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The Most Dangerous Hazards When Buying REO Properties

Foreclosure pitfalls

While REO properties (“real estate owned” bank foreclosures) can appear on the surface to be great deals, make sure you’re aware of these potential pitfalls that could mean unexpected gargantuan costs down the road. These hazards should normally be avoided even when acquiring non-foreclosed investment properties. However, there is an even greater danger with REO’s. In many instances, water and electricity have been turned off by the bank that owns the property. This safeguards them from further property damage in case of any leaks or winter freeze-ups.

However, banks that own REO’s tend to be sticklers in the adage “caveat emptor” (buyer beware) when they place their inventory of foreclosed homes for sale on the market – and they require all offers be in “as is” condition. Also, they usually refuse to turn the water and electricity back on prior to closing. So you’ll be in the dark, quite literally, regarding your house inspection.

When buying a foreclosed home, make sure you get a very experienced house inspection company to go over the property in tremendous detail. If they can’t make a determination about some of the following major hazards, you’ll have to build in a slush fund for the probability that one or more of these hazards are present. Crunch your offer numbers accordingly…

Mold

Buying a property with mold is a major headache. While the reasons for the mold problem itself is usually an easy fix, mold remediation is not. In addition, trying to get a mortgage on a foreclosure with mold present is going to be problematic, since the lender will want it removed prior to your closing on it. (I am currently representing a buyer in the purchase of a ranch house with mold in the unfinished attic. The seller foolishly had bathroom fans on the first floor empty hot, humid bathroom air without venting of any kind directly into the attic space…You can’t make this stupidity up. The situation had apparently been this way for years. In winter, the attic space would actually develop frost, according to one current tenant of the building. Naturally, there is an accumulation of mold throughout the attic now. And in order to sell the property, the seller must address the issue. And to do so properly, a specialized mold abatement company, licensed by the state, needs to be called in to properly remediate the problem.) So make sure there is no evidence of mold anywhere in any REO you’re considering purchasing. Especially since banks will still expect you to be making an offer on their property in “as is” condition only.

Structural problems

Any foundation cracks need to be inspected for size, shape and duration for how long they’ve been there. Different cracks mean different things. Let your house inspector make the call as to how big a potential problem any given crack could represent in the future of the property. If it’s simple settling over a long period of time – not a big problem. But if the issue means a total rebuilding of the foundation – well, obviously, this will be a major costs that could run tens of thousands of dollars.

Pest issues

Any good house inspection company will be able to ascertain very quickly the presence of pest infestations. Termites tend to be number one on the potential list. If evidence of past termite infestations is old and not active, and the damage to the house sills have been minimal, or repaired, there shouldn’t be a problem moving forward. But if the damage is active and extensive, calling for sill replacement, this could also pose a potential cost you didn’t expect that could run in the thousands of dollars. Be very wary when confronted with the evidence of termite damage in foreclosed homes.

Plumbing leaks

If the water has been turned off, you really won’t be able to get a good idea of any potential problem lurking in the house, especially if there is the presence of much older piping in place. In this case, you must plan for the worst – and expect the pipes to have burst or leaked at some point in the past. Using “caveat emptor,” you’ll need to either plan on a very expensive renovation of all plumbing in the building. Or simply be prepared to walk away. And make an offer on another property in the foreclosure process instead.

Electrical issues

Likewise, if an REO has no electricity on, it is impossible to ascertain the integrity of the entire electrical system. Are some wires old? Are some fixtures shorting out? A house inspector won’t be able to inspect anything that’s hidden behind the walls. They must have the electricity turned on to determine the potential hazards. With REO’s, just like with plumbing when the water has been turned off, expect the worst. You’ll have to decide if you’re prepared to rewire the entire house – or move on to another offer. Just be aware of the potential hazards.

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The Best Property Investing Advice

Creating The Buffer Zone

All start-up businesses are plagued by the same problem: a lack of sufficient capital to get through the initial rough period where cash flow is crucial, and tends to be almost non-existent until the business hits a critical mass of revenue. The same applies for any beginning foray into the property investing field. The best advice I can impart is that you set aside an adequate amount for reserves to get you through your first couple of years of operation. This means, you’ll need self-restraint in order to not want to tie up all your available capital in the most expensive, or the biggest projected money-making endeavor. If you leave 15%, 20% or a bit more in adequate cash reserves, you will be able to deal much better with the obstacles that are sure to befall you as any beginning property investor would encounter.

