REO/Preforeclosure investment questions for a novice

17 Replies

I would really like to start out investing in foreclosures or pre-forclosures, and would like some advice. I think this is a really good topic.

Have you found more success on finding REO for a great price or pre-foreclosures for a straight sale?

How often do your tenants actually work out in a lease/purchase?

Have you ever experienced an un-expected negative cash flow? If so how did you prevent that in the future?

When buying either REO or Pre-Foreclosure do you typically put money down? Are you able to work off the appraised value to get a lower LTV when purchasing either type of property?

I have recently found an reo in my area that seems to be a good deal, I just don't have any money and I have average credit. Is there anything I can do?

I'll try a few of your questions.

No matter what you're trying to buy, it will be a lot of work. Plan on looking at hundreds of houses and making dozens of offers to buy one. Having found one REO means you're on your way. Now go find 50 more and make offers on 20 of them.

If you don't have any money you don't want to be in the landlord business. You need to have a few grand in cash in the bank to handle any unexpected thing that pops up.

Read in the Rental Property forum about true rental expenses. If you fall for the "cash flow = rent - PITI" lie, you'll certainly be in a world of hurt very quickly. You cannot prevent "unexpected negative cash flow". I take it by that you mean a two month vacancy where the tenant bugs out and leaves a big mess and damage you have to repair. There's nothing unexpected about that. Irritating and unpredictable. But rest assured things like that do happen. So you plan for them by having cash reserves and being realistic about your cash flow projections.

Very tough to buy REOs or Pre-foreclosures with no cash. One approach is to use hard money to buy and fix the house, then refinance into conventional loans. However, that's expensive with the hard money costs and the refinance costs. And both the hard money lender and the permanent lender will want to see cash reserves. Fannie Mae guidelines require six months PITIA (A = anything else like HOA fees) for the property you're financing or refinancing.

If you really have no cash, and want to get into this business, stop spending and start saving every penny. Dave Ramsey's "Total Money Makeover" is a great place to start.

Conventional lenders will use the lower of either the appraised value or the purchase price. Hard money lenders will look at the value when its fixed up, but only do short term loans 6-12 months at very high rates 12-18%, up to 4-6 points. Conventional lenders are going to limit you to a 75% LTV. Maybe 80% if you find the right lender. Certainly no higher. Appraisals are tighter and tighter. Plan on holding at least six months before you can refi, and even then you'll need to find the right lender. Most banks will want you to hold it a year before refinancing.

Average credit would be 720 or higher. If you're credit is lower than that, start working on your credit.

You might want to look for properties you can buy with owner financing, subject to, lease options, or other creative techniques.

I've been talking to a friend that is a broker on wall street who is also interested in investing in foreclosed real estate owned properties, and we may want to become partners in a deal.

Although both of us have limited funds, and apprently we have slightly better than average credit (I haven't checked mine yet but ive never been late on a credit payment). Assuming we can get together the six months PITI (around $5500 for the price of places I'm looking at)

A few of the reos I've been looking at are around 30-40% less than the appraised value. So the loan I would need would be less than the value of the home because its being sold under market value.

The problem is, I can't see us getting a loan from anywhere. We are two men in our twenties looking to invest, with moderate to little income. We would rely mostly on renting the homes to pay the expenses (Although we would have a few thousand cash saved up just in case). Not to mention we don't have nearly enough money for a down payment, and really don't have any strong relationships with private lenders or banks.

So, in a nutshell, is there anyway I could get the money needed to purchase an reo without a down payment? I mean, it seems like its plausable to make money as the reos I'm looking at are in a good neighborhood, and are selling for below market value. If we were to rent and hold one of the units for 1-2 years and wait till the market rises a bit we could see a sizeable return. We could probably see a return immediatley if we were to re-sell soon at around market value.

What are my feasible options?

If you rely on rent to pay any loan that you could get, your doomed. That is partly what burst the bubble.

