The majority of my work in real estate has been with fixer-uppers, either as a homeowner, investor or realtor.  I don’t pretend to be an expert in foreclosures but I have evaluated quite a few as potential investment opportunities.  Many of my clients who are interested in fixer-uppers also inquire about foreclosures as a possibility.  There is a perception that foreclosures generally offer an easier return on investment over a fixer-upper. 

But the evidence that I am seeing about foreclosures in Madison versus what I know about fixer-uppers shows that is largely not the case.  Obviously, there are examples that don’t fit this trend, and this could also change if the market continues to struggle.  But my contention is that buying the right fixer-upper is a less risky, more profitable way to make a nice return on investment in real estate, especially for the inexperienced investor who does not have deep pockets.  Let me lay out my case.

My success with fixer-uppers has come from a very traditional method of doing fixer-uppers – buy the worst house on the best block you can.  The old adage about is location is even truer for rehabs.  And why is this so?  Good neighborhoods appreciate faster than bad, are more resistant to market downturns, and usually provide more potential for upside growth on your fixer-upper.  These houses can also get driven up because demand can often be lower than average and emotion can play into the transaction.

If you read through my site, you’ll learn that I usually suggest that my buyers buy this kind of house if possible.  I also suggest that they look for key amenities that will make the house more saleable.  These amenities are determined by the norm for the neighborhood but usually the key items are minimum square footage, adequate number of bathrooms and bedrooms and lot location and size.  If you can find a house that is priced well with these amenities being correct and then if the investment and work is less than the projected sales price, you might have a winner. 

This is an old formula that many people have made money on.  Your hard work usually pays off and you can sleep at night because you have done a good deed – you improved a home that might have slipped and you kept a nice neighborhood nice. 

Now that you have my formula, let’s compare it to what is happening with the foreclosure market in Madison.  Here are the different segments that I see:

1. Sub-prime borrowers – With the sub-prime loan foreclosures that we are hearing so much about, lenders have let borrowers have homes with little or no money down.  Most of these loans have also occurred within the last couple years.  So, the combination of a loan with little or no money down and a home that has appreciated very little creates a situation where there is very little flexibility for the bank to negotiate.  If you research the foreclosure process in Wisconsin, you will see that there are many fees/penalties that are tacked on to these loans and the foreclosure process is very lengthy.  This all creates a situation where the house might have a higher balance than it is worth.  Obviously, banks need to get these loans of their books, but the thought that you can get one of these houses at a huge discount is probably not feasible.  These houses are potentially very marketable as well if they have not been trashed by the foreclosed so they will probably sell well on the retail market. 

2. Long-term owner foreclosure – Ideally, this is the type of property that an investor would want to find.  The perfect scenario is where someone has lived in their home for a long time or put a large down payment on the houses, has come into some financial difficulties and now needs to get out of their home quickly.  An investor that comes in quickly might be able to help the seller out of their house and get some instant equity for a quick sale. 

This in theory sounds feasible but in practice I think it is a little messy.  In Madison, people generally are very knowledgeable about the value of their homes and most people will not allow themselves to overly taken advantage of.  Also, many people don’t have a real good idea of what their house is worth, especially if the economy is down or if they need to do some work.  People usually need some independent pricing advice and often the market needs to beat them up a little before they realize the true value of their home.  So getting the house at the right price can be more difficult than it initially might seem.

Finally, you have to walk that ethical tightrope that can leave you open to criticism or worse.  If you have someone who owns a large part of their home, are you really comfortable taking a large part of their wealth because they are not in the correct mental state to manage their sale correctly?  This is a question you will have to ask yourself.  And just because you got, for example, a willing parent to sign the docs, do you think the children will let this happen?  Probably not.  I am not a lawyer nor am I giving you legal advice, but that sounds like a potential litigious situation.

3. Foreclosures that are fixer-uppers – What I see most commonly on the MLS are foreclosures that need a lot of work.  Sometimes these make financial sense, but often there is too much work needed to be worth it.  I think these fall largely into two scenarios –
1. Someone has lived in the house for a long time and hasn’t maintained it.  These houses have long term neglect issues, like rot and mold that are not always easy to totally assess.  These items must be cured before you go on to renovate, and trust me, there are always hidden surprises in those walls.  All these defects must be corrected before you get to update.   Often, it seems like these houses go higher than they should, perhaps because of the sheer cheapness of the house or incorrect assumptions on necessary expenses.

I have a buyer that put in an offer on a house like this.  The house was listed at $115,000, and in sparkling shape would sell for around $150,000 without a garage, maybe $165,000 with a garage.  The basement was incased with mold and the kitchen floor was so rotten from water leaks that the cabinets were falling through the floor.  Everything had to be gutted and all the systems would have to be replaced.  We offered around $80,000 and that was the highest that we would go.  Someone came in with a full price offer.  If you back the expenses, carrying costs, and selling expenses out it just doesn’t make sense.  A good lesson here – Just because you can do a project doesn’t mean you should.

b.      The second scenario I see a lot with these foreclosures are poorly attempted or half completed renovations.  These houses might be half gutted shells with poor work, often un-inspected, and what is finished might have to be torn out and redone.  (Remember, building permits go with the house, not the person.  So, for example, if someone wires a house without a permit and you buy it, you are responsible for that work, which means you could have to gut entire sections of the house to show the work.)

It also seems like these houses are higher priced than they should be.  Often these houses have had multiple home equity loans taken out on them because there is perceived equity in the house, and there probably would have been, had the homeowner actually completed the work in a professional manner.  In actuality, these owners have actually removed equity from their house.  Now the bank has a house that is probably worth less than the first mortgage and there are secondary mortgages on it as well. 

Why does this house default?   Because the owners are tired of the mess and they want out!  If you find a house like this, really do your due diligence well because there are probably a lot of problems buried in those walls.  In this situation, it might take this house a long time to sell and the bank might negotiate with you because of the obviousness of the necessary work.  But again, quantify the work and investment needed and make sure it is the best option.  My experience has shown that there are often better, easier, and less risky alternatives.

4.  Not quite attractive-enough foreclosures – I think there are a lot of houses that are foreclosures out there like this.  They might be ok homes in decent neighborhoods but they aren’t really anything exceptional.  The bank will price them for what they have in them and the buyer might get a little free equity, say 10% or so.  But, in the end, these houses will largely be harder to sell because the neighborhood probably has a surplus of existing inventory and the house doesn’t stick out.  With Madison’s high level of inventory, these houses will sit longer and appreciate slower.

In the end, I really think that the foreclosure market is overblown and there are at least as good of deals on the regular market.  There might be that “diamond in the rough” in that awesome neighborhood, but don’t assume you will get it for a steal and don’t assume you are the only person that wants it. 

My experience right now is that there are good deals out there in plain sight.  I would take the well-maintained “old lady” house in the good neighborhood any day of the week over 95% of the foreclosures I have seen.  If you want to do a fixer-upper, consider the full market and not just foreclosures.  And if you buy a foreclosure, buyer beware.

If you want to know more, contact me at trost@starkhomes.com.

Disclaimer:  This is not investment advice and should not be construed as such.  Markets vary and can change quickly.  Consult your tax advisor with regards to tax issues, attorney with regards to legal issues and investment advisor with regards to investment issues. 

Written by Troy Rost, August 25, 2007

Copyright 2007