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by Robert J. Gonzales
What goes up must come down. Beginning in the late '90s, the U.S. housing market saw an unprecedented, and in hindsight unrealistic, run up in value. Then the subprime crisis hit in mid-2007 and overnight the reversal of fortunes began. One year later and home sales are lethargic, new construction has all but dried up, and analysts predict that as many as 6.5 million homes will go into foreclosure over the next five years. How times have changed. But changing conditions create new opportunities. This article offers tips for buying distressed real estate – from identifying properties to assessing and limiting risks.
1. Don't Forget the Basics
Investing in distressed real estate is first and foremost investing, so it's important to not lose sight of the principles that apply to any real estate investment. Chief among these is to understand the market and the economics of a deal in light of the intended use. If you're buying property to hold and lease, it's important to know what rental rates the market will bear so you can calculate a realistic cap rate and know how much you should be willing to pay. If you are buying property to flip, understand the costs and have a well-defined exit strategy. Financing is a critical part of most real estate deals. Start arranging financing sooner rather than later, and be prepared with sufficient cash reserves to cover expenses such as taxes, insurance, and upkeep in case a tenant or buyer doesn't materialize as soon as expected. Finally, don't get emotional about any particular piece of property – and if a deal seems too good to be true, it probably is.
2. Understand Value Investing
Buying distressed real estate is value investing, the investment strategy that seeks to buy assets that are disfavored by the marketplace and thus "on sale" (as opposed to growth investing, where buyers invest in an asset they hope will grow faster than the rest of the marketplace). Value investors look for asset categories that are out of favor generally, for specific assets that are on sale, or ideally, for both. The U.S. housing market is certainly out of favor right now. Are we at the bottom? Who knows? But, prices nationally are well off their 2007 highs, and the declines in many cities have been steep. Just as important, consumer and investor enthusiasm for real estate has evaporated...an enticing signal for value investors.
Buying in an asset category that is currently out of favor may mean there are fewer buyers to compete against, but that's no guaranty of buying at a discount. An investor's specific acquisition target must also be on sale. When is a particular parcel of real estate on sale? The most common circumstance is when the owner is motivated to sell quickly, as in one of the situations described below.
3. Identify Your Target
Finding distressed properties takes effort, but that's one reason it can prove financially rewarding. Here's where to look:
REO Properties. When a borrower defaults, the lender may exercise
rights under its mortgage or deed of trust, typically leading to a foreclosure
sale. If there isn't sufficient interest at the foreclosure sale, the lender will
buy the property by using its debt to credit bid. Lenders also come to own
real estate through deeds in lieu of foreclosure, where the borrower agrees
to surrender the property to avoid foreclosure. Most lenders are in the business
of lending money, not owning real estate, so they endeavor to sell their
so called "real estate owned" or REO properties either by listing with an
agent or directly to the public. As a result, these properties are fairly easy
to locate and don't offer a substantial "off the radar" discount. But some
lenders, under the right circumstances, may be motivated to move REO properties
quickly, so discounts can be found. The following major U.S. banks and mortgage
lenders maintain their own REO websites:
Foreclosure Sales. Foreclosure sales can be a good source for distressed
real estate. However, sales of desirable properties can draw a crowd,
making bargains less common than some people think. Also, properties
with substantial equity (value exceeding secured debt) don't often end up
in foreclosure because their owners sell or refinance before letting things
get to that point. But, buying opportunities can be found for those willing
to do some legwork and be patient. The first step is to find the local
publications where foreclosure sales are advertised. Sale notices include
the date, time, and location of the sale, and identify the lender, the
property location, and the lawyer conducting the foreclosure. Deciding
whether a particular property is worth bidding on starts with figuring out
what comparable properties are selling for, then determining the lender's
payoff through public records or by contacting the lawyer involved. The
lawyer might also reveal if the lender has issued instructions to allow the
property to sell for less than payoff to avoid having it become an REO property.
Bankruptcy Filings. Bankruptcy cases can be fertile ground for the
distressed real estate investor. Bankruptcies are public events, with
information on assets and liabilities readily available through the
PACER website for $.08 per page. Select the bankruptcy court you want to
search, log in, then run a report for recently filed cases. Starting with
Chapter 11 cases makes sense since there are relatively few of them and
many involve real estate. Next best are Chapter 7 cases that were
converted from Chapter 11 or 13, then Chapter 7 cases generally.
