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2007-01-30 09:27:00

Foreclosures: Causes and Triggers

Timing is everything, this is old news, you hear it all the time. Another cliché you hear all the time is that to make money as an investor you must "buy low/sell high". Yet many people do just the opposite. It's the old herd instinct, do what everyone else is doing. I guess we feel safety in numbers, we certainly don't make any money this way.

Successful investors understand the business cycle, they know when to buy and when to sell. A glance at history shows us that there are four phases to the business cycle: expansion, prosperity, recession, depression. Economists have tracked it in detail since December of 1854. Since then it is generally agreed that the economy has progressed through 30 expansion phases and 30 contraction phases (recessions or depressions depending on the degree of severity). There are more investment opportunities available to an investor when there are fewer investors to compete for them. It is the old law of supply and demand.

Many people attempt to learn about foreclosures by attending foreclosure classes and then jumping into the foreclosure market. After a few feeble attempts, they are convinced that you can't acquire property in this manner and go back to being a "Couch Potato".

What they fail to understand is that foreclosures is just one segment or type of real estate acquisition technique and although there are always opportunities for the person who is committed to searching for them, some periods of time may provide you with more foreclosure opportunities then other periods of time. If you recognize this, you will be more effective with the management of your time and will actually achieve investment success sooner.

Before we discuss the specifics of foreclosures, let's discuss what your expectations of this are. Just because you can pick up a property at a foreclosure sale does not in and of itself mean you made an astute decision. There must be value for what you are purchasing, either existing value, value that you can create in the property, or value that will be there at some point in the future, which you recognize and no one else does.


What are the forces that influence value?

Physical - convenience of schools, churches, playgrounds, shopping center.

Social - population trends (birth, death, in and out migration), marriage and divorce rates, educational and religious standards, etc.

Economic - natural resources, direction of growth, employment opportunities, wage levels.

Political - zoning, government loan programs, rent assistance programs, growth control, fire and police protection

Are the loans against the property greater than the value of the property itself?

How many foreclosures in this market?

If everyone here jumped into the foreclosure market, it would bid up prices (perhaps you could form foreclosure investment groups so as not to bid against one another).

What does it take to purchase at a foreclosure?

Usually money.

Why? arrearages of up to six months, plus foreclosure expenses.

But does it have to be your money?

Timing - the economy and foreclosures, don't waste your most precious asset. You want to spent time attempting to acquire foreclosure property at the time which will give you the greatest probability of success.

Historic trends  - the historic trends in delinquencies and foreclosures are very interesting. The long term trend in foreclosures over the past 30 to 40 years has been upward. During the mid 1950's, delinquency rates have increased from about 2.5% to 5.5% and the percent in foreclosure has risen from about .07 in 1962 to about .19 in 1984. The important observation here is that many delinquencies are filed but very few enter foreclosure and a smaller number are sold at sale (Mortgage Bankers Association data, not including Jr. liens). The Mortgage Banker's Assn. National Delinquency Survey (MBA-NDS) includes mortgages held by institutional lenders only; creative financing, seconds and thirds held by the seller are not included. It includes conventional, FHA, and VA loans. MBA data on delinquencies and foreclosure from 1953 to 1984 is included here.

What are some of the causes of high delinquency rates and ultimately foreclosures? Understanding the reasons will help us determine if enough reasons are present to make the odds of finding a property that fits our criteria that much better.

Causes of Defaults and Foreclosures

A. General economic factors such as inflation, income and  unemployment, and interest rates.

1. Inflation can be expected to affect foreclosure sales  negatively, that is, the higher the rate of inflation, the lower    the number of foreclosures. A higher rate of inflation implies   higher home prices, and the higher the home prices (with the same amount of debt), the greater the equity.

Given a default, the greater the equity in a home, the lower the chance of a foreclosure sale.

Example:  In most instances, if there is equity in the home, a defaulting homeowner will sell the home in the market, and pay off the loan rather than allow a foreclosure sale, which will adversely affect their future attempts to obtain credit.

             Value at purchase:        $150,000.00
             High Inflation (10%):         15,000.00
             New Value:                  $165,000.00 
Even if they bought the property "Nothing Down" if they put it on the market for $155,000.00, at $10,000.00 below market value, it should sell quickly and the owner would avoid the adverse effects of a foreclosure.

If the market is slow and it cannot be readily sold,  this is the opportunity our investor is looking for.  If the market is slow, you may be able to assume the loan, give the owner a $5000.00 note, and take over  the payments. When the  market turns, you can sell the property for a profit.



2. Income - The greater the level of income, or increases in income, this less chance of default. Unemployment will increase defaults and foreclosures. Keep your eyes on local employment and unemployment trends. Factories closing down or cutting back will increase foreclosure opportunities (it will also probably affect rentals and this is a consideration you must take into  account as you analyze the property for purchase).  

3. Interest Rates - The higher the interest rates, the greater the chance of delinquency and foreclosure. Higher rates imply lower demand for homes, lower home prices, and  fewer sales. During periods of high interest rates, a defaulting homeowner will experience greater difficulty  in selling the home on the open market and there will be a greater chance that the home will go to foreclosure sale.

4. Equity Loans (Homeowner's loans) and Balloon Payments - Lender laxity in underwriting standards and inflated appraisals have resulted in over encumbered properties, properties which will either sell for less than the loans at foreclosure or become the property of the lender.

It should be noted that reduced income and unemployment are, technically, reasons for default, but not necessarily reasons for foreclosures. An owners loss of job or reduced income may be the reason for default, but whether this leads to a foreclosure sale depends on the state of the real estate market at the time of the default. 