If you plan on selling in just a few years, you may be doomed as well. There is no guarantee that prices will begin to rise soon despite what is being said by the govt experts as they need to install confidence into RE to stall the falling prices. What happens when their "rebates" end, do prices begin to fall again? Or do they stagnate for a few years?

Realistic options are to save up enough money to accomplish that purchase with cash, then fixup the property and rent it out until you have recooped the purchase price plus fixup price. This will get you on your way. Keep maticoulous records for the next 2 years and you may then be able to get a commercial loan for your next purchase.

The only way I'm aware of to buy a REO with little cash out of pocket it hard money. Not no cash, but less than the 25% down payment plus reserves a bank will want to see.

A HML will usually lend 65-70% of the ARV (HML - hard money lender, ARV - after repaired value). Some HMLs require a down payment, some don't. Find one that doesn't. If you can find a deal at about 60% of ARV, meaning the purchase price plus fixup are 60% of the CONSERVATIVE ARV, and you can borrow 70%, you should be able to do the deal with minimal cash.

Not sure what you mean by "appraised value". Unless YOU personally pay for an appraisal, its hard to get an appraised value. Certainly any value provided by the seller is suspect. An "assessed value" by the county is largely irrelevant. There are several threads on determining ARV. You have to get to know the area intimately and get a handle on recent sales and current retail listings.

If you buy at 60%, and borrow 70%, you'll end up with about 5% left after the closing costs, points, purchase and rehab. Don't think "yea, money" because that's going to go for the payments, holding costs, and the inevitable extra work. If you're lucky, it will be enough to tide you over while you're fixing it up and getting it rented. Once rented, the rent should cover the hard money payments.

A rental isn't a deal unless the rent is at least 2X the permanent P&I payment. Really, needs to be 2X the (P&I payment + $100).

You need a house that needs some work. You can't make this work if the house needs to no work. If you buy for, say, $100K and the house needs nothing, but you claim its really worth $150K, you don't have a leg to stand on. The eventual lender will say, no, you paid $100K. It was in perfect condition (your claim, not theirs), so its worth $100K at most. You have to put some work into it to justify the higher price.

You WILL have to qualify for the loan. That means decent credit (720 plus would be good, maybe can be a bit lower). Don't assume, check and see what your scores really are. That also means enough income to cover the payments. The rent may or may not be counted. If it is, they will take 75% of the rent less the PITI payment and what's left is the "net rental income". If its a good deal, this should be positive. You will have to show those reserves.

Again, learn about other types of deals. Find an owner who owns their house free and clear and doesn't need money right now. Get them to owner finance with a small down payment. Find someone who's so desperate to get rid of the house they will just let you take over the payments. Buy the house subject to the existing loan.

You bring up some good points. And any house that I would look at would probably need work, whether it be cosmetic (fix holes in walls, new flooring, paint etc.) or plumbing, electric, heating system. Most of the simple stuff I could do myself to cut down cost.

HML seems like its more realistic, however I fear the high interest rates. I would think the PITI would be higher than any rent income that we would get on the property.

I unfortunetley haven't found any foreclosed properties where the rental would be 2x the PITI, atleast not ones that I think are in my price range (so i guess maybe I haven't found any ''great deals'' =/). Because we wanted to start small, with maybe a condominium or semidetached home, with 1-2 bedrooms. Most of which in the area we are looking at rent between $800-$1400, and the mortgage on such a home would probably be anywhere between $600-$1000, and thats with a 20% down payment on a conventional loan. So there wouldnt be too much net rental income after the PITIa (especially split between 2-3 people).

Are main objective is for the property to be fully self sustaining from the rent, paying for PITI fully with net rental income left over. Then, put the property up for sale at market value during that time, or wait till the market values go up a bit and sell. I don't foresee we'll be making much money (or at all) on net rental income.

This being said I have a few quick questions:

Question 1: Would it be easier or more likely to start with a smaller home? I know that with fixing it up a smaller place would obviously be easier, and as for renting I think its definitley easier to find tenants for a 1-2 bedroom condo/semi-detached than it is for a 3-4 bedroom detached home, and I think theres less chance of failure and less dangerous with a smaller place because we would be able to deal without a tenant paying rent easier (with a big expensive house we probably wouldn't be able to deal with a high mortgage at all without rent income). BUT, i've probably seen better deals in somewhat more expensive foreclosed homes in my area (4 bedroom detached going for 50% less than market value).

