Distressed Property: California Dreamin’

Distressed properties have traditionally been found primarily in marginal areas that experienced sharp declines in market value amid economic decline.  However, in the deep industry recession of 2007-12, even high-quality Los Angeles neighborhoods  experienced substantial foreclosure volumes.  While foreclosures are now relatively rare, there are always some opportunities in this market segment.

Foreclosure Background and Timeline

California is a ‘deed of trust’ state which means that the property deed is held by a third-party trustee not the lender or homeowner.  Generally all foreclosures are non-judicial as lenders foreclose on the deed through a Trustee’s Sale rather than going to court.  In LA county, these sales are literally held on the district courthouse steps in Norwalk or Pomona.

The start of the process begins with the filing of a Notice of Default (NOD) when a homeowner is late on their mortgage payment (traditionally done if payment is more than 30 days late).  The homeowner then has 90 days to cure the default by making all late payments and associated fees.  After the 90 day period expires, the lender files a Notice of Trustee Sale (NOS) giving at least 20 days notice prior to sale of the property at auction.

The property will be sold at auction to either an investor making a cash bid above the lender-set opening bid (with no opportunity for property inspection) or the lender will bid an amount equal to the Unpaid Principal Balance (UPB) of the mortgage plus penalties, fees, etc.  Since that amount is owed to the lender, they have no out-of-pocket cost to acquire the property.

If the lender purchases the property at auction, it is referred to as ‘bank-owned’ or ‘real estate owned’ (REO).   Banks generally assign properties to a third-party asset management company that handles the eviction (if necessary); ‘trash out’ and any required repairs; and assigns the property to an REO specialist real estate agent that will list it for sale and coordinate the property sale with the asset manager.

To recap, the market characterizes distressed properties at one of three stages:

  • Pre-Foreclosure:  the property owner is up to 90 days late on their mortgage payment and a Notice of Default (NOD) has been filed.
  • Auction:  the property owner is more than 90 days late on their mortgage payment and a Notice of Trustee’s Sale (NOTS) has been filed.   The borrower can catch up on payments and pay penalties due at any time prior to the auction.
  • Bank-Owned or REO:  ownership of the property has now been transferred to the bank (or an investor) and it will be sold by a real estate agent in the future.

Most foreclosure investors buy properties at the trustee’s sale or when the property gets listed for sale in the local MLS.  In Los Angeles County, there are many active foreclosure investors and bidding is highly competitive at auction and for MLS-listed REO properties.

Investment Strategies

There are different acquisition strategies that are applicable at each stage of the foreclosure process.

Stage: Pre-foreclosure

During the pre-foreclosure stage, purchase offers can be made to the homeowner as a ‘short sale’.   That is, the sale price is less than the unpaid principal balance (UPB) and therefore requires approval by the lender (s) as well as the homeowner.   Because of the multi-step approval process, a short sale can take a long time to consummate, often a minimum of 45 days and frequently more like 90 days or more.   A short sale allows the borrower to get out from under the mortgage loan(s) but the amount of forgiven debt creates a tax liability.  While a short sale has a less deleterious effect on a borrower’s credit rating than a foreclosure, it is still a significant negative.

Stage: Auction

Buying a property at the Trustee’s Sale has several challenges.  It is an all cash purchase, literally requiring bidders to attend the auction with cashier’s checks.  There is no property inspection allowed so property purchases are true ‘as-is’ transactions.  Once the property is purchased, the former owner still needs to be evicted which can take 3-4 months.  Finally, auctions are frequently rescheduled either because the homeowner is pursuing a short sale or declares bankruptcy.   This means that acquisition visibility is very limited because a target property auction can be cancelled or rescheduled 3-4 times over a multi-month period.  Buying at auction requires a discount to market value of at least 15-20% in order to compensate for the associated risks.

Stage: Bank-owned (REO)

The blind spot for most investors occurs during the period after the lender has acquired a property at auction and before it is listed for sale on the MLS.  Banks don’t publicly identify which asset management company has responsibility for a specific property and asset management companies don’t identify which real estate agent in their network has been assigned responsibility for listing and sale of the property.  This doesn’t occur until a sign goes up in the front yard and the listing goes active in the MLS.

One strategy is to build relationships with asset managers and local REO agents who will let you know when an REO property is going to be listed for sale.  Ideally you should have the listing agent write the offer for you.  By having the listing agent write the purchase offer, they have the opportunity to retain 100% of the real estate commission rather than split it with a buyer’s agent.  In the industry this is referred to as ‘double-ending’ the transaction.  It’s perfectly legal as long as both buyer and seller provide written authorization.

This provides a powerful incentive to the listing agent to promote your offer and convince the asset manager to accept your offer.  Mathematically, another investor would have to offer twice the price for the listing agent to make the same money as they would by double-ending the deal with our offer.

To a certain extent, this has become standard practice in Los Angeles as competition for REO properties has intensified.  Investors need to be disciplined and prepared to lose multiple property bidding wars before they land the right opportunity at the right price.

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