REO or Pre-Foreclosure?

That's the big question for many investors looking to buy foreclosures – Should I buy an REO (bank owned property) or a pre-foreclosure (still owned by borrower, but in default)? How you answer that question can determine how easy or how difficult a time you have with your foreclosure investment.

Most investors, your author included, feel that buying an REO (an acronym for real estate owned) is a cleaner deal. Typically you are assured of good title to the property including title insurance. That means that usually you don't have to worry about the old borrower/owner coming back trying to claim the property under some sort of extended equity of redemption, old taxes or liens that were unpaid, or even old owners or tenants who refuse to move out. (You did make having the property vacant a contingency of your REO offer, didn't you?!)

All of these problems can occur if you attempt to buy a property in pre-foreclosure.

On the other hand, the biggest complaint investors have about REOs is that there are no real REO bargains. Rather, the lenders have rejuvenated the properties and are trying to sell them for full market value through an agent. How's an investor supposed to flip a property bought at full market value?

It's just the opposite for pre-foreclosures. The assumption here is that that a pre-foreclosure can, indeed, be bought for far below market value. Just get the borrower to sign it over, refi and/or flip, and you've made a huge profit.

Thus, the conventional wisdom goes, an REO may be cleaner, but there are no bargains. A pre-foreclosure can be more complicated, but you can get a real steal. Maybe.

In my own experience I've found that the value of REOs is greatly underappreciated, while the bargain value of pre-foreclosures is often overestimated. Here are 4 important questions to ask to help you decide which is the better investment avenue for you:

1. Do You Have To Deal With The Lender?

Dealing with a lender, as investors with recent experience know, can be a real burden. With an REO, you obviously have to deal with the lender, since it owns the property. Many investors complain that lenders are so overwhelmed by the number of foreclosures they have, that they don't have the staff or the time to talk or act.

That's certainly been true, but most lenders are now ramping up and many will soon be up to speed. Their REO departments often are the fastest growing element of their business.

On the other hand, when you're buying a pre-foreclosure, typically the borrowers/owners are underwater. That means that in order for them to sell, you'll need to get the lender's permission for a “short sale,” where the lender accepts less than the loan balance.

Thus regardless of whether it's an REO or a pre-foreclosure, dealing with a lender is virtually a certainty.

2. Can I Get A Bargain?

When you negotiate in pre-foreclosure directly with a borrower/owner (and with a lender in a short sale), usually you've marked down the property so much that if the deal actually goes through, you've got a bargain. But, that's a big IF. Keeping the borrower/owner interested in moving forward, getting timely action from the lender, and doing it all against the backdrop of the foreclosure timeline takes knowledge, skill, perseverance, and probably most of all, luck. There are many variables to control and too often nothing comes of a lot of work.

On the other hand, with an REO you've only got the lender to deal with, and there are no fixed timelines staring you in the face. The challenge here is to get to the lender early, before it fixes up and lists the property. Negotiate with the lender then, and you may get a bargain.

However, most investors I've talked with complain that they can't find out who the lender actually is or get to the right person to talk to before the lender spends money on the property and lists it. They come in on the deal too late in the process.

My suggestion is to follow the foreclosure trail. Who buys the property at auction will lead to the lender who actually owns it (not some servicing company). And going to the top (even to the CFO) as well as restricting what you ask for (for example, you request REOs within a specific neighborhood or group of streets) can have better results.

3. Can I Get Good Financing?

Two years ago that wouldn't even be a question. Today, it's often the biggest. Can you line up financing on a foreclosure you want to buy?

You're certainly on you own with a pre-foreclosure. Finding a lender who won't simply shunt the property aside because of its foreclosure status can be a big hill to climb. And being an investor (non-owner-occupant) is sometimes a financing killer.

On the other hand, with an REO, you've got a captive lender – the owner. The lender that owns the REO wants to sell, knows that it can be hard to get outside financing, and usually has the wherewithal to handle the financing itself. So why go elsewhere? Make the purchase contingent on seller financing. (Sometimes you'll even get a break on the terms, the points, and the interest rate!)

4. What About Fixing Up The Property?

Virtually all foreclosures, REOs and pre-foreclosures alike, need rejuvenation. Nationwide, lenders today are averaging $9,000 a property for this. That typically includes new windows and screens as needed, painting, basic landscaping, and new carpeting. Of course, that's just the average. Many properties require far more costly fixing up.

Whether you buy a pre-foreclosure or an early (before fix-up) REO, this is money you'll need to spend. So, there's no saving here. Of course, you can get an REO that's already been rejuvenated. But, as noted earlier, you'll probably end up paying full market price.

So, what's best, an REO or a pre-foreclosure? Obviously every deal is unique. Nonetheless, I still prefer REOs IF I can get them from the lender before it invests money in rejuvenating the property and listing it. For me, the hassles and unknowns of dealing with both a lender and a borrower/seller in a pre-foreclosure are just not worth the trouble required.