The good old days of doing business on a handshake have gone so far away that the Hubble telescope couldn't find them. Even at my tender age, I have witnessed enough legal action resulting from deals gone awry, sellers-turned-psycho, and downright skullduggery to make even the most hardened investor's blood curdle. And the heat of the battle takes place, unfortunately, in one of the best arenas to make an honest living in: real estate-pre-foreclosure investing.
Who is to blame? Sometimes the seller, sometimes the investor. If I had to make a guess as to who causes the most problems, it would be sellers. Over the years, I have only heard of a handful of unscrupulous investors who tricked homeowners who thought they were getting a loan into signing a deed, forged documents, took over a loan and pocketed the rent payments, or something equally evil. Of course, these are the only incidents you hear about on the news. My guess is because “Fair and Honest Investor Buys House, Makes Profit” isn't a very sexy headline.
The real concern, and the focus of this article, is sellers in default who either:
A) Lie about their property, its condition, their hardship story, etc, in a deliberate attempt to defraud an investor, or
B) Experience seller's remorse after their problem is solved, and use false accusations that they actually believe in an attempt to undo what they agreed to.
Which do you think is the more common scenario? I don't believe it's A. Although the old expression “buyers are liars and sellers are worse” has some truth to it, I think that most sellers in default are honestly seeking a way to solve their problem through ethical means. And any untruths they do tell can be uncovered with the proper due diligence prior to purchase.
Therefore, I think that B is the more common scenario in which fraud is committed. And by “committed,” I mean “frantically slung as a weapon by the seller in a misguided attempt to undo a transaction that is perfectly legal by making you the scapegoat for their own selfishness, irrationality, and/or situational ethics.” This doesn't make headlines, but it does make a frequent topic of conversation at local REIA meetings, where I have heard similar stories told ad nauseum.
Scenario B is far too common, but even more so when a pre-foreclosure investor does things that make them more likely to be accused of fraud. I have listed three unsafe scenarios below. I will preface them with a golden nugget of wisdom that I have gleaned from years of networking, news-watching, and personal experience, and then voice my opinion on the subject with more passion than Basic Instinct, Don Juan Demarco, and The Notebook combined.
“No matter how many times you explain how the deal will take place, how slowly you go over it, how many times they tell you they understand, or sign and initial a document that spells everything out in excruciating detail in 4th-grade English using size 16 font, sellers in pre-foreclosure will immediately create and believe their own memories of what they agreed to the very second that their payments are caught up.”
If you are not familiar with the concept of implanted memories, just remember the movie Total Recall and you'll know exactly what I'm talking about (but with a little less violence). The unavoidable fact above must always be remembered, dealt with head-on, and used to guide your decisions when working with sellers who are behind in payments. And now for those three unsafe pre-foreclosure scenarios:
1) Asking them to sign blank documents – I think the wild, wild, western days of showing up at the seller's house with a mobile notary and getting them to sign a deed and blank documents for any and every conceivable type of transaction (short sale,cash offer,subject-to, note, deed of trust, etc.) on their kitchen table are over. This shoot-first-ask-questions-later style of getting a deal done has “Six o'clock evening news scandal” written all over it.
While it may certainly be more convenient for the investor to get everything signed in advance and then figure out what kind of deal is possible later, and though the investor may truly have the seller's best interests at heart, think of how it will appear to a judge when the seller says later in court, “He had me sign all these blank documents, and told me he'd take care of everything, and I didn't know what I was doing”
I don't think we can afford to be so cavalier in our dealings – at least until pre-foreclosure investors cease to be perceived as vultures, guilty until proven innocent, which I calculate will happen approximately three times the length of time from now that hell will take to freeze over.
2) Letting the seller stay in the house – I cannot think of any kind of transaction so generous, so humane, so hazardous. For starters, leasing the house back to the seller is a risky gamble (since, in my experience, 9 out of 10 of them will miss at least 2-3 rent payments per year, which, unless you have a money bin as bounteous and deep as Scrooge McDuck, will cause considerable damage to your cash flow).
If you give them an option to buy it back, you're walking on thin ice. Because, if for some reason they are not able to buy it back again (missed payments, worsened credit, stricter lending environment, decreased property values, etc.), you will become the bad guy for daring to ask them to move out so you can finally recoup your investment, free up your funds, and thus avoid becoming broke, busted, and disgusted.
And if you lease back to a seller whose house you bought subject-to, put on your headgear and get ready to rumble. You might as well drive to the nearest courtroom and have a seat, because you're going to go there soon anyway – ask me how I know this. It's just too easy for a seller to wish they hadn't sold their house so badly that they actually believe they still own it, or should own it. And, because so few attorneys know anything about subject-to deals, it won't be hard for them to find one to put you in the hot seat.
3) Advancing funds prior to closing – Imagine meeting the kindest, sweetest, most innocent seller you've ever met. They're in foreclosure through no fault of their own (illness, tragic accident, etc.) and have tried everything to fix their situation, with no success. You finally get in touch with them a day or two before the auction, and agree to save them from their pending disaster. But there is one problem – you won't be able to close on time.
Maybe the title company can't get the title search done fast enough, schedule you soon enough, your private lender is on vacation, or something. If you could just delay the auction one more day, you could conduct the closing and be the hero. But, of course, the only thing that will buy you the time to close is to reinstate the loan now, before the closing. The helpless seller's credit, dignity, and financial future is in your hands. Do you do it?
Although it goes against every altruistic bone in my body, I would not advance any funds before closing even if it means they lose their house and I lose a deal. I promise you that if you do, you will, in all likelihood, witness a formerly sweet, rational, and grateful seller transform before your eyes faster than you can say Bilbo Baggins. Your funds will be tied up with no legal recourse other than to enforce your contract to buy, which will take more money and several months, in which time they may fall behind again and lose the house (and your money) to foreclosure.
Or, you could be sued after all you've done and be accused of taking advantage of the seller, even though your funds are being held hostage at their mercy. And even if you have them sign a note and deed of trust as security before reinstating their loan, you may be going into dangerous territory by breaking lending, licensing, and possibly usury laws. The potential downside makes it not worth the risk.
So the moral of the story is this – given the current legal climate, the fallen nature of sellers once their problems are solved, and the inherent financial risks, it is wise to avoid the three types of pre-foreclosure investment methods mentioned above. It's not enough to be honest and do what you promise. It's also not enough to have excellent documentation and CYA agreements. They can certainly help your case in a lawsuit, but don't think for a minute they will actually prevent suits from arising to begin with. Instead, you have to avoid the very appearance of fraud, even if it means losing a few deals (which is infinitesimally better than losing a few lawsuits – or even winning them, for that matter).
Nothing is worse than a lawsuit, even when you win. It will cost you a teacher's salary in legal fees (not to mention the legal fees of your private lender, if you used one and they are named in the suit) as well as tying up your invested funds and hostage profit for 1-2 years. That's a 1-2-3 combination of knockout blows to your cash flow, and could put you out of business. And in bad economic times, litigation only increases because everybody needs money. Therefore, when it comes to protecting yourself from false accusation while investing in pre-foreclosures, an ounce of prevention is worth 60 megatons of cure.