Profit from foreclosures is more than buying a property at a foreclosure auction and then reselling that property for a windfall gain the next day. In this article, we will consider three ways you can profit from foreclosures.

1. The Foreclosure Sale
2. REOs
3. Distressed Owners

Before we dig in, though, let’s consider the process of foreclosure.

The Foreclosure Process

Foreclosure is the result of default. When borrowers fail to make their scheduled mortgage payments, for example, because a contract is shirked, foreclosure can occur.

A legal “notice of default” or a “lawsuit to foreclose” (depending on the state) is typically filed to initiate a foreclosure. This notice is delivered to the borrower at least one month before a foreclosure sale (typically between 60 to 180 days) and subsequently posted on the Internet or in newspapers as public notice.

In response, the borrower can do several things to prevent or delay the foreclosure.

1. Workout the loan with the lender and perhaps reinstate or even refinance their mortgage defaults
2. File a legal defense against the lender and in turn drag the process into court and delay it for a year or longer
3. File for bankruptcy and automatically stay the foreclosure action. In some situations, a bankruptcy court can even annul a foreclosure sale that has already occurred.

Okay, but with no loan workout, and when legal defenses or delaying tactics are ignored or run out, the foreclosure sale date arrives and the property is auctioned to the highest cash bidder. Thus bringing us to the first way you might profit from foreclosures.

The Foreclosure Sale

Though foreclosed property sells at a price lower than market value, foreclosure auctions are not that easy because they are not a typical market value transaction.

No information about the property is given other than its legal description. You must pay cash. There is no “contingency” allowance for financing. The property is sold “as is” with no guarantees or assurances about the title, condition, environmental hazards, or even that the property will be conveyed free of occupants (you may inherit the owner, tenants, or squatters).

Savvy bidders can turn big profits at foreclosure sales, true, but there is a caveat. Never bid blind at a foreclosure sale—you have to do your homework.

REOs

Lenders that win the bid at a foreclosure auction classify and sell the property as an REO (”real estate owned”). Thus bringing us to the second way you can profit from foreclosures—purchase an REO direct from a mortgage lender.

Since lenders often want to remove REOs from their books as quickly as possible, they may grant buyers favorable terms such as low or no closing costs, below-market interest rates, and low down payments. Moreover, when the property needs fix-up work, lenders are prone to accept offers at a discount price. Lenders don’t give REOs away, but you can get good deals.

You can find REOs by attending and following up after foreclosure sales, or by contacting a real estate agent who markets REO listings.

Distressed Owners

Lastly, you can profit from foreclosures by buying property from distressed owners.

Divorce, job loss, accident, illness, business failure, and other setbacks do cause people to miss mortgage payments and get into foreclosure. You may be able to help them salvage their credit record and some equity, while at the same time secure a bargain for yourself. But its no simple deal.

1. Owners in foreclosure, for example, often owe more than their properties are worth, meaning you must talk the lender into a “short sale”. This is not easy.
2. Many who face foreclosure contend with the claims of multiple creditors. You must be sure that none of those creditors has filed a lis pendens, or the IRS a tax lien. If so, you will have to clean it up to gain clear title.
3. Before you finalize a pre-foreclosure purchase with a property owner, you must thoroughly inspect the property and accurately estimate the costs of repairs and renovations. You cannot profit from foreclosures whenever you gloss over inspections and make only an eyeball guesstimate of expected costs.
4. Someone facing foreclosure will not be an easy to deal with. So don’t act like a foreclosure shark. Rather than a “Here’s my offer-take it or leave it” approach, develop a sensitive, empathetic, problem-solving approach. You’re more likely to come up with a win-win agreement.

Here’s to your success.

The term leverage means that you use a relatively small amount of cash to acquire or control a property.

Let’s say, for instance, you plan to buy a $200,000 rental property that produces a net operating income (NOI) of $20,000 a year. If you finance this unit with $20,000 down and borrow $180,000 (a loan-to-value ratio of 90 percent), you have highly leveraged your purchase.

Think of it this way. Though you put up only 10 percent of the purchase price, you virtually own and control a property. Whereas if you paid $200,000 cash for the property, you would not have used any leverage (i.e., other people’s money).

Okay, but here’s how differing amounts of leverage can magnify your cash-on-cash returns. We’ll consider the following four examples and calculate rates of return based on alternative down payments of $200,000 (an all-cash purchase), $100,000, $50,000, and $20,000. We’ll assume the financing at 8 percent for 30 years, or $7.34 a month for each $1,000 you borrow.

Example 1: $200,000 all-cash purchase

ROI (return on investment) = Income (NOI) / Cash investment

= $20,000 / $200,000

= 10%

Example 2: $100,000 down payment with $100,000 financed. Yearly mortgage payment equals $8,808 (100 x $7.34 x 12). Cash flow equals $11,192 ($20,000 NOI less $8,808).

ROI = $11,192 / $100,000 = 11.2%

Example 3: $50,000 down payment with $150,000 financed. Yearly mortgage payments equal $13,212 (150 x $7.34 x 12). Cash flow equals $6,788 ($20,000 NOI less $13,212).

ROI = $6,788 / $50,000 = 13.6%

Example 4: $20,000 down payment with $180,000 financed. Yearly mortgage payments equal $15,854 (180 x $7.34 x 12). Cash flow equals $4,146 ($20,000 NOI less $15,854).

ROI = $4,141 / $20,000 = 20.7%

As you can see with the figures in these examples, the highly leveraged (90 percent loan-to-value ratio) purchase yields a cash-on-cash rate of return double that of a cash purchase. In other words, the higher the leverage (the more other people’s money you use) the greater your rate of return.

A short sale is one in which the property has yet to be formally foreclosed on, but the lenders have agreed to take less than is owed on the loans to get a payoff on the balance owed.

A short sale typically is allowed by lenders to prevent a real estate foreclosure because they believe that it will result in a smaller financial loss than foreclosing, moreover it’s typically faster and less expensive than a foreclosure. For the property owner, the advantages include avoidance of having a foreclosure on their credit history

Why Do Short Sales Exist?

Short sales exist because owners get in trouble and lenders have found that they can minimize their loss on bad loans by getting the property sold before they have to go through the formal foreclosure process.

Why Are There So Many Short Sales?

Short sales have become especially popular due to the combination of falling real estate prices and real estate financed with low down payments. Many property owners simply owe more on their properties than they’re currently worth, and lender’s rather agree to a short sale and forgive the unpaid debt then to foreclose on the property and re-sell it.

If you’re in this position that your property is worth less then what you owe, call your lender. You may need to make a half dozen phone calls before you find the person responsible for handling short sales, but you do not want to talk to the “real estate short sale” or “work out” department, you want the supervisor’s name, the name of the individual capable of making a decision for a short sale.

It’s not guaranteed that the lender will consent to a short sale, and there are other things that can derail it, but it may be your best option, and you’ve got nothing to lose by asking.