In the market for a “real estate owned” property? REOs for short, these kinds of sales expose buyers to a lot of potential risk. But they also provide a lot of opportunity for big return on investment, too — much bigger, and faster, than you might expect with many traditional sales.
Experienced REO buyers swear by this method of wealth-building through real estate. “One of the best lessons I have learned over the years from other investors is that you don’t find deals, you make them,” explains Mark Motes, a real estate investor at Mark Buys Houses, who buys fixer-upper properties in the Birmingham, Alabama, market with a team of local experts.
“There is never a perfect investment situation. It is your skill as an investor to make educated decisions about your investment decisions.”
So how can you develop that skill that makes the pros so confident — and drives major return on investment? Start here: This primer on buying REO homes is packed with advice from seasoned experts with many successful transactions (and a few not-so-successful ones) under their belts.
What is an REO sale?
These are properties that have been foreclosed, and the ownership has fully transferred to the bank or lender. Properties get to this point after the borrower stops making mortgage payments for a period of time. At that point, the property is then foreclosed, and the house goes up for auction and is sold to the highest bidder.
If it sells, the lender recoups some of the outstanding loan amount through the sale. If not, ownership passes to the lender, and the house becomes an REO property.
But lenders would rather recoup their money than own a house. So if it doesn’t sell at foreclosure, the lender will list it on the market, a process that might include removing liens on the property, evicting any occupants, and possibly making necessary repairs to ensure the house is livable.
Finding REO homes: How the experts do it
You can look for these homes on the multiple listing service (MLS) or on various auction sites. Check them often.
“In this business, there is a saying: Old data is bad data,” Motes says. “So making sure your data sources are current is crucial to finding these properties.”
There are online tips and tools available to help you find bank-owned homes. But the best, most personalized and local way is to connect with a real estate agent in your area who has helped other buyers looking for this type of property.
“Most REOs are sold on the MLS,” explains Todd Miller, who worked in mortgage banking for over a decade, has purchased several REO homes, and now runs the personal finance website TightwadTodd.com. “However, some brokers have the exclusive listing of these properties with the owner. So find out who is listing the current REOs and work on developing a relationship with this person or company.”
Grant Wydeven, a 25-year old investor who has already purchased multiple REO and wholesale properties, suggests people seeking to buy REOs might join a local real estate investing group and meet with property wholesalers. “Get on their email list, and soon you’ll be getting multiple emails a week about great as-is properties,” he says.
Andrew Ervin, founder of Maxsin Investment Group, which buys several REO homes a month, suggests doing the extra legwork to find homes like this before the bank even gets custody of them, if possible. “Go to your county’s office and ask for the pre-foreclosure list,” he says. “Reach out to people on the list, and give them an offer!”
Will buying an REO home be a good investment?
To figure out whether a property is worth it to you, first establish what you intend to do with it: Do you intend to live in it, flip it, or hold it as a rental property? What will it cost to renovate it so you command either market rent or a sale at a price that represents a margin you’re comfortable with? Alternatively, Miller says, “If you’re planning to live in the home, you’ll need to determine the amount of equity you’ll want to have created from restoring it.”
From there, you’ll obviously want to look at the list price as a factor. But that’s only part of it.
“The second and really most important thing is you bring a contractor in with you to find out the cost of the repairs,” explains Joseph Baylis, a top-selling agent in the Trenton, New Jersey, area who has significant experience in short sales and REOs, and who specializes in dealing with investors.
“You add those two together, you get a licensed RealtorⓇ that you know and trust to let you know the after-repair value (ARV). Then you calculate your carrying costs, your commission on your exit, and you make sure that you have a comfortable profit that makes sense for you.”
Baylis says that the rule of thumb in his area is to feel confident you can clear at least $30,000. “That’s the minimum profit that you’d wanna make on a flip,” he says.
He cites an example of a $200,000 purchase that needs $50,000 in repairs, plus carrying and commission costs of about $30,000 — all of which adds up to $280,000. “You better make sure that you can clear $310,000 [on the sale] or it’s not worth it.”
While all investors are looking for return on investment, most take a similar approach, slightly varying their target ROI: For Motes, he’s looking to see if he can purchase the property for a maximum of 80% of the ARV, minus the rehab costs. “That gives us some breathing room for closing costs, holding costs, and selling costs, while still having the ability to make a reasonable ROI,” he says.
Ervin puts it similarly: “The best way to get a good deal on a banked-owned house is to do your due diligence and over-budget your rehab cost… because you never know what you’ll run into.”
