Understanding real estate owned (REO) properties as investment opportunities

For homebuyers on a budget and newer real estate investors who are looking for a good deal, real estate owned (REO) properties may look like an appealing option because they typically come at lower prices than similar properties.

While there are great opportunities for the right person, REO properties are a bit more complicated than typical homes, so it’s important to make sure you know what you’re getting into before you take the plunge.

What is a real estate owned property?

An REO property is a property that is owned by a bank or mortgage lender. Typically, this happens when the property fails to sell at auction during foreclosure proceedings, so lenders take possession of the home.

Foreclosure occurs when a mortgage borrower defaults on their loan. If the borrower can’t make up the missed payments, the lender can seize the property from the borrower. Usually, this only happens when a borrower falls well behind on their payments and isn’t able to work with the lender to find a solution.

What to know about REO properties

REO properties have typically been seized by lenders after a homebuyer defaults on their loans. This means that many REO properties share a number of features.

• Flexible sale prices. Most lenders are looking to offload REO properties as quickly as possible given that they already failed to sell during a foreclosure auction. That means prices can be very flexible.
• The properties are often in disrepair. People who fall behind on their mortgage payments aren’t likely to be able to afford maintenance on a property, so the home may be in disrepair and may be what’s known as a distressed property. This can be especially true if the foreclosure process was drawn out.
• The properties are often short sales. A short sale occurs when someone sells a home for less than the amount owed on the mortgage.
• Lenders and bankers own the property. You won’t be buying the home from another family or individual. REO properties are owned and sold by banks or lenders, so there won’t be an individual on the other side of the transaction to work with. That means the home will typically be sold as-is, the owner won’t be willing to do any repairs.
• Expect to work with an REO specialist. REO properties and transactions are different from most home sales. Finding and working with someone who specializes in these types of transactions will make your life much easier.

How does an REO property gain its status?

There are several steps that need to take place before a home becomes an REO property. The process begins when the original owner defaults on their loan and ends once the home goes into foreclosure and fails to sell at auction. These events usually occur behind the scenes and are intended to help lenders avoid a loss.

The original homeowner defaults on the mortgage

When a homeowner becomes delinquent on their mortgage, meaning they begin to miss their monthly payments, their loan goes into preforeclosure.

Homeowners can still avoid foreclosure at this point by either coming up with the money to pay what they owe or by working with the lender to modify their mortgage and make it affordable.

In some cases, borrowers choose other options, such as giving the lender the deed to the home in lieu of foreclosure, but lenders may not be willing to accept a deed in lieu of foreclosure, especially if the home is worth much less than the mortgage balance.

Typically, lenders will prefer for the owner to sell the home and repay the debt, as that will limit the lender’s losses.

The property goes into foreclosure

Foreclosure happens once the lender takes action against the borrower for failure to pay their debt. The process varies from state to state. Some states require a court proceeding for foreclosure, while others allow the lender to foreclose without needing to go to court.

Most states do have a mandatory schedule of notices that must be provided and procedures that must be followed throughout the process.

At the end of the process, the property goes to auction and can be purchased by the highest bidder. The occupants of the home must vacate the property or work with the new owner to become legal tenants, or they may face eviction.

The home becomes a postforeclosure property

In some cases, a foreclosed home may not sell at auction. For example, a home that is very distressed and needs significant repairs may not be appealing to potential buyers, leading to no one submitting a bid.

Banks and lenders can hold on to a foreclosed property but typically look to sell it as quickly as possible to recoup the money lost. This motivation to sell can sometimes lead to good deals for people willing to buy foreclosed homes. There are pros and cons to buying these kinds of homes.

Pros of buying REO properties

If you’re looking to buy a home for a low price, REO properties may be appealing. However, there are risks involved, so potential homeowners or people looking to get a cheap investment property should think carefully.

Low price

Lenders are more motivated to sell REO properties in order to recoup their losses from the foreclosure, so they are more likely to sell the property below market value in order to get rid of it quickly.

Keep in mind that REO properties have already failed to sell at auction, so you likely have a good amount of room to negotiate a lower price. Do your research and look for things like property records that list the home’s assessed value, which can sometimes be lower than market value, and use that data when making your offer.

Rarely are there outstanding taxes

You’ll want to do a title search and see what kind of guarantees a lender will give you, but a good thing for buyers is that you usually won’t have to worry about things like tax liens or other unpaid bills.

Unlike a tax deed sale, where the local government is selling a home that has not had its property taxes paid, lenders who are selling foreclosed homes need to ensure that the taxes are paid to prevent the local government from selling the property itself.

Still, it’s a good idea to do a title search and purchase title insurance to make sure you know about any liens that are placed on the property.

You’ll be negotiating with motivated banks

Banks are not usually in the business of real estate investing. They prefer to use their capital to offer mortgages to homebuyers. Owning a home means having a lot of money invested in a property that the bank isn’t equipped to turn into a productive, revenue-producing asset.

That means banks usually want to sell these properties as quickly as possible to recoup their money, which can then be productively used for future loans.

Don’t be afraid to negotiate aggressively. Try to use hard data about home values in the area, costs to repair the home, and anything else you can find to get the best deal possible.

Cons of buying REO properties

While you might find REO properties appealing due to their low price, they’re not for everyone. It’s important to think about whether you’re willing to put in the work required to make an REO property into a good home or investment property.

Sold as is

Most REO properties are sold as-is. That means that the owner won’t be willing to do any repairs or make adjustments to it before you buy. What you see is what you get.

