Foreclosures: Bargain hunters beware!

You might think that a slowing real estate market would make foreclosure investing a snap.

Don't bet on it.

By Cybele Weisser
MONEY Magazine staff writer

February 16, 2006: 12:08 PM EST
NEW YORK (MONEY Magazine) - Buying foreclosures once appealed mainly to the small group of hard-core real estate investors who were willing to dig into untouchable rehab projects and wrestle with deadbeat tenants.

But in recent years, scores of self-help books, Web sites, gurus and classes have sprung up, touting the notion that buying property from distressed homeowners is not only the surest path to real estate wealth but also within easy reach of anyone with spare time and gumption.

Now, with rising interest rates and softening prices threatening to derail homeowners who stretched to buy with risky loans, the message from this movement goes, this is the year for foreclosure bargains. Or is it?

Foreclosure investing has always been fraught with risks -- decrepit money pits, troubled tenants who refuse to clear out. But rather than creating more buys, the torrid market of the past five years has added a whole new level of risk by leaving fewer genuine deals available for thousands of eager new investors.

"It's a tough market today. The low-hanging fruit has already been picked," says Gary Eldred, author of "The Beginner's Guide to Real Estate Investing." "There are some nuggets of gold lying around, but you have to dig through a whole lot of dirt and rock to get to the good stuff."

Armed with the time and the temperament, you can make money buying and selling foreclosures. But now more than ever, it's important to steer clear of the common misconceptions and learn from seasoned investors who've done it right.

Myth no. 1: A big spike in foreclosures is right around the corner.

If you've been waiting for the McMansions in your town to start going on the auction block, your wait isn't over just yet. Many homeowners who took short-term adjustable-rate loans or home-equity lines of credit a few years ago are already grappling with higher monthly payments, and more will be doing so next year.

Despite that, the foreclosure rate -- currently less than 1 percent of all loans -- isn't expected to change much in 2006, says Alexis McGee, president of listings Web site Foreclosures.com.

That's because in most of the country, anyone who has owned a home for even a year or two is likely sitting on enough equity to sell or refinance if the loan payments become unaffordable.

Another brake on foreclosures is that banks are no longer playing hardball with strapped homeowners.

"Compared with the late '80s and early '90s, lenders use velvet gloves," says Eldred. "They've realized that giving people a six-month moratorium on payments, stretching out the term on the loan, reducing the rate -- it's still more profitable for them than going through a foreclosure."

Finally, the foreclosure process can be lengthy, ranging from a month to more than a year, depending on state law.

What would push more homeowners over the brink? Hard economic times have always been a catalyst, says Doug Duncan, chief economist at the Mortgage Bankers Association. For example, in states that have recently lost industrial jobs, such as Ohio and Michigan, foreclosures rose significantly in 2005. So if the national economy sours this year, expect a big jump in foreclosures in 2007.

Another catalyst is overbuilding. Regions that have enjoyed a boom in new condominium development -- South Florida, for example -- could soon suffer a spike in foreclosures if investors are unable to rent or unload their condos for a profit.

Myth no. 2: Foreclosed houses sell for far less than their market value.

In a study of foreclosure sale prices in more than 600 counties nationwide in 2005, Christopher Cagan of data provider First American Real Estate Solutions found that, on average, foreclosed properties sold for about 15 percent less than comparable homes in the area that were not distressed. But in states where real estate prices have risen the most, including Arizona, California and Virginia, foreclosed properties sold for within 5 percent of full market value.

"In general, you're not going to get a great discount in a great location, right where your job is, a place that you really want to buy," says Cagan.

Bear in mind that his study looked only at homes that went into foreclosure, not those in danger of being seized, where you can often find better deals. But Cagan's numbers also don't take into account the inevitable costs of repairing the property, which are often far higher than expected.

"At first blush a deal can look really good," says Dartmouth business school professor John H. Vogel, "but by the time you figure out why it's selling at such a discount, you often realize the price was very rational."

Myth no. 3: Anyone can make money in foreclosures.

If you've read one of the many books touting the benefits of foreclosure investing, or attended one of the increasingly popular seminars, you've likely come away thinking that it's a snap.

Wrong. There are three ways to buy foreclosures: directly from a homeowner in trouble (pre-foreclosure), from a bank that has repossessed the home (real estate owned, or REO) or at public auction.

Each involves a different set of rules and regulations -- and challenges. Whichever method you choose, the chance you take right now is that you will overpay for the property. Few foreclosures are on the market, while the number of interested buyers has grown faster than Brangelina's brood.

"Five years ago, there were the same five or seven people at every auction," says veteran foreclosure investor Roy Cloughen of Long Island, N.Y. "Now there are 75 to 80."

Most experts say there's little point in looking at REOs today; lenders aren't repossessing many properties, and the few REOs that come up for sale usually command full market price.

Auctions are by far the riskiest way to invest, says Rick Sharga, vice president of marketing at foreclosure listing site RealtyTrac.com. "You are buying the property sight unseen, and you will be responsible for any taxes, liens or second mortgages still on the property."

If someone is still living in the home, you must handle the eviction. Moreover, auctions tend to be frequented by the most experienced investors, who know plenty of tricks to confuse the novice bidder.

"I'll do a big jump in price and then a little jump, just to increase their confusion," says Cloughen, who has watched plenty of inexperienced auction buyers end up paying more for a home than it was actually worth.

If you want to try your hand at an auction, it's essential that you research state laws beforehand and come armed knowing what similar properties in the neighborhood are selling for. And don't forget the money. Most auctions require you to make a 10 or 20 percent cash deposit on the spot, with the balance sometimes due within a day. Finally, decide what price you're willing to pay and stick to it.

"You just can't get emotional and caught up in the bidding," says Jon Kaplan, who owns a contracting business in Cleveland and dabbles in foreclosure investing. "Overpay, you'll get killed."

If you're willing to knock on doors and ask embarrassing questions, you may find deals among pre-foreclosures. For a $15- to-$50 monthly subscription, you can get listings from Web sites that search court filings and other public documents for homeowners behind on their mortgage payments. You can then contact the homeowner and try to negotiate a deal.

Trouble is, the listings on many of the Web sites are out of date -- and a lot of people are reading the same lists. That's why Pamela Smith, a part-time flight attendant and real estate investor, taps a network of realtor contacts she's developed and checks listings of borrowers in default in her county paper for leads. Notes Smith, "You have to be aggressive."

Auctions are by far the riskiest way to invest in foreclosures. The public sales tend to be frequented by the most experienced investors, who know plenty of tricks to confuse the novice bidder.