send my tenants an invoice on the 20^th of each month, and provide addressed envelopes for them to use.  Since some of my tenants are immigrants with English as their second language, it really helps insure the rent is sent to the right address and zip code.  On the 3^rd day of the month, if I don’t have the rent I send a 7 day letter notifying them that they must pay the rent in full, plus the late fee, in 7 days or we may begin eviction.  Eviction can take several weeks, so don’t delay on sending the 7 day letter.

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