Purchasing a distressed property is one of the best ways to make money in real estate. This guide covers everything you need to know about finding, buying, and investing in distressed real estate.
What is a Distressed Property?
A property becomes distressed when an owner ceases to pay for it or when it’s worth less than what the borrower owes on the mortgage (aka “underwater” in industry-speak). The term “distress” refers primarily to the hardships that affect homeownership, not to the state of the property itself.
However, many distressed properties also fall into disrepair because their owners no longer have the means to maintain them. Owners may also deliberately inflict significant physical damage on a property once they realize they are going to lose it. Some properties have suffered damage as a result of a natural disaster or environmental degradation.
Property also becomes distressed due to fraudulent activity. The lender initiates a repossession process in order to protect their asset from mortgage fraud or other claims on the property.
How Investors Benefit from Buying Distressed Property
Distressed properties can be a great investment opportunity because they can be purchased at a discount and then renovated and resold for a profit. But, where do you find these gold mines?
To find distressed properties, you should first understand the conditions that produce them. Armed with this information, savvy investors will know where to focus their energies when searching for foreclosures and distressed properties to add to their portfolios.
5 Ways Properties Become Distressed
If you’re serious about investing in distressed real estate, brushing up on the different ways properties become distressed can help you find great deals. Some of the most common causes include:
1. Financial Distress
A mortgage is deemed “delinquent” when the borrower fails to make payments according to loan terms and deadlines. If the borrower doesn’t pay past-due balances and accrued penalty fees, lenders begin the foreclosure process.
Homeowners stop paying mortgages for various reasons, including:
- Lost wages
- Unexpected bills and expenses
- Legal matters
- Market shifts and equity loss
- Property requires substantial investment to repair
When a mortgage becomes delinquent, lenders begin the foreclosure process, and the property hits the pre-foreclosure stage. At this point, the property is considered “distressed.”
Housing Market Weaknesses – Causes and Indicators
Leading up to the Great Recession, predatory lending practices allowed individuals without the means to purchase property to take on mortgages they could not afford. Additionally, when the housing market tanked, many people were left holding on to properties that were worth far less than what they owed on them. This set of conditions led to a dramatic escalation of the number of defaults and foreclosures, particularly in states that had looser standards for originating a mortgage.
Weaknesses and indicators investors should look for:
- An economic downturn
- Areas hit by natural disasters, like fires and flooding, or economic weakness in the local market
- States where the cost of housing has risen dramatically over the last decade, threatening to outpace incomes.
Being unable to afford a mortgage payment is one cause for mortgage default. Another is the inability to pay property taxes.
For most individuals, property taxes are the second largest expense of homeownership. For people on fixed incomes, the rising cost of property taxes, even where the property is fully paid off, is a significant risk.
States typically use Tax Deed or Tax Lien Sales to recover taxes owed. Here’s a table outlining how each state handles its recovery.
2. Physical Distress
When a property has structural damage or physical distress, homeowners enter a bit of a chicken-and-egg situation.
Some owners on the brink of foreclosure choose to deliberately damage their property or strip it of any items with resale value. Others default on their mortgage because they don’t have any money to put into their property. By the time the lender forecloses on the house, there is a backlog of maintenance issues needing to be resolved.
In some cases, owners simply walk away from properties with significant structural damage. Some forms of physical distress include:
- Black mold infiltration
- Sinkhole on the property
- Earthquake damage
- Storm damage
Sometimes, a property’s physical distress results from illegal or contested activity on the previous owners’ part (think meth labs or dog fighting rings). They might be hoarders who have allowed the property to disintegrate around them.
These properties can make good investment opportunities, but investors need to be experienced enough in calculating the approximate cost of repairs before they secure the place.
3. Environmental Distress
Some distressed properties are an environmental hazard either because the prior occupants violated laws or local codes enforcing dangerous chemical substance handling and disposal or because they were engaged in a business where hazardous chemicals are routinely used, such as a dry cleaner or a gas station.
Although there are some residential properties with environmental distress, it’s far more likely to encounter commercial properties with these problems. Here are some things to look for:
- The property was used in manufacturing, particularly where hazardous chemicals are routinely used.
- The property is older and may contain asbestos or lead paint.
- The property is near a wetland, subjecting it to closer regulation by the Environmental Protection Agency (EPA).
- The property is near a gas station and could have groundwater contamination due to leaking underground tanks.
- The property will need extensive remodeling that could unearth potential environmental issues.
As with properties that have physical damage, properties with environmental distress can be a good investment, but because you run the risk of uncovering expensive issues in the process of flipping the property for resale, approach such investments with caution.
4. Vacant and Abandoned Properties
Abandoned houses can also qualify as distressed properties, provided some conditions are present. These properties are a blight on the neighborhoods surrounding them, bringing down property values and attracting pests, vandals, and squatters. Fun fact: the crime rate can double on blocks where there are vacant properties.
What is the Difference between a Vacant Property and an Abandoned Property?
- Vacant property
Properties are considered vacant when a homeowner no longer occupies the site. The homeowner may have moved overseas, gone into assisted living, or any number of other circumstances. Vacant properties can be a financial drain on the owners because they still need to maintain the loan, maintenance, and taxes regardless of whether the property is occupied or rented.