The typical defaulting homeowner and properties are usually financially overencumbered. The borrower has obtained too many loans on the property or loans that are too large, resulting in little or no equity in the property. Little or no equity in the property implies a greater likelihood of default and foreclosure.

During times of demand for homes, when many homes are being bought and sold, there is upward pressure on home prices and homes are easy to sell. A defaulting owner can simply sell the home on the market and prepay the loan or loans. It is only when the market for homes is slow (based on economic reasons discussed), when there is downward pressure on home prices, when there is little or no equity in homes, that it will be necessary for a defaulting homeowner to allow the home to go to foreclosure sale.

Your advantage as an investors rests in your knowledge of real estate and knowledge of the foreclosure process. Foreclosures are rarely planned, and the owner in default is frequently uninformed about loan arrangement and seldom prepared to cope with the specific and threatening procedures and consequences. As a result, it is not uncommon for them to underestimate the extent of their financial obligations.

Most borrowers in default want to retain their property, as a matter of fact, only about 2% let their property go to sale. These are usually the overencumbered properties. Methods to avoid the foreclosure are:

1. Borrowing further against the equity or some other form of collateral. This often is just a "stop gap" measure which buys    time until a long term, permanent solution can be worked out.

2. Borrower can put the property on the market and sell it to a financially capable buyer, who can meet all the financial obligations associated with the debt.

3. Take on an equity partner who has the cash to handle the immediate crisis.

4. Borrower may negotiate with lender to forestall the foreclosure.

Human beings being what they are, borrowers in default frequently fail to take timely and effective action to avoid the foreclosure. It is not uncommon for them to procrastinate during the early period of the process. This often means that a substantial portion of the time allowed for reinstatement or redemption, when the debtor could act to avoid the sale, is lost. By the time that they realize the importance of seriousness of the situation, there is little time remaining to prevent the sale. Reasons for on the part of the borrower in default are:

1. They are often poorly informed and lack the knowledge to save the property. A survey of borrowers by the California State  University and the Real Estate and Land Use institute recorded  the following comments from borrowers in default:

"I had no idea what was happening during the whole foreclosure process. Even my lawyer couldn't or wouldn't explain the process so I would understand."

"We are totally confused about the whole process. No one would try to explain what was going on."

"I had no idea what was happening throughout the whole foreclosure proceeding."

2. They sometimes receive inaccurate advice. In the same above mentioned survey, borrowers attributed their lack of information about the default and foreclosure process primarily to poor advice from real estate professionals such as lenders,  attorneys, real estate licensees, and trustees.

3. In some cases, there does not APPEAR to be a practical solution to the cure the default either because of lack of equity, no  financially capable buyers available, or just that the debtor    is so destitute that they cannot spend the money necessary for    legal or other assistance that might help them solve their problem.

The Foreclosure Investor operates from a non traumatic and objective state of mind. By working with and educating the debtor in default, you are providing a service in the foreclosure proceeding that will ultimately benefit all parties to the transaction. You may not always end up with the property, but you will have helped another human being, and sometimes you will end up with the property.

By understanding all that we have discussed, you will develop a system that will allow you to use your time to the greatest advantage. Try to find the property before the ultimate crisis point, but remember, most people will procrastinate so the likelihood of your wholesale offer being accepted increases later in the default period.

Finding Distressed Properties

Before we look specifically at where to find distressed properties, it will be useful to examine the practices of lenders as they relate to the foreclosure process. Many lenders, especially institutional lenders, are reluctant to foreclose. They are in the business of loaning money, not owning real estate. Generally their policies are to avoid foreclosure if there is any other reasonable alternative to cure the default. In a survey conducted by the California State University - Real Estate Land Use Institute (CSU-RELUI), the following reasons were given by lenders explaining their reluctance to foreclose.

1. Often times the institutional lender is the only bidder at the foreclosure sale, resulting in the institution acquiring the collateral property. To many "REO's" may  result in adverse regulatory action.

2. Owning and selling property acquired through a foreclosure cost the lender money for legal, administrative, management, fix-up, insurance, taxes, and costs of the ultimate disposition or sale.

3. They often times lack the ability to manage the property.

4. Lenders are conscious of their public image and do not want to be seen as heartless foreclosers. Such an image may affect their future mortgage loan volume.

Because of the above, lenders will usually make every reasonable effort to work with a good faith, honest, and conscientious debtor to avoid foreclosure. It should be noted, however, that a lender has a much greater incentive to work with a borrower when there is little equity in the property. When the property contains a significant amount of equity, the lender has a greater financial incentive to take possession, depending upon their current  Real Estate Owned(REO) portfolio.

Where do you find foreclosure properties?

1. Develop relationships with lenders - prior to notice of default. Also their REO departments.

2. Understand Jr. Lien foreclosures, communicate with Jr. lien holders.

3. County Recorder or Court House -- a visit to the Hall of Records or Court House will usually reveal properties in foreclosure.

4. VA/FHA properties -  Information about HUD and VA properties are available through the multiple listing services and at their web sites.

5. Advertising - by placing ads, you may be able to reach owners in default, and eliminate some of the competition that you would encounter after the public notices are published.

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6. Communicate with owners prior to foreclosure.

7. Private Records Services - for a fee, investors can subscribe to lists compiled by private companies of default actions affecting real property. These companies employee "readers" and will alert subscribers to notices of default.


(Saul Klein is CEO of Real Estate Electronic Publishing Company, home of RealTown.)

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