Question 2: Is it better to look for multifamily homes? I'd think so to get multiple rent incomes, but are there any underlying cons?

Question 3: How accurate is zillow? I get a lot of numbers and things from zillow, as to the value or 'zestimate' of a house, and the other houses in the area. Are these realistic, or are they just round-about numbers?

Let me say this again. Break even on a rental requires the rent be 2X the P&I. Not 2X the PITI. 2X the P&I payment. Read the threads in the Rental Property forum about the 50% rule and the real expenses of rental property. If you can't buy a good deal DON'T BUY ANYTHIHNG! Give us the details of a possible deal and we'll help you understand if it will work. The goal here is to make money, not to own property. Owning property is a means to an end.

If the PITI is $600 and the rent is $800, there is NO net rental income. Even with the lender's forumla, which I think is a bit optimistic, there's ZERO income: $800 * 0.75 = $600 - PITI ($600) = $0. The other extreme, $1400 rent on $1000 PITI is the same deal. These are not money makers, they're money sinks.

You're right to fear hard money. Its expensive. The choice is to save up the cash or to find creative deals.

Are main objective is for the property to be fully self sustaining from the rent, paying for PITI fully with net rental income left over.

Then the rent MUST be at least 2X the Principle and Interest payment. End of story. If its not, you won't meet your goal.

The best deal is one that works financially. Get to know your area. What is the rental demand? What are the rents? The ranges you give are too large to be useful. You need to know within $50 what your prospective property will rent for. Drive around and call for-rent signs. Look on craigslist. Look in the paper. Know the rents, don't guess.

Look at what properties stay vacant and for how long. In most areas, 3/2's are the optimal size. Enough for a family but low enough rent to be affordable. But you need to know your area.

You don't have the cash to do a multi-family.

Zillow is useless for values. Back away from the computer, go out and look at 100 houses in your area. Find out what they're listed for. Watch them and find out what they sell for. Find out what recent sales have been. You can get that from an agent, maybe from the county or maybe from a title company.

I apologize if I seem confused I'm going day by day to understand many concepts that will help me succeed. I surely don't want to get into anything without knowing all that I need to know, and having a well layed out plan for my goals.

I looked up on the 50% rule. I suppose it means:
If I have a 1 bedroom apartment where the monthly mortgage (principal and interest) will be $500 a month, the rent of the unit should be $1000 a month (or $1100, as you said 2x + $100) to be completely self-sustaining. Any extra rental income would be cash flow I assume.

I've been looking at long lists of REO's in my area (within 20 miles in my county) and have even driven to a few to check them out (nothing formal, just looking at the exterior of the properties). I have too, been looking at craig's list getting an idea of rent costs in the area. I have a few places in mind that I've been looking at, and maybe you could give me some incite on the specifics.

I found a foreclosed 1 bedroom condo in a good suburban area (mostly middle class working people) walking distance to a bus transit center, shopping, main streets and good schools. Its 2 stories, and needs some work (bathrooms are quite filthy and may need some light plumbing work, needs floors (just has plywood), window shades, kitchen in mediocre shape, etc) It was built in 1988 and the exterior is in good shape. has 459 sq ft. Zillow listed the property tax for 2009 at around $1250.
it's listed by a brooklyn foreclosure real estate agent. the price is 169,900.

A place like this (fixed up) would probably rent around $850-$1000 in this neighborhood without utilities. I couldn't see renting it for more than $1000.

At 4.65% with 20% down the monthly P&I comes to $700. So this wouldn't fall into the 50% rule category.

Also, zillow's 'zestimate' value for this condo is $261,500. Is that even accurate at all? I cant see this place being sold for that in this market. 3/2s in this area been selling for about 400-500k max. Do you think a 1 bedroom condo could sell for 260k when 3/2s are selling for 400?
I also saw a 2/1.5 for with 1,480 sq ft 270k sell recently in this area.