To that end, his team comes up with an estimated repair budget — and sets it on the higher end, “so we have a little wiggle room if we missed any repair cost.” They calculate the square footage of the home, then multiply that figure by the cost needed for light, medium, or heavy rehab. In his estimates for his area, light rehab costs about $15 per square foot, medium costs $30 to $35, and heavy $45.
In the end, they settle on an offer that is lower than what they’ll really pay, in order to leave room for a counteroffer from the bank.
His pro tip? Never go over your maximum allowable offer in a bidding war unless you are an experienced investor with your own contractors, or if you plan on doing most of the rehab yourself.
“Learn how to walk away and go find the next deal — there are plenty out there,” he says.
Potential pitfalls of buying REO homes
These homes are sold as-is, and in many cases, the ROI comes from the fix-up. But you need to do your legwork to confirm that the neighborhood comps support your purchase, and that the home isn’t a clunker that could cost you way more than its earning potential.
“I’ve had some that I’ve sold that needed very, very little. The investor made a lot of money, and they were very happy, and then they came back for more,” Baylis says. But the deals don’t always go like that.
“I sold one to a good friend who wanted to get started in real estate but was inexperienced,” he recalls. “It was over an hour away from where he lived. It took him a lot longer than it should’ve. He made lots of mistakes along the way, and he ended up losing money when he sold it. And that was painful, because he was a personal friend of mine.”
Plus, consider all the possible hidden issues with REOs, and understand that you may not get a detailed, accurate seller’s disclosure because the bank doesn’t necessarily know much about the property’s condition.
For example, Baylis says, “I often run into underground oil tanks that weren’t disclosed. If there’s an underground storage tank that leaks, it’s a huge issue because the EPA gets involved, the state gets involved, and you have to have a licensed contractor dig up the tank. Typically, that’s $5,000 to $10,000 but I’ve seen it go $2 to $3 million because any seepage has to be cleaned up.”
Bottom line, he says: “If you’re buying a house with an underground tank and you’re not doing any testing, you’re really rolling the dice.”
Another issue that can happen with an REO? Squatters.
“Sometimes they’re actually the previous owner who never left and doesn’t have rights to the house now,” Baylis says. “Or people see that the house is vacant for years, and they move into it, sometimes even turning on utilities in their name and living rent-free for years.”
When that happens, the police aren’t the solution, Baylis says, because law enforcement considers it a “landlord-tenant issue.” So an REO buyer might be in a position to have to evict a squatter after purchase — and consider that there’s been a longstanding eviction moratorium due to COVID.
And even when you do manage to evict a squatter, Baylis says, “They might destroy the place on the way out.” So you might very well be much happier purchasing an REO home without a squatter problem.
In summary, there’s a lot of risk exposure to a buyer when there’s no disclosure.
Working with the bank on buying an REO property
Remember that working with a bank is much different than buying from an individual, as you would with a traditional sale. “You’re having to go through a lot of protocol and bureaucracy that [you wouldn’t with] an individual seller,” Motes says.
Indeed, patience is key — because working with a bank can slow down the whole process in a major way. “The bank controls every aspect of the transaction,” Miller says. “They determine how fast the process moves, when you’ll close, and often which attorney will close the transaction. Buyers who buy REOs are at the complete mercy of the banks who own them.”
To that end, he had an REO purchase that took six months to close. “I complied with their every wish within hours of receiving it, and since they dragged their feet for so long, they re-negotiated the purchase price with me,” he says. “And not to my benefit!”
Baylis describes another common issue he encounters when working with the banks on REOs: For an REO, the buyer typically comes with cash or has at least 20% down. “But let’s say an REO is listed at $200,000, and somebody has a preapproval from their lender for a purchase for $200,000,” he says. “They don’t realize that that’s for a house that they’re going to live in. So I have people putting in new offers all the time for full price, and over full price, and they send me their pre-qualification — but it says they’re qualified if that house was ready to live in. Buyers don’t realize that that prequal does not allow them to buy an investment property. And that’s a big problem.” (For such a property, you’ll need at least 20% down, or cash, or to get a rehab loan.)
Why bother buying REO homes? This is why
Does all of this sound like a lot of potential for drama? Well, that’s a logical interpretation, because there are a lot of potential pitfalls and headaches involved with this type of sale. And there’s certainly no guarantee of success.
But savvy investors say it’s well worth the risks and effort as a way to build personal wealth through real estate.
“Buying rental properties listed on the open market with conventional financing is way too slow,” says Wydeven, the 25-year-old real estate investor. “Unless you can save $30,000 to $50,000 a year for a down payment, you’ll be old by the time you’ve amassed a sizable portfolio. It’s all about getting creative with finding and financing properties!”
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