Canada is experiencing significant increases in foreclosure. Many seasoned investors are spending much time and resources to identify “distressed” (read: foreclosed) properties, in an effort to acquire them at significantly below market value.
Upon acquisition, the investor can improve the property and sell at a higher price or simply keep it as a rental property.
What is a foreclosure?
Many have heard the term foreclosure in their life, but few understand what it means.
Practically speaking, foreclosure is the legal process of transferring property ownership from the borrower to the lender.
Why is a property foreclosed upon?
Normally, foreclosure is caused due to non-payment of a mortgage. This can happen for a number of reasons including loss of job, divorce, disability or other even death.
Other reasons causing foreclosure is one that is more common in today’s climate: lenders failing to renew mortgages. Yes, it is true.
For years many have treated a mortgage renewal as a simple signature on a renewal notice sent to you in the mail.
In the last 12 months however, some lenders are no longer renewing mortgages either because the lender is out of business or because they no longer offer the mortgage product, such as a revenue property mortgage.
As the borrower, you may have made all your payments on time, however upon renewal date, the lender has the right not to renew, despite your good payment history.
If you cannot find a replacement lender within a reasonable amount of time, (sometimes up to 90 days) the existing lender will initiate foreclosure.
Why do savvy investors seek foreclosures?
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 value they use is called “forced sale, cash value.”
The general idea of “forced sale, cash value” is to determine what a person would pay for the property, if it were to be 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.
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 either refinance or sell the house, before the lender is given a chance to take it over.
The 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—#8212;not 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 neighborhood.
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 check 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 interest in making a fast dollar, but would like to make more profit, over the longer term, then they may simply keep it as a rental and sell it in years to come.