Are foreclosures a good investment?

Every Cloud Has A Silver Lining ( be hopeful because difficult times always lead to better days ... ) - Unknown (quoted from GoEnglish)

Everyone knows about the huge sub-prime mortgage debacle that is unfolding in our country right now. According to the New York Times, (link to article), six million people are expected to default on their mortgages this year. In addition to that, houses are rapidly decreasing in value all over the United States due to lack of demand. Although this is really bad news, for some, it presents a huge opportunity.

This opportunity is to diversify your current investment portfolio. I have been looking into expanding my investment portfolio into the real estate arena because stocks are still highly volatile and the prices in the real estate market have fallen drastically. Plus, having a guaranteed way to make passive residual income is very appealing. However, before diving in head first, I wanted to take the steps to educate myself on the topic to see if it is a viable way to invest.

Earlier this week, I attended a Foreclosure Investment Property Seminar at the Georgia Tech Alumni Association given by Mary Beth Lake who is a Realtor with the Harry Norman Realtors company. She provided us a very informative and interesting presentation that covered the pros and the cons of investing in Foreclosure properties. I felt that this presentation is great information to share with anyone who was thinking about investing in Foreclosures or Real Estate in general. Below is a summary of the presentation she provided as well as some of my added notes:

Investment Real Estate (Foreclosures)

Investment Real Estate: Real estate that generates income or is otherwise intended for investment purposes rather than as a primary residence. (Citation)

Foreclosures

Foreclosures are typically "distressed" properties that a bank repossesses in means to recover the cost of the loan that a homeowner has defaulted on. Foreclosure usually progresses in the following stages:

1. Pre-Foreclosure
• If the homeowner misses one mortgage payment, the foreclosure process can begin.
  
• Sometimes during the pre-foreclosure stage, the bank will work with the homeowner and agree on a "Short Sale" in which the bank agrees to take a lower price on the home than what is actually owed.
2. Foreclosure by the Bank
• The bank goes through the process of evicting the tenant out of the home and repossessing the home to put it up for sale.
• The bank can advertise the home on the courthouse steps to have the property bidded on.
  
• Some states are non-judicial meaning that the bank does not have to take the home owner to court to evict them.
  
3. Sold/Auctioned as a Foreclosure
• The bank can sell the home on the courthouse steps.
• If the home does not sell, the bank can choose to list the who with an Real Estate Owned (REO) Agent who can either choose to sell the property through a public auction or by using the traditional means such as the Multiple Listing Service (MLS).
  

Caution: Pre-foreclosures and Short Sales can take a lot of time and require a lot of patience. Short sales are very risky and foreclosure homes are usually sold without any disclosures. This is important to know because states like Georgia are "Buyer Beware" which means the buyer would not be able to hand back the property if they decide they do not want it anymore after signing the contract.

Due Diligence

Prior to investing in the foreclosure market, much due diligence needs to be done to determine whether or not the home is a good investment. To assist in the planning of this one must realize the four financial benefits of owning investment real estate and how to calculate them. The four benefits are the following:

1. Income
2. Principal Reduction
3. Income Tax Savings
4. Appreciation

Income: Revenue generated by the Real Estate property (rent).

Principal Reduction: Reducing the amount borrowed or the amount still owed on a loan.

Income Tax Savings: Deductions that you can claim on your income from owning Investment Real Estate. For more details, click the "Financial World" link. (Financial World )

Appreciation: An increase in the value of an asset over time. (Investopedia)

To assist with the analysis of the investment property, the presenter (Mary Beth) provided us with an excel spreadsheet she acquired from Tom Lundstedt who gives seminars about investing in Real Estate. (Thanks Mary Beth and Tom!) This file is accessible to our members through the "files section" on the Pamplona Finance Google Groups Page.

For those who review the pre-filled excel spreadsheet, the scenario to accompany that file is listed below:

Scenario:

• You are investigating a property in east Point that is listed for $139,000. You think that you can negotiate the seller down to at least $130,000.
• You plan to put 20% down and pay all the closing costs.
• You would like to close in early December 2008 so that you can make any necessary repairs over your holiday break and hopefully have it leased by January 1st 2009. You plan to lease it for a year.

Some other useful tips during due diligence is to do the following:

• Use the tool to analyze multiple homes in the area.
• Fill out a Schedule E for Real Estate Investments to claim on your taxes.
• Can request a Schedule E if purchasing this home from a Real Estate Investor.

For more information about the Schedule E, consult about.com article here.

Gathering the Money to Invest

With the economy being in the state that it is, many investors are not able to reach deep into their bank accounts to put the money up to obtain an investment property. Most first time investors will have to take some type of loan from a bank and pay the money back over an extended amount of time. This part of the presentation was given by George Connolly who is a mortgage broker with SunTrust Mortgage. Below are the initial requirements needed to finance a Real Estate Investment if borrowing the money from a bank:

1. 20% of the sale price down payment.
2. 3% closing cost of the loan.
3. Six month property emergency fund to cover mortgage and monthly expenses when the house is not generating income.
4. $5,000 - $10,000 in liquid reserve for repairs, emergencies.
5. Monthly expenses
• Accounting Fees
• Attorney Fees
• Landscape Maintenance
• Utilities
• Taxes
• Insurance
  

The Exit Strategy

With all businesses, it is important to know what you are going to do once you figure that the property is no longer a good investment or you are ready to cash in. In the optimum situation, the house will appreciate over time and you will build equity in the home. Equity is the difference between the current market value of the property and the amount the owner still owes on the mortgage. (Investopedia) There are three ways to move the equity:

1. Sell the current property and buy another.
• Will have to pay Capital Gains Taxes. (Captial Gains Tax Calculator)
  
2. Refinance the current property and use the money to buy another property.
3. 1031 Exchange.
• 1031 Exchange - A tax deferred exchange that is for like-kind investement with property with a specified strict time period. (IRS)

More Useful Information

• Always purchase Owner's Title Insurance.
• Financiing can make the difference between a property performing well or going down the drain.
• Don't confuse Inflation with Appreciation.
• Places to purchase a great deal
• Excellent School Districts
• Developed/Developing areas
• Places you would not mind living yourself
• Get a team of proven professionals to assist you with investment decisions. Team should include the following:
• Accountant
• Attorney
• Loan Officer
• Property Management Company
• Realtor
• 1031 Exchange Qualified Intermediary

One thing that the presenter shared with us is that Foreclosed homes are a lot of work and may not be as lucrative of an investment as many people think it is. To help with your decision, I have included a video that I took while surveying a home that I found on www.ushomeauction.com.

In summary, if you are willing to put in the effort, time and money needed, a foreclosure can be a good investment. However, I think that it may be worth the time and effort to spend a little extra money on a non-foreclosed home as it may require less work to make it habitable for re-sell or a tenant. From my research, I have learned that it if you want to invest in Real Estate, do not just limit yourself to searching for foreclosed homes.

Do you think that Foreclosures are still a good investment? Please leave your comments below.

Stay Disciplined!