If you buy an as-is home that you later find needs significant repairs, you could be on the hook for tens of thousands of dollars in repairs.

Uncertain title status

In some cases, the status of the house title can be uncertain. For example, foreclosure can often happen in situations where a homeowner dies and it is unclear who the heirs are, leaving no one to pay the mortgage. Later on, they could come and make a claim to the property, even after you buy it.

This could lead to expensive legal battles and, in the worst case, losing a home you spent good money to buy.

Be sure to work with a title lawyer and title insurance company to be sure to buy title insurance when you purchase an REO property.

Can require expensive repairs

As an investor, home repairs can be a big drain on a property’s profitability. One drawback of REO homes is that they may be in disrepair and require a lot of money to fix up, even if that fact isn’t immediately apparent.

Generally, it’s a good idea for homeowners to save 1% to 3% of the purchase price of the home annually for maintenance. However, a foreclosed home can easily exceed this figure. You might think you’re buying a solid investment to flip or rent out when, in reality, you wind up buying a money pit.

The best thing to do to avoid this risk is to hire a good home inspector. They’ll be able to help you identify potential problems that could come with costly repair bills.

May be occupied

Depending on the nature of the foreclosure, the home’s previous occupants may not have moved out. That means you could be buying an REO property that has people living in it.

If you want to evict the occupants, the Protecting Tenants at Foreclosure Act requires giving the tenants 90 days’ notice. In some cases, you may be required to honor the terms of the existing lease. Laws in some states may give tenants rights beyond this. Consult a local real estate attorney if you have any questions.

In short, you may have to wait quite some time and deal with a lot of legal paperwork before you can use the home.

How to buy REO properties as a real estate investment

REO properties are a unique alternative to the traditional homebuying process. Homes are often cheaper and come from motivated sellers but can require a lot of elbow grease and determination to make them into livable homes or investment properties.

If you think you’re up to the challenge, use these steps to buy an REO home.

1. Find a real estate agent with REO experience

A real estate agent is a professional who can help you throughout the homebuying process. Usually, agents will help you tour homes, negotiate with sellers, and submit offers to purchase properties. In all, working with a good agent can make navigating the purchasing process much smoother.

REO properties require specialized knowledge that isn’t necessary for most home transactions. Getting an agent with REO experience means having someone who can help you find good investment opportunities, negotiate with banks, and ultimately get a good deal.

2. Get a preapproval letter

Next, you should aim to get preapproved for a mortgage and get a preapproval letter. This is a letter from a lender saying that you have a good chance of qualifying for a mortgage and outlining the amount you could borrow.

Keep in mind that loan terms can differ depending on whether you’re buying a primary residence or an investment property, so make sure your lender knows which you’re planning to buy.

Preapproval shows sellers that you’re serious about buying a property, which is especially important given how motivated REO property owners are to sell.

Some real estate investors skip this step, instead choosing to buy a home in cash. Cash offers are appealing because they avoid the lengthy mortgage underwriting processes.

A portfolio loan, which is a mortgage that the lender won’t sell on the open market, is another option for people looking to finance a home. They can offer unique underwriting conditions and payment terms, making them more flexible and appealing to investors.

3. Find an REO property

Once you have your preapproval, it’s time to start shopping for a property. You can find REO properties online using a few different websites.

If the REO property is owned by the investor, these can be found through portals maintained by the major mortgage investors:

• Fannie Mae’s HomePath
• Freddie Mac’s HomeSteps
• Federal Housing Administration (FHA)-owned homes sold on the Department of Housing and Urban Development (HUD) Home Store

If the mortgage investor does not manage the REO, then the mortgage lender does. In these instances, the mortgage lender would have to be contacted to purchase through the auction platform or listing agent.

REO properties may be labeled as such on multiple listing services (MLS). These services, commonly pulled in through home search sites may include ways to filter by REO properties, and you’ll likely be able to figure out who the REO agent is.

4. Submit an offer

Once you find a home you’re interested in, work with your agent to submit an offer. Usually, REO homes are sold as-is, so the main thing you’ll be concerned with is the price.

It can often take some time to get a response to an offer on an REO home because offers go through multiple rounds of review. You may also have to deal with mandatory waiting periods. For example, if you’re planning to buy a HomePath property, which is a foreclosed home owned by Fannie Mae, you need to wait at least a few weeks before you can buy a home unless you’re a first-time buyer.

5. Hire a home inspector

A home inspector is a trained professional who can look at a home and identify potential issues with it. For example, an inspector may help you identify problems with a home’s foundation that could cost tens of thousands of dollars to fix.

REO homes are usually sold as-is, so the seller won’t be willing to make any repairs to the property, even if an inspector finds an issue, so some REO sellers may not be willing to let you conduct a home inspection.

Because of that, it can be hard to secure an inspection contingency during closing, but it’s well worth doing if the seller is willing.

An inspection contingency gives you the right to get a home inspected before you purchase it and gives you the right to back out of the sale if expensive repairs are found. A good inspection contingency can save you thousands or tens of thousands of dollars by helping you avoid buying a bad home.

The bottom line: REO properties can be high risk, high reward

Whether you’re a homebuyer looking for a cheap property or an investor who wants a good deal, REO properties offer a high-risk, high-reward option. Do your due diligence every step of the way, and don’t be afraid to back out of bad deals, and you could be rewarded with a cheap home.

If you’re ready to get started with buying a home, consider exploring your financing options with Rocket Mortgage®.