Are your clients thinking about buying foreclosed property? Buyer beware
By Christopher P. Hill, RFC
Wealth and Income Group LLC and FuneralResources.com
There are many headlines and news reports about defective foreclosures, major lender nationwide suspensions of foreclosures, and governmental investigations of foreclosure fraud. You need to make sure that you are not a victim of this legal morass.
Profits from foreclosures
Buy low and sell high is also a formula for making money in real estate. One way many people buy low is to purchase a property which has been foreclosed against. Often, a bank may be eager to get rid of a property that is costing it money and cannot be sold for top dollar because it needs a lot of work after it was trashed by the former owner or vandals. The investor buys the house, fixes it up, and resells it for a profit or adds the house to their rental portfolio. Because of substantial fix-up costs, cash requirements, and holding period costs, the investor usually needs to buy the property at 40 percent or more under the market value.
John and Jane have been working for 20 years, but are nowhere near their dream of retiring with a large financial cushion. They went to a real estate seminar that explained how to make millions by buying foreclosure property and they paid hundreds of dollars for books and tapes sold by the speakers. They follow the guidelines they learned; buy a foreclosure property, fix it up and put the house back on the market for a profit of over $50,000.
After listing the property with a realtor, they are served with legal papers from the former owner demanding that John and Jane turn over the house to the former owner due to a defect in the foreclosure process. John and Jane lose the case, have to pay an attorney $50,000 to defend themselves, and lose all of their investment and their savings of $100,000, as well as all of the sweat equity and lost weekends they put into the house. Their foreclosure dream has become a nightmare.
Foreclosure legal process
The buyer of a foreclosed property can have title problems if the legal procedure followed by the attorney overseeing the foreclosure is defective. There are many stories in the press now about defective foreclosures. In general, the law says you can't take someone's house unless you provide them with the mandated notice, advertise the sale in the paper, have a proper auction and follow any required court filing procedures. Everyone can understand the heartbreak of someone who loses their home to a foreclosure, and the law provides some protection to homeowners against arbitrary foreclosures.
After notice and advertisement, an auctioneer typically sells the property at a public auction and this process results in a legal transfer of title under state law to the new owner who made the highest bid at auction, all against the will of the foreclosed owner. Given the volume of foreclosures and bank losses, the lenders may have put the foreclosure legal work out to the lowest bidder and achieved defective results. Where a foreclosure does not properly transfer title to the auction buyer, and the person who bought the property at the auction may never receive good title; the property may still be legally owned by the person against whom the foreclosure took place.
This all depends upon a complex set of state rules. Each state has its own esoteric legal steps that have to be followed to legally transfer title through the foreclosure process. If the process was not followed correctly, the title of the buyer at auction could be defective and the auction buyer may be unable to pass good title on to the purchaser.
How can this happen?
As a buyer of a property which has been foreclosed, you could have a loss of investment in the following cases:
1. You didn't buy title insurance:
You got a loan to buy the foreclosed property and the lender received title insurance but you did not buy title insurance for yourself. Title insurance is where a capital-rich insurance company enters into a contract to guarantee that the title to the property is good. There are lender policies and buyer policies. For the buyer to be protected, the buyer has to buy their own policy. The buyer may not understand this, or try to save money by only paying for a lender policy, mistakenly thinking they are protected by the lender insurance policy. A lender title policy protects the lender from loss, but not the buyer.
2. You got a quit claim deed:
In the deed, there is generally a guarantee from the seller, called a "warranty" of title. If there is a title defect and you have a warranty deed, you have legal recourse against the seller if the seller had a title defect in their foreclosure. If there is no guarantee in the deed, you may have no recourse against the seller of a property with a defective title.
3. The bank went bankrupt:
The bank or large federally regulated institution went bankrupt and even though you had a warranty deed, you are now an unsecured creditor in a huge nationwide bankruptcy case headquartered in Delaware, and you have to hire a Delaware attorney for a large fee to collect three cents of every dollar you invested.
4. Your title insurance does not protect you:
You go to settlement and pay for title insurance. You ask to read the title insurance policy to make sure that you are protected against a defective foreclosure on the property prior to signing the settlement papers. If you have a title insurance contract that says you own the property with no exceptions for the prior foreclosure and you lose the property due to a defective foreclosure, then the title company is supposed to pay you for the losses up to the dollar limit of the title policy. The settlement company says they will get around to writing up the policy a couple of weeks after settlement. The settlement company gives you a letter saying they will commit to issuing you a title policy with certain exceptions.
The exceptions listed concern anything to do with the foreclosure. Unless the exceptions for the foreclosure are later removed, the title insurance contract will not protect you from defects in the foreclosure process. The problem is that you may have to go to settlement before the title company has even looked at the foreclosure paperwork to determine if there is a problem. All you get is a promise that they will issue a policy later and you have nothing in writing that they will guarantee there are no problems with the prior foreclosure. You may have only bought yourself a lawsuit if the title company later finds a problem with the foreclosure.
5. You lost your fix-up costs and profit:
Larry and Louise bought a title policy with no exceptions for the foreclosure with a limit of $150,000, the price they paid for the house. They put $50,000 of fix-up and carrying costs into the house, and are ready to sell it for $250,000. But they lost the property due to a defect in the foreclosure process. The title company makes good on the insurance policy, and pays Larry and Louise the policy limit of $150,000, and Larry and Louise are out $100,000.
How to protect yourself
In general, this has not been a common problem in the past and in many cases will not be a problem today, even if there is a defect in the foreclosure. But press reports indicate that the numbers of foreclosures that have "gone bad" have dramatically increased.
To protect yourself, obtain a copy of the title policy with insurance against foreclosure defects prior to the settlement. If you have this option, select a title company that you know and trust to thoroughly review the foreclosure record. If you expect a large profit, have a clause in your purchase contract that provides that your own lawyer must approve the foreclosure paperwork as a condition of going to settlement. This will focus everyone's attention on getting this taken care of prior to settlement.
The facts about today's real estate market:
- Demand for home buyers is slowing
- The number of homes for sale is growing
- The length of time to sell houses in most areas is increasing
- There is currently an extremely large and growing number of homes in banks inventories
- Foreclosures and "short sales" are exponentially rising
- Time Magazine recently published an article stating that the number of homeowners who are more than 90 days delinquent on their mortgage payments is estimated to be about five million
We can all probably remember back in 2001 and 2002, when many people were buying technology stocks because they were a "bargain" at $100 after dropping 50 percent from their $200 highs. Well, as you know, most of these stocks either went out of business or ultimately dropped to prices below $10. So sometimes, a "bargain" is not always as easy to identify as we would like.