Experienced investors seek foreclosures because they know that the court system uses a valuation system for properties that are in foreclosure usually at a far lower amount than market value.
The general idea of "forced sale cash value" - as foreclosures as known in the courts - is to determine what a person would pay for the property if it were to 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. It may be 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 the forced sale cash value.
Value Relative to Mortgage
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 refinance or sell the house, before the lender can take it over.
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 homeowner at a value that is both low enough to generate a high margin, and that will be enough to pay out the lenders on title.
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 $7,000 just for the lender's lawyers, including the borrower's lawyers, court costs, court-appointed realtor costs, bank late interest, fees, other charges and arrears payments.
Example of a Foreclosure Purchase
For example, let's say a property has a market value of $425,000, based upon comparable sales in a neighbourhood. The property is in foreclosure, so the court-appointed appraisal firm determines a forced sale, cash value of $360,000.
Additionally, let's say the owner of the property owes the lender a mortgage amount of $280,000. In this example, we have "market equity" of $145,000 and "hard equity" of $80,000.
Despite the equity in the property, the homeowner may be happy just to have another person write them a cheque for $50,000 above the amount owed to the lender, and walk away from the headache.
Of course, the investor does not get the instant $95,000 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 interested in making a fast dollar, but would like to make more profit, over the longer term, they may keep the property as a rental and sell it in years to come.
Have you bought a foreclosure property? Leave your comments here.
Julie Vesuwalla is an associate broker at Century 21 The Professionals Ltd. in Calgary, Alberta.