Holding back

Sure, you’ll want to use up your full capital reserves to maximize your return. But don’t. Hold back. Keep that extra amount in the bank for the proverbial rainy day. It may appear so attractive to utilize the maximum amount of your investments to gain an even better deal, an even better (or greater) mortgage amount – but don’t do it. Restraint, restraint, restraint. This will ensure you create a safety net for yourself. Until you know how the business will go, and you’ve acquired sufficient knowledge to be able to predict better how each succeeding property acquisition will perform, lay back, and keep that certain rainy day amount in reserves.

Sleeping better

When interest rates go up, or the market tanks, or your tenants don’t pay on time, or your taxes skyrocket suddenly, you’ll be able to sleep better knowing you’ve planned for emergencies. The last thing you’ll want to do is go back into the borrowing pool to finance an already-extended property. That’s where things get disastrous fast. Especially when you can’t make your mortgage payment (see financial crisis of 2008 – 2011), and are forced to either go through a short sale , or worse, a foreclosure on your property. Or possibly worse – being forced to place your investment property on the market at a fire sale price in order to unload it quickly. Very, very hazardous, and not for the faint of heart.

Socking cash reserves away

So play it safe. Put those cash reserves away, and know it’s OK to make mistakes. Mistakes that I can guarantee, you will definitely make as a beginner property investor. You’ll certainly be best prepared for entering the property investing arena in this fashion. Finally, always take your time crunching your numbers on each potential property acquisition. The more conservative the numbers for rent and expense items you plug in, the better equipped you’ll be to handle any market downturns and surprises that will hit you financially.

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Quick Property Investment Tips

Advice for the beginner investor

Novice property investors should be cognizant of these quick and simple property investment tips. They will keep you pointed in the right direction. Always refer back to them when you hit a snag in the process… (It also makes sense to try to memorize them, and recall them as you begin searching for new investments to acquire.) In this way, you too, can become a savvy, experienced property investor.

Purchase for retention

Make sure you always purchase rental properties for retention purposes. The longer you hold, the better equipped you’ll be to take advantage of long term appreciation in the property. You’ll also concurrently be writing down any mortgage note you’re paying off, thus increasing your equity valuation in the property. If you make a plan for purchasing a property at set intervals (for example, every couple of years – or yearly, even better), then you’ll be able to slowly accumulate a portfolio of properties (your “stable”) that will continue to throw off ever-increasing amounts of cash flow, as well as capital appreciation.

The power of leverage

Make sure you take advantage of leverage, when possible. While making all cash offers on properties may be advantageous to netting the best price on any one property, it is not advantageous to utilizing other people’s money to grow your investments through the concept of leverage. If you can obtain a mortgage, by all means do so. The greater the loan to value ratio the lender will allow, the better. Just make sure you don’t overextend yourself, and that you’ve double-checked your expense numbers properly. You want to ensure you have a comfortable positive cash flow on any property you’re thinking of acquiring.

Beware the bargain basement

While the concept of “stealing” a house in an auction or other competitive bid situation sounds really appealing, always be wary of the cost of a “steal.” Finding a great bargain in a poor location is like finding fool’s gold: you’ll end up paying for it down the road. Long term difficulties with obtaining market rent, high vacancy rates, and terrible capital appreciation tend to make that “steal” a steal for the seller! So be very, very careful when a deal feels too god to be true. It probably is.

The location axiom

Naturally, more desirable neighborhoods will yield greater upside potential in terms of capital appreciation. This does not mean buying a property in a rundown area is bad. Just be aware that a cheaper price for a lesser neighborhood will require you to understand the vagaries of dealing with the neighborhood…which will probably be run down in five or ten years, or whenever you will be selling the property. Keep your sights set realistically. If a bad neighborhood is all you can afford, make sure you don’t expect much from the property n terms of its capital appreciation over time. Or, at the very least, buy in a changing neighborhood – one that’s experiencing the start of some gentrification. (Hint: let the changing face of local stores be your guide here.)

Cash flow is great, but…

Make sure you always keep an eye on the capital appreciation rate in any given area you’re searching in. It’s the holding and growth of the marketplace of houses surrounding your building that will add value to your property in the long run. Be very mindful of this fact. Your year-to-year cash flow is obviously important to paying the bills and allowing yourself a profit on a regular basis. But it’s when you are ready to sell the building that most of your profit should be made…

Create an individualized investment strategy, and stick to it

Critical to this concept is that you’ll need discipline. In addition, you’ll need a plan. And most importantly, you can’t have discipline and a plan without also being scrupulously devoted to research and numbers-crunching for any potential property you are looking at. Simple math errors, not doing total due diligence on a property, accepting seller information only – these are like death to a property investor. You cannot tolerate mathematical mistakes. If you know this is not your strong point, then enlist the aid of a partner – or at the very least, seek the outside help of a trusted, math-oriented friend. Either way, this is the simplest way to mess up. So don’t.

