Whilst the term "distressed" when applied to property is not all that new, in the past couple of years the term has certainly become more prevalent in the industry, especially in the US. With this article we outline some of the key points regarding distressed property and things to bear in mind when considering it as an investment.
What is a distressed property and why should I be interested in it?
A property that requires a forced sale by borrowers who have breached their banking covenants with lenders. Investors are particularly interested in distressed real estate because they are usually priced significantly below market value.
How and when do these opportunities arise?
In the past couple of years the US property market has been dominated by distressed property. In September 2009 it was reported that 14.4% of outstanding US mortgages were either delinquent or in foreclosure. (Source: Mortgage Bankers Association) Due to inability to sell and defaults on home loan repayments, many US properties have come onto the market at heavily reduced prices.
Why are there so many distressed properties in the US?
There are several factors that have contributed to the amount of distressed property in the US:
- Global financial crisis - A lack of liquidity in the US banking system triggered the financial crisis with knock on effects leading to restriction on lending and higher interest rates
- Finance structures - An increase in no or little money down mortgages and interest only loans meant house owners were buying beyond their financial means.
- Rate increases – Increases in interest rates has meant that adjustable rate mortgage payments have risen rapidly, doubling and in some cases even tripling monthly payments.
- Increase in unemployment – Pay cuts and staffing cutbacks have led to the inability to afford repayments for a large number of homeowners.
Distressed property has always been around, typically on a lower level though due to family circumstances such as divorce, death or illness of the homeowner or a member of the homeowner's family, all of which can have an effect on income and subsequently lead to mortgage defaulting.
Three of the different types of distressed property explained.
Pre-foreclosure is the period of time before an official foreclosure is put on a property. This happens when the owner defaults on loan repayments and the lender records a notice of default with the county recorder. Up to 5 days before the foreclosure the property can be taken out of pre-foreclosure, by paying the past due amount on the loan. The way in which investors buy these properties is through approaching the seller before the bank gets involved, they will then negotiate a price that suits them both, so that the seller can avoid foreclosure and the buyer gets a good price. The purchase price must be high enough to cover the outstanding loan balance(s) as well as the seller's closing costs.
A short sale takes place when a property is going to sell for less than what is owed on the seller’s loan, the seller has to prove hardship to the lender and it is noted in the listing that the property will be a short sale. This is a long process for both the investor and the seller because approval of the final purchase price has to be sought from the lender before the sale is closed, just because the seller accepts an offer it does not mean that the lender will.
The average time for this process is typically 4 – 6 months although it can take longer. The seller is legally required to provide disclosures regarding the condition of the property which allows the investor to budget for any repairs that are necessary.
The foreclosure process will vary from state to state but the basic proceedings are the same. When the default notice period comes to an end the lender will foreclose the property, they will then hold an auction on the court house steps where, if the property is sold, the buyer must pay for it in cash. When this route is taken by an investor they will not have access to view the property for inspection.
If the property is not sold at the auction at a price that will cover the loan, then the lender has an automatic bid for the property and becomes the owner. The property is then known as REO (real estate owned) and is sold through a broker by the bank. Investors can get a good price for the property because the bank want to recoup the money from the loan, the downside is that the buyer will not know what repairs the property will need because the bank have no right to disclose the state of the property to the buyer.
What you could be taking on
The physical state of a distressed property will depend on how it is sold, (as mentioned above) there may only be cosmetic repairs needed to the property but sometimes there will be more costly structural problems that need correcting. Obviously an avocado bathroom and garish wallpaper will not cost too much to change but a falling in roof and subsidence will.
The property may still be occupied; during foreclosure the buyer may need to evict tenants, owners or even squatters from the property after they receive the title and this eviction process can be costly and stressful.
When investing in distressed property it is important to carry out due diligence and research into the chosen property. Investors need to choose carefully and understand the process.
Distressed properties may seem very cheap but investors need to be aware that there may be debts attached to the property which the purchaser could be liable for that could be up to 10's of thousands of dollars (as this is the procedure in the US). Investment options exist though that overcome this problem; strategies that allow investors to buy refurbished distressed property with tenants in situ, turning the property from distressed to de-stressed.
- Thursday 10 June 2010