An important question of mine would be:
How much could I offer on a place like this? I mean, If I can get them down significantly, than perhaps it would be worth it, but obviously not at its current asking price. Is it realistic to try to get them down 40k? If I can get the loan down to 130k, with 20% down, at 4.65%, the P&I come down to about $530, which is much closer to the 50% rule. Its been on the market for almost 2 months.

I have bunch of other places in mind but this one is small and personally manageable. I would be able to do most or all of the cosmetic work myself and I have a friend thats a good plumber and I know a good contractor. But the important thing would be to try to get the price down significantly. Do you think thats possible?

One more quick question (if you can answer): My friend is reading a book by Robert G. Allen entitled Nothing Down for the 2000's. Does this guy have a good reputation, or is he just another guru? My friend gave me a copy of the book but before I read it I'd like to know if the techniques in it are proven to be good, especially for the current market, and I'd like to know if Mr. Allen has any actual experience in real estate investing or if he is just another salesmen.

Phil, If you decide to go with a hard money loan you might want to be very careful. If you have little funds you might find yourself in a heap of trouble if the appraisal comes in lower then expected. You need to be prepared if the value comes in lower and the lender tells you that you need to bring $10K to close and you didnt expect this, what are you going to do? Do you have those funds to close? The hard moneny lender is going to want their money back and you will need to close or refinance.

My suggestion is that you build up some cash reserves, improve your credit to at least 720. If you have 6 months reserves for the home you want to buy then you could look at buying. I know you might be excited and ready to go but play this game smart.

If the rent is $1000, the 50% rule says the expenses will be $500. That includes operating expenses as defined by the IRS (taxes, insurance, maintenance, property management, snow removal, legal fees, CPA fees, etc.), capital expenses (roof, improvements), and loss of rent from vacancy. If the P&I payment is $500, you're right at break even. To have, say, $100 in true cash flow, you need to have the P&I payment be only $400.

As you've deduced the market controls rent, not you. So, the single most critical parameter is to figure out a realistic number for the rent you will get. $850 to $1000 is too large a range. Do more homework, and come up with a number within $50 of what you think you will get. Search craigslist and make phone calls. Determine amenities. Watch how long units are vacant.

Paying $170K or even $130K for $1000 in rent is a bad deal. For $1000 in rent, you need to be down around $70-80K. If you can't find that, don't buy anything! No deal, and its corresponding "no monthly loss" beats the heck out of pulling money out of your own pocket each month.

Ignore the down payment for this calculation. Do you first calculation assuming 100% financing. Why? Because your money has value. If you pay cash for a property, it will always cash flow. But if you put in $100K and you get $3000 a year in cash flow, that's a crap deal. You can get that at a bank with a CD and have no risk and none of the hassles of owing rentals. Like my spending last Thursday, Friday, and Sunday nights and $320 getting my tenants heat working.

So, do the calculation assuming 100% financing. If it works out, ie, generates some real cash flow, then re-do the calculation using your down payment. That will generate more cash flow. Divide the annual cash flow by the cash you have into the deal to get your "cash on cash return". Compare that to alternative investments for that cash and see if you're happy. Personally I want to see 20% plus, given all the hassles and risk of real estate.

Non owner occupied rates are not 4.65%. I just closed a loan a couple of weeks ago at 5.875%. A year ago NOO rates were 7%. You're looking at owner occupied rates.

You should assume you will need to put 25% down. If you can only do 20%, you need to shop for a lender first, and be sure they can really close the loan. If you're doing hard money, be EXTREMELY conservative with the post-repair value. You MUST, MUST, MUST look at all the comps and especially the low end. Once upon a time you had some influence over the appraiser, and could nudge them toward the higher comps. No more. Assume they will use the lowest three good comps. The challenge with an appraisal is to get them to use the lowest three fixed up comps rather than the lowest three REO comps.

