Investing in foreclosures is risky and not for everyone. But returns can be great. By Pat Mertz Esswein, Associate Editor March 21, 2007 This story originally appeared in the December issue of Kiplinger's Personal Finance magazine. It has been updated to take into account the recent crisis in the subprime lending industry, which has seen a sharp rise in defaults on loans.The growing number of homeowners who are falling behind on their mortgage payments could spell opportunity for real estate investors. Most of the problems are among homeowners with "subprime" mortgages -- loans extended to borrowers with poor credit, low incomes or both -- and particularly among subprime borrowers with adjustable rate loans, which total roughly 7% of the $10 trillion mortgage market. They are being pummeled by spikes in their mortgage interest rates as the low introductory rates expire. Some 700,000 of such loans are likely to go into foreclosure between now and the end of next year because the homeowners won't have enough cash to cover higher payments. That would suggest that the time is right to invest in a foreclosure. But buying a foreclosed home to flip or rent out isn't an easy, quick, cheap or surefire route to wealth. The typical deal comes with more problems than the average do-it-yourselfer can handle. Advertisement Even so, investing in a foreclosure can be rewarding if you're willing to do your homework. Compared with a year ago, foreclosures are up more than 25% nationally, according to RealtyTrac, an online marketplace for foreclosed properties. A total of 130,500 new foreclosures were filed during January, the most in the two years since RealtyTrac began tracking the numbers. Nevada, Michigan, Georgia, Colorado and Arizona lead the states with the highest rates of new foreclosures compared with total households. Investors Andy Heller and Scott Frank say they're "licking their chops" in anticipation of diminished competition for foreclosures as fair-weather investors flee the market and would-be owner-occupants look for easier pickings. "This is the time when you should be diving in," says Heller, who co-wrote, with Frank, Buy Even Lower: The Regular People's Guide to Real Estate Riches (Kaplan, $19). Range of discounts At the market's peak, in the first half of 2005, the nationwide median discount off market value of foreclosures was 14.6%, according to Christopher Cagan, director of research for First American Real Estate Solutions, in Santa Ana, Cal. Advertisement The slower the local real estate market, the greater the chance that you'll find a bargain, as foreclosing lenders are forced to offer bigger discounts to lure a smaller pool of buyers. The discount ranged from a tenth of a percentage point in California to 40% in New York. Cagan thinks that the current median is about the same, but he expects that it may deepen in 2007 if the number of foreclosures continues to increase and the housing market stays in a slump. How much of a bargain you need to make a deal work depends on your post-purchase plans. The shorter the time you intend to hold a property, Heller and Frank say, the greater the "minimum investor discount" you require. They recommend trying to buy homes for 20% to 30% off market value if you plan to flip the property; 10% to 20% off if you'll rent it out with the option to buy; and 5% to 10% if you intend to rent it out indefinitely. Keep in mind that the days when you could flip for a quick profit are over -- at least for now. Savings per square foot Bruce Reeks has been adding to his retirement savings by buying foreclosures. Reeks, who owns 15 such properties, identifies a bank-owned foreclosure on a multiple listing service, then compares its price per square foot with those of homes recently sold in the same subdivision. The difference signals opportunity, he says. Last year, Reeks purchased a five-bedroom, two-bath home in Austell, Ga., northwest of Atlanta, for $102,900. After he spent $7,800 on repairs, the property appraised at $142,000. If Reeks had flipped the house, he would have made about $24,000 after commissions and other costs. Instead, he collects rent of $1,190 and pays $850 per month toward the mortgage, reaping a gross profit of $340 a month. Meanwhile, Reeks builds equity as he pays the mortgage with the renter's money, he enjoys tax write-offs, and he expects to benefit from price appreciation. He anticipates cashing out his portfolio in the next five years and retiring to Asheville, N.C. Advertisement Foreclosure laws vary by state (for an overview, go to www.realtytrac.com, then verify the information with your county's clerk of court). You can buy foreclosures three ways: negotiate with a homeowner before the bank forecloses, bid at a county foreclosure auction, or, as Reeks does, buy a real estate owned property, or REO (see below). Plenty of pitfalls. At a foreclosure auction, you'll buy a home "as is," and you might not be able to do more than peek through the windows beforehand. Cleveland agent Mike Phillips says you could be bidding on a home that has been vandalized -- sometimes by a distraught owner who has stripped it of everything valuable. Long-vacant homes may have water or mold damage. And the property may have legal warts: liens, difficult-to-evict tenants or, in some states, a mandatory "redemption period" that gives the former owner time to try to get the home back. REOs, properties that lenders have bought back at auction, generally offer the easiest route for novices. With an REO, you won't become entangled with a harried homeowner facing foreclosure. You'll probably find nicer properties than the dregs left on the courthouse steps by lenders. And although an REO is likely to be sold "as is," you will have the right to an inspection, a title search and contingencies. Another advantage: You can finance the purchase with a conventional loan. However, the buyer of an REO is generally not likely to get as deep a discount as an investor in other kinds of foreclosures. In Stone Mountain, Ga., Kelly Wiley shopped REOs but took a slightly different tack on buying-and-holding. Wiley, a real estate agent with Metro Brokers/GMAC, decided to look for a foreclosure large enough for herself and her sons, Javon, 13, and Juwan, 11, and to rent out her former home. To start, she focused on a few desirable neighborhoods, setting strict standards for price and condition. Over two and a half years, other buyers outbid her on several homes, mainly because she took anticipated repairs into account when calculating her offers. Advertisement Last summer, Wiley finally found her dream home: a four-bedroom, two-and-a-half bath house in Stone Mountain. It was in move-in condition and listed for $214,000. Wiley bought the property for $199,900 with a no-money-down, fixed-rate mortgage, for which the rental income on her former home helped her qualify. Her new home appraised for $221,900. "I had instant equity," she says. Buying it back from the lender For novice foreclosure investors, the best bet is often a real estate owned home, or REO, a property that a lender bought back at auction to resell for close to market value. You can find REOs on local multiple listing services, which may be available online. Other sources include the Web sites of federal agencies and government-chartered corporations or their affiliates, such as HUD.gov, Ocwen.com (for VA-owned homes), FannieMae.com and FreddieMac.com; national online listing services, such as Realtytrac.com and Foreclosure.com, available by subscription; or property wholesalers, such as Homevestors.com (the "We buy ugly houses" people).