"I want to buy a foreclosure."

I'm interested in foreclosures is something I often hear from clients, but few people really understand the process, and specifically what it means to buy a foreclosed property. It's not for the faint of heart. Though you can occasionally find a bargain, there are unique risks involved with buying a foreclosed or bank-owned property. First, let's clarify some definitions.

It's possible that someone can be "upside down" on their mortgage (that is, they owe more on the mortgage than the property is worth) and antsy for a quick sale before it gets worse. In this situation, the seller is said to be "bringing money to the table" because they literally need to write a check to the settlement company even AFTER receiving the proceeds from the buyer. The seller hires an agent (in most cases) and the property is listed in the MLS--the buyer may or may not even be aware that the seller is in this situation. But what if the seller doesn't HAVE funds to bring to the table? Then it becomes a...

Pre-foreclosure or "short sale": The bank is a third party to this transaction because they have negotiated with the seller to take a loss on their loan. The property will likely be listed in the MLS, but there are special addendums and disclosures because the bank has to approve any contracts. In some cases, this delays the process, which can make timing for a settlement and move date tricky. Read more about short sales in my previous blog entry here. If no buyer is found, then the property becomes a...

"Foreclosure" or trustee sale: This is the proverbial auction on the courthouse steps. Properties are advertised in the newspaper, but typically no real estate agents are involved (because there are no commissions paid--can't blame us for staying away from those!) Note that the property may or may not be vacant at this point...a buyer may be forced to evict the previous owner. This isn't typically the auctions you'd think with bidders standing around with placards. The bank is unlikely to take a bid less than what is due on the loan, and if there's no equity in the property, why would someone buy it? So you need a property that's worth more than the loan, and if that was the case then it wouldn't be a foreclosure to begin with! So most auctions quietly pass with no bidders. If you do wish to bid, it's typical for the bank to demand a 10% deposit at the auction, and you have 15 days to close. These properties are typically sold "as is." If it's a condo, the seller (the bank) is not required to provide you with condo or HOA docs, as in other sales. If the "auction" ends with out a winning bidder, the property moves to...

"Bank Owned" or "REO" (Real Estate Owned): The bank usually works with a Realtor to list the home in the MLS and it's advertised just like any other property. They are usually sold "as is" (no home inspections) and special addendums are required. The addendum is sure to include a penalty for any change or delay in closing--anywhere from $65 to $200/day. While the banks are quick to penalize buyers for any delays, they don't usually hold themselves to the same standards--Some banks have very quick turnaround time on offers (days) and some have very bad turnaround time (months). This uncertainty makes settlement and move-in dates are very tricky, if not impossible, to manage. I've seen buyers put in an offer and wait 3 months only to be told that theirs was not the winning offer. This is typically also not an option for anyone with a brokered loan or stated income loan, again, because the timing is so difficult to manage.

I've found that the only REO properties that are priced significantly cheaper than the market are those that are in very poor condition, and maybe not such a bargain at all. There are always exceptions, and yes, a handful of really great deals out there. But to limit yourself to "foreclosures" is cutting off some of the best deals out there! I've actually found that the best "deals" are where sellers have some equity and can actually afford to sell below market, and have the incentive due to a life change (new job, new baby, etc.) to motivate them!

So to recap: Most people who are looking for "foreclosures" are actually looking for "short sales" or "REO/Bank-Owned" properties. Both categories of sales come with unique risks--specifically:

1) timing--if you have a specific timeframe for moving, make sure you have a backup option for living space
2) financing - related to timing
3) property condition--you won't get to ask for repairs, and may not even be allowed to have a home inspection prior to buying

My advice? Look at all the listings, not just "foreclosures"--which we now know really means short-sales and REO, in your price range. You never know where you're actually going to have the most negotiating power!

FAQ: Earnest Money Deposits

I love the Post's Saturday Real Estate Mailbag. There's always something interesting in there. (Though if you read it long enough, you do start to see the same questions over and over.) Here's a good tried-but-true one that I often get from clients -- how much should you put as earnest money? What IS "earnest money," anyway?

Simply put, earnest money is a personal check that you write (payable to your real estate broker or another third party) that accompanies your offer on a property to indicate to the seller that you are sincere, or "earnest," in your endeavor to buy their property. It's a "good faith deposit" on the property. Once you agree to terms, the seller will be removing their property from the market and passing up potential future offers, so it's only fair that they have something more tangible than your signature to rely on. It's a buyer's way of putting "skin in the game."

The check gets cashed upon contract ratification, and the deposit is held by that third party until settlement, at which time it is applied to your downpayment or closing costs. In the event of any overage, it's refunded to you at settlement. In the event of a default by the buyer, the seller theoretically can claim that deposit (though in reality it's extremely difficult to make that happen.) Here's a great FAQ from the mailbag:

DEAR BOB: What is the normal earnest money deposit that should be offered by a buyer for a $350,000 condominium? Is it a percentage of the sales price, or is it based on something else? -- Ottilia C.

DEAR OTTILIA: There is no "normal" earnest money or good-faith deposit for the purchase of a residence. At a minimum, however, it should be 1 percent of the sales price to show serious intent. That would be $3,500 in your situation.

If you are making an offer substantially below the seller's asking price, a larger deposit can impress the seller. However, your deposit should not be more than 5 percent of the purchase price. Always make your check payable to the firm you want to handle the closing of the sale, such as a title-escrow company or perhaps a real estate lawyer -- not the seller.

Of course this column is syndicated nationwide, so may not represent the typical transaction in this area. Though there is no specific requirement, in my experience and in the current buyer's market, you should be prepared to put about $5000 as a deposit for a transaction value up to about $350K, $10,000 up to about $600K, and for anything higher than that $20-25K would likely be considered sufficient. Obviously the more you put down, the more seriously your offer will be considered, particularly in a competitive bid situation (yes, they still happen!)