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Walking Through The House Of Mirrors

Be very wary…

Just like a fanciful walk through the twisting, colorful and dizzying amusement park attraction, the House of Mirrors, that bend your shape and leave you rubbing your eyes for better perception, so too is the effect on real estate investors trying to read the current state of the U.S. housing market. My singular property investment advice: be wary of what you see in the current housing recovery.

All factors and new data suggest a rapidly improving housing arena. But, like the House of Mirrors, everything’s bent totally out of proportion and recognition. And, we’re left with the main issue I’ve preached in two previous articles here this year: all investor’s eyes need to remain squarely fixed on the unemployment rate – not how the housing market is doing. For it is that unemployment rate that should dictate how you invest in these current economic times.

Here’s what others are saying…

In an article from this week’s Time magazine (“The Housing Mirage,” by Rana Foroohar, Time, May 20, 2013), she notes that in regards to the present housing market conditions, “prices are up, but the market is far from healthy. We’re missing key elements of a true recovery.” She goes on to ask, “if housing is back, why is the percentage of people who own homes lower now than it was over a decade ago.” Of course, it’s because property investors have been gobbling up most of the foreclosure market over the last few years. And this is especially true with institutional investing firms.

She goes on to note “that a relatively small group or rich investors…is driving the real estate market. That includes private-equity titans like Blackstone (which owns a portfolio of 20,000 rental properties) as well as high-wealth individuals who can pay cash up front for property for themselves or to rent out. “Investors remain the dominant force behind the house-price bounce back,” says Capital Economics property economist Paul Diggle. That’s reflected not only in the lower rate of homeownership but also in the swelling ranks of renters. Not since 2002 have fewer rental properties been empty in the U.S., and rents are rising sharply in many cities.” And that’s a scenario that makes property investments in residential real estate all the more valuable in the coming months, if not years.

Let the unemployment rate be your guide

Ms. Foroohar makes the case that tight credit policies by banks are still placing a stranglehold on mortgage lending nationwide. She then makes a point I had predicted back in my article of January 1^st here, entitled “Predictions For 2013.” I had written then: “watch the unemployment rate.” I then went on to offer up these pearly bits of property investment advice:

“The unemployment rate will be one of the most important figures to keep a watchful eye on in the coming year. If it starts ticking upwards because of the effects of no deal being reached by Congress on the proverbial fiscal cliff, then look for overall U.S. rents to continue to increase as homebuyer malaise begins to sink in. So individual rental property owner’s should be able to see increases in their cash flow as the new year progresses. Clearly, residential rental properties will become even more valuable than they were in 2012. So it would behoove the individual property investor to continue to search for and acquire additional rental property in 2013.’

And now, five months into 2013, Ms. Foroohar backs me up. She quotes Jonathan Miller, CEO of a New York based real estate appraisal firm, who said “to have a sustainable and healthy market, all that really matters is employment….You need higher employment and wages to support housing consumption and looser credit. If we see some real economic growth over the next two to three years, then we’ll know the housing recovery is real. Until then, we’re in what I call a precovery.”

The bottom line

She then goes on to bring it all home: “ this precovery has been underwritten by the government at historically unprecedented levels. Every month, the Federal Reserve is purchasing $40 billion worth of mortgage-backed securities. And Freddie Mac and Fannie Mae stand behind the bulk of new mortgages.” Finally, she notes that “it has long been said that you can’t have a sustainable economic recovery in the U.S. until the housing market is back. In truth, it may be the other way around. Until you have more jobs, rising wages and a middle class that can afford to take out a mortgage….you can’t have a real housing recovery.”

Sounding like a broken record

And, as I’ve been saying for months, the housing arena does not indicate nor showcase the deeper, structural problems such as tapped-out consumers pinched by a slowing job market, higher taxes and lower savings. I had also previously written that “if the unemployment rate were to go up next year, look to continue acquiring residential rental property, since rent prices will then continue to escalate. And cash flows on rental properties would commensurately increase as well.” I would have to amend that statement slightly, and say, if the unemployment rate remains stagnant, as it has been, or goes up, then look for increased cash flows on your rental properties.

My best property investment advice continues to be taking your existing properties and make sure you continually maintain, if not upgrade, them in a down economy. Especially in this House of Mirrors economy, where rent prices continue to escalate. Continue to make your product more attractive relative to your competition. In this way you’ll be able to maximize cash flow and profits. Also remember the advice I gave in that earlier article on the coming shape of our economy, and how it will affect what you do in your property investing strategy for the coming year. “Consider the next year as a good time to try refinancing your investment properties to help increase your overall cash flow on all your collective properties. With rates at all-time historical lows, and with an economic downturn occurring, you’d be able to lock in excellent rates for the long-term on your portfolio of real estate holdings.

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