I would never invest in 1BR condos. One bed is too small. You'll only get a single person or a young couple, and they will move on as soon as they can. Condos are going to have HOAs, and they can suck you cash away from you on a whim. The 50% rule should be considered a lower bound on a condo, and you should plan that a jump in dues or a special assessment could kick you much higher. Evaluate the HOA carefully to be sure its funded and well managed. Better still, stay away from condos. They're the first to fall in value when the market declines and the last to come back.

Ignore zillow values. They're absolutely worthless. Get out and look at 100's of properties in your target area. Watch sales. Get the sold prices. Watch the listings. With some time and careful tracking, you'll learn the values for your area, and what affects those values (e.g., busy street, good parking, etc.) There are lots of online valuation sites. None can substitute for your first hand knowledge of an area. Many years ago when I was house hunting in Sugarland, TX, the agent showing us around could drive by any house in the neighborhood and describe the interior and give a value. And this is a neighborhood with million dollar houses on one corner down to $100K houses on the opposite corner. I was amazed she could do this. But after doing it for a while, I can come pretty close in my working neighborhoods.

Robert Allens stuff may have worked before the bubble burst. Not now.

Its very difficult to get a seller down from $170K to $130K. You want to buy at a price that makes sense to you ($130K doesn't, for you example), but the asking price gives you an indication of whether or not you can manage to buy that property. A bank is not going to come down from $170K to $130K on a property that's been on the market for two months. After 8-10 months, maybe. But in that interval, they will drop the price, and when it hits the "good price" value, it will get snapped up.

To play the REO field, you must be an all cash buyer (real cash, either yours or a pertners).
To go after pre-foreclosures, you can do either short sales or equity sales of desperate sellers. Those two avenues can allow for an easier entrance for someone with limited funds.

As a buy and holder, I strongly urge you to avoid hard money loans. Those are usually designed for flipping and do not be suckered into the "just re-finance out of it into a fixed 30 year loan". Just ask the millions of people who got creativbe loans and were told that and now can not get any other regular financing!

The hard money/refi route it expensive, and you better be dang sure you can qualify for the refi, but I've done this successfully twice. Plan on at least six months from the initial purchase to the refi.

I'll also say that I'm not going to try it again until I have higher confidence about pulling off the refi.

And, I would not want to try it without 10% of ARV in spendable cash.

Okay, as for financing we've decided to stay away from hard money because it would be extremely risky for us. Instead, my partner luckily has a good amount of contacts and found a few private investors in the area and one of them (who has experience purchasing real estate directly from home owners and builders, not from a bank as we plan on doing in this case) has offered to sit down with us next week. This is going to be interesting, but unfortunetly we're probably getting ahead of ourselves because we don't have a solid framework for our plan. Also, this weekend we drove around and checked out about 20 foreclosed properties, and we've found a few that we believe to be profitable (however there are drawbacks).

First off, I need some advice on the financing situation. I went into the private lending forum, and theres a lot of talk about how to find a private invester, but little about what exactly should be negotiated in a deal with one. We've found the private invester (if all goes well), so what next? My partner said we could borrow a down payment and money for rehab, but I felt we would still need a conventional mortgage after that and would still get denied. Another idea was to ask him to lend us the full price of the home plus rehab, but in which case we felt he would just own the home and wouldn't need us. So we really don't know what the best way would be to utilize the private money. I understand that he would not be doing this for free, and would want to set terms so that he could make a profit, and benefit from what we have to offer.
But, as for financing with private money, we simply don't know how to go about it. We don't know how much money to ask for, and how it would benefit him (whether we would pay him principal and interest monthly or he takes a chunk of the profits when the home is sold, or both).

Now, to the easier part, the homes we looked at. We looked at a nice looking, clean exterior, semi-detached 3/2.5 home (built 1991) with 1280sqft for $127,000 ($99.22 per square foot) (asking price was just reduced $5,000). Its considered a 'mother/daughter' home, which means its 2/1.5 upstairs and 1 bedroom in the basement, which I believe is rentable. Not sure if its legally rentable as a two family, and its listed as a single family. The interior is semi-complete, it needs flooring, the stairs need refinishing, kitchens and bathrooms are in OK shape, needs new eletrical fixtures and a few other things. Its been on the market for 3 and a half months, and its owned by Bank of America.

