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Tuesday, 18 October 2011

Investment in Foreclosures - myth or reality for the average person?

Foreclosure investment: an elusive myth or apparent reality?

It is raining foreclosures. Canada is experiencing significant increases in foreclosure. Many
seasoned investors are spending much time and resources to identify “distressed” (read:
foreclosed) properties, in an effort to acquire them at significantly below market value. Upon
acquisition, the investor can improve the property and sell at a higher price or simply keep it as a
rental property. This article will briefly introduce you to the idea of foreclosure, why investor’s
like to find them and an example of how buying a foreclosure works.

What is a foreclosure?
Many have heard the term foreclosure in their life, but few understand what it means. Practically
speaking, foreclosure is the legal process of transferring property ownership from the borrower
to the lender.

Why is a property foreclosed upon?
Normally, foreclosure is caused due to non payment of a mortgage. This can happen for a
number of reasons including, loss of job, divorce, disability or other even death.

Other reasons causing foreclosure is one that is more common in today’s climate: lenders failing
to renew mortgages. Yes, it is true. For years may have treated a mortgage renewal as a simple
signature on a renewal notice sent to you in the mail. In the last 12 months however, some
lenders are no longer renewing mortgages either because the lender is out of business or because
they no longer offer the mortgage product, such as revenue property mortgage.

As the borrower, you may have made all your payments on time, however upon renewal date,
the lender has the right not to renew, despite your good payment history. If you cannot find a
replacement lender within a reasonable amount of time, (sometimes up to 90 days) the existing
lender will initiate foreclosure.

Why do savvy investors seek foreclosures?
Experienced investors seek foreclosures because they know that the court system uses a
valuation system to value properties that are in foreclosure at a far lower amount than market
value. The value they use is called forced sale, cash value. The general idea of forced sale, cash
value is to determine what a person would pay for the property, if it were to be purchased using
all cash, not bank financing. Like in many things in life, a buyer usually gets a good deal if they
pay for something with all cash, instead of credit. You may normally experience this type of
pricing in garage sales, flea markets or shopping bazaars. Hard to believe, but this same concept
applies in the foreclosure system.

During the foreclosure process, the courts order an appraisal on the subject property in order to
determine both the market value and forced sale, cash value. In general terms, if the borrower’s
mortgage is worth more than the forced sale, cash value then most likely the borrower will end
up losing the house to the lender. If the forced sale value is higher than the mortgage amount
owing, then the borrower will be given time to either refinance or sell the house, before the lender is given a chance to take it over.

The savvy investors seek those properties where the mortgage amount owing is far less than the
forced sale, cash value so they can negotiate a purchase from the current home owner at a value
is both low enough to generate a high margin and that will be enough to payout the lenders on

Why do people who are in foreclosure sell their houses to investors at a value far less than what
the market will offer?

Many times homeowners who are in foreclosure simply do not want the stress. In other cases, it
may be cheaper to sell the house fast, rather than incur legal fees that can average over $12,000.00
just for the lender’s lawyers ---not including the borrower’s lawyers, court costs, court appointed
realtor costs, bank late interest, fees, other charges and arrears payments. If the foreclosure goes for a long time, over 6 months (or into the years - yes this can happen), total foreclosure costs can come to over $20,000.00, not including the loss in house value because of the stigma associated with foreclosure.

Example of a foreclosure purchase:
For example, let’s say a property has a market value of $425,000.00, based upon comparable
sales in a neighborhood. The property is in foreclosure, so the court appointed appraisal firm
determines a forced sale, cash value of $360,000.00. Additionally, let’s say the owner of the
property owes the lender a mortgage amount of $280,000.00. In this example, we have “market
equity” of $145,000.00 and “hard equity” of $80,000.00. Despite the equity in the property, the
homeowner may be happy just to have another person write them a check for $50,000.00 above
the amount owed to the lender and walk away from the headache.

Hard to believe but yes, this happens. Of course, the investor does not get the instant $95,000.00
equity for free, they must also have enough money or financial strength to either payout the
existing mortgages or bring the arrears payment up-to-date and convince the lender to let them
take over the payments.

Now the new owner can fix the house up, or better yet, if the house is already in great shape, just
clean it and list it for sale. If the investor is not interest in making a fast dollar, but would like
to make more profit, over the longer term, then they may simply keep it as a rental and sell it in
years to come.

Where to find foreclosures:

Mortgage brokers specializing in foreclosures
Other Investors
The court house

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