Chapter 13 cases are the least likely to yield targets since most individuals
who file Chapter 13 do so for the purpose of saving their home.
Court approval is required before property can be sold "outside the
ordinary course of business" in a bankruptcy case, so one strategy is to be
on the lookout for motions seeking to sell real estate. Proposed sales will
be either by public auction or private sale. If a public auction is proposed,
contact the auctioneer to find out what due diligence information is
available. If the property meets your acquisition criteria, go to the auction
and bid. If you're interested in a property for which a private sale has
been proposed, contact the seller (usually the trustee in a Chapter 7 or
debtor-in-possession in a Chapter 11) to let them know you will pay more
and file an objection to the sale motion. If sale procedures have been
established by the court, it will be necessary to follow them to have a
competing offer considered.
Bankruptcy is also a great place for unsolicited offers. The fact that
real estate owned by an entity in bankruptcy is not currently for sale
shouldn't deter an interested investor from testing the waters. The
identity of the seller and the dynamics of the deal will differ depending
on whether the case in question is a Chapter 11, an asset Chapter 7,
or a no asset Chapter 7. Bankruptcy means financial distress, so
you might find the owner to be surprisingly receptive and motivated.
This is especially true in Chapter 11 cases where the company's
management (or owner in an individual case) is generally allowed to
exercise reasonable business judgment in disposing of assets, subject to
court approval as previously mentioned. In an asset Chapter 7 where there
is equity in real estate, the trustee will most likely be the seller. In
a no asset Chapter 7, check to see if the debtor intends to surrender
the property, in which case the mortgage lender will soon be allowed to foreclose.
The most aggressive, and potentially most rewarding, way to acquire real
estate in bankruptcy is to purchase a lienholder's position and then
pursue rights as a secured creditor against the debtor and the property.
A key to this strategy is to buy the creditor's loan at a discount.
A purchaser who buys debt at a discount retains the right to collect the
entire debt. All that changed is the entity holding the paper, not
the amount of the debtor's obligation. Why would a lender ever sell its
position for less than full value? Typically because of payment risk,
which of course the buyer will inherit. Additionally, a lender might
be motivated to accept a "bird in the hand" and avoid the time, effort,
and expense that could be required to collect. This can be especially
true for smaller lenders located out of state. Stepping into the shoes of
a secured lender requires a good understanding of and tolerance for
the risks involved, which include getting stuck with a structured payout.
Lien Filings. A final way to find distressed real estate is to go directly to
the source. In addition to bankruptcy filings and foreclosure
notices, many local business journals publish information on tax liens
and mechanics liens. Lien filings are a strong indication of financial
distress and tracking down owners can lead to acquisition opportunities.
4. Limit Risks
Careful planning and execution is important for all kinds of real estate investing, and buying distressed properties is no different. With that being said, investing in distressed real estate can actually afford protections not available in typical deals, so long as the property is acquired at foreclosure or through a bankruptcy sale. Buying property at a properly noticed and conducted foreclosure sale extinguishes all interests junior to the lien being foreclosed. Bankruptcy sales offer even greater protection. If done properly, the purchase of a property out of bankruptcy will come with an order of the bankruptcy court declaring that it is free and clear of all liens, claims, interests, and encumbrances.
As discussed above, one strategy for acquiring distressed real estate out of a bankruptcy case is to purchase a claim secured by property and then assert the lender's rights. To be successful, this approach requires a good understanding of lien law to be certain of what is being purchased. It also requires a sophisticated understanding of the bankruptcy process. At least in Chapter 11 cases, the investor must also be willing to accept a payout over time if a reorganization plan is approved by the court.
5. Seek Professional Help
This final tip could have been mentioned in several of the previous tips. However, it is worth underscoring that buying distressed real estate is a risky business that is not for everyone.
No single component of a successful distressed real estate investment should be all that difficult. But the sheer number of steps involved (e.g., what kind of property do you want, how do you find candidate properties, how do you conduct due diligence, how do you get financing, how do you successfully bid on the property, etc…) means that there are plenty of opportunities for your deals to go sideways.
For any real estate deal, the size and complexity of the transaction should govern what professionals are needed and the scope of their involvement. Engaging legal counsel experienced in financial distress situations, particularly those involving real estate, is vital.
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