If it can be rented as a two family, the upstairs should get atleast $1200 and the basement should get $700 (conservatively, probably could get more compared to craigslist and the local paper for that area). So, $1900 rent monthly. 50% rule states that my expenses will be $950 a month. A no money down 30 year mortgage (no money down) for $127,000 at 7% interest comes to $844.93 a month. That leaves $105.07 positive cash flow a month. So the numbers seem to fit. However, there is a con. The neighborhood isn't terrible, but the home is directly across the street from public housing. We passed by late tonight (12:30am) just to see how it looked at night, and there were some shady characters hanging around the parking lot of the development directly across the street. Steel bars on the basement windows were also noted. My partner made a good point that this home might be a good candidate for section 8, if we would want to go that route. Selling the home in the end to turn a profit would probably be more difficult because of this.

All in all, does this sound like a possible deal?
Does the public housing across the street scream STOP? Are we more, or less likely to get problem tenants using section 8 (I hear pros and cons about it).

Do you think we could get the bank down a couple of grand; say maybe 10-$15,000?

With that low of cash flow, is it worth it?

The value of the house seems low, so if we could rent it for a few years with a small cash flow in return and eventually sell at ARV along with a rise in the market in a few years, is it possible to turn a strong profit?

And, also, what should I do with our possible private money investor? If he feels this is a good deal, how should the financing work? I've need been in a situation like this and really don't know where to start.

Thanks for reading...


I don't know your current market conditions in your area, but from what you have explained, YES - I would be scared and possibly put on the brakes.

Second, renting this as a two family may not be possible. If not, your rental income would dramatically reduce and this is already low on the cash flow.
I prefer buying and holding in areas where I can expect better future appreciation and better ease of liquidating, but that is just my personal biz model.

Originally posted by Phil Mondiello:
... Do you think we could get the bank down a couple of grand; say maybe 10-$15,000?

Just got a verbal acceptance on an REO, and it was not long on the market (bank repo'd it from another BP member :wink: ). After a week on market, bank came down $5K, and I offered $10K below that new listing price - offer accepted. So they will come down $15K, and the price on mine was a bit lower than yours, so it's worth a try so long as the competition is not actively pursuing the same property. If it gets competitive with multiple offers, then the bank might not move.

Originally posted by Phil Mondiello:
If we were to rent and hold one of the units for 1-2 years and wait till the market rises a bit we could see a sizeable return. We could probably see a return immediatley if we were to re-sell soon at around market value.

What are my feasible options?

We've learned now that RE, just like any other financial market, can go up or down. Over the long term, it will present a return, investors seem to get into trouble when they have no capital to buffer losses and make no money at closing.

If you have credit less than 720, no money and are hoping that there's no vacancies AND appreciation that seems shaky. It sounds as though you can build in "instant equity" by focusing on reducing that 60 - 70% of FMV. Why not set a maximum of 60%? It will take a much larger volume of deals to move to closing but pay off long term WHEN a market depresses and you have lots of wiggle room before any losses are incurred.

Phil, You have recieved a ton of great advice from Jon and others here. FNMA and Freddie both are tightening requirements on investment properties, requiring two years history to count rental income in qualifying; which for beginning investors usualy puts their DTI through the roof. So, it is getting even harder to qualify for buy and hold properties. Two options for starting are to whoslesale REO's using 100% transactional funding or to assign pre-foreclosure contracts for a fee. Both do require you to have a buyer in place by the time you have to close. Many investors have started in this Wholesale arena. Hard money is an option, but is likely to be difficult to get without some of your own cash or "skin" in the game, and as Jon said can be dangerous - make sure you are very confident in your deal, and count much less than previously on the "I'll just refinance out of it" strategy.
To your success,

any thoughts on what to present to my private lender?

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