- Abandoned property
Properties are considered abandoned when owners walk away because they have determined, for whatever reason, that it’s no longer economically feasible to keep the property. Usually, the owners either had no equity or their property was worth less than the mortgaged value. The property has probably not been maintained over the years and may have structural damage. Signs of neglect will be readily apparent during a drive-through inspection.
Theoretically, every vacant or abandoned property is a distressed property.
Owners may be tired of the expenses associated with maintaining a second or vacation home. Adult children may be in a state of limbo, unable to make decisions about the family home once their parent is no longer living there. You never know until you make contact.
For investors willing to do the legwork, identifying vacant and abandoned properties and contacting either the lender or owners involved can be an extremely profitable strategy for acquiring distressed property.
5. Forced Sales and Legal Distress
Each year, thousands of properties become distressed due to adversities in the lives of the people who own them. Here are three common reasons properties become distressed:
It’s not uncommon for relatives to inherit properties that soon become a financial drain, either because the property tax is too expensive, there are costly repairs that need to be made before the property can be sold or rented, or the mortgage is underwater. These homes may remain vacant for years or eventually become abandoned.
Financial difficulty and divorce frequently go hand in hand. Many couples find themselves getting a divorce while simultaneously going through a foreclosure process. They may have no other choice but to sell the family home in a short sale to be free and clear of the debt. There might be a second home or vacation property that needs to be sold at a loss.
The average age for a couple to divorce in the United States is 30, and 60 percent of divorces occur when couples are between 25 and 39. In other words, divorcing couples are too young, as a general rule, to have built enough equity in their home to come out ahead. If they happen to divorce when there is a downturn in the real estate market, their home may well become a distressed property.
Bankruptcy is another means by which properties become distressed. How the property becomes distressed during this process depends on the type of bankruptcy in play.
Chapter 11 Bankruptcy
Under this bankruptcy filing, the court will assist a business or an individual in restructuring and discharging their debt. In some cases, this process means liquidating all assets, including any residential or commercial real estate.
However, the goal of Chapter 11 is to restructure debt, not liquidate assets. Because the goal is to allow the business (or person) to continue normal operations without the crippling burden of debt, the business owner often becomes a Debtor In Possession (DIP), meaning that they continue to hold on to a property that would have been discharged as part of a liquidation bankruptcy process.
This arrangement allows them to continue operating their business until it can be sold. Commercial bankruptcies frequently involve DIP financing to help businesses stay afloat during the process. When the company continues to fail to pay its debt, the property becomes distressed. You may be able to negotiate a sale directly with the property owner or the bankruptcy trustee.
Chapter 7 Bankruptcy
Also known as liquidation bankruptcy, a Chapter 7 status also creates distressed properties. In this form of bankruptcy, all assets that are not exempt are seized by the court and used to settle the individual’s outstanding debt. The family home is generally considered an exempt asset (via homestead).
However, in many cases, the homes of individuals going through Chapter 7 are heavily mortgaged, underwater, or already going through a foreclosure process. Investors who wish to purchase these properties in distress can do so through the trustee appointed to oversee the bankruptcy.
Since bankruptcy is a legal procedure, the lender and debtor information and all it encompasses is public record. In fact, you can get a great amount of detail on the individual and company bankruptcies through the Public Access to Court Electronic Records, aka PACER.
How To Find Distressed Properties (9 Sources)
There are a few places to search for distressed properties. Some sources are easy to use, and others require extra effort and sometimes, luck.
1. Foreclosure Listings
Traditional foreclosure listing sites are a good starting place to search for late-stage foreclosures, short sales, and auction properties from the major lenders. Some sites to check include:
Is foreclosure listing site information reliable?
Not always. Banks often have separate holding companies for properties they acquire after an unsuccessful foreclosure auction, otherwise known as Real Estate Owned (REO) properties. For that reason, when you look at the standard foreclosure listings, REO properties will be filtered out.
The sites only list late-stage foreclosures. You will miss properties in various stages of pre-foreclosure, where the borrower has already defaulted on their mortgage note, but the bank has not yet officially foreclosed on the property.
2. Prospecting Software
BankProspector is proprietary software that helps you identify and connect with local, regional, and community banks to find REO properties that will not appear on ordinary foreclosure listing sites. The software also allows prospective investors to check on non-performing loans or notes to identify properties with borrowers already behind on their mortgage payments.
BankProspector’s real-time data and up-to-date decision-maker contact information let investors streamline the distressed property search and purchase process while increasing profit potential.
Learn more about how you can benefit from getting off-market real estate deals direct from the bank by joining our free training webinar.
Another good place to look for distressed properties is on an auction website. For local sales, you can check the daily newspaper; in many states, lenders are legally required to post notice of an impending foreclosure sale.
If you wish to cast a wider net, auction listing sites like Auction.com and Tranzon.com allow you to search for specific property types in your target area. Constantly updated to include the latest properties on the auction block, you can bid on properties through the site. And just like the world’s most famous bidding site, eBay, there is a “buy it now” option for selected properties.
4. Abandoned Houses
Looking for abandoned houses (distressed properties deserted by the owners) is a creative strategy that can reap benefits. These properties still cost the owners annual taxes and, in some cases, mortgage payments. You may be able to purchase a home by approaching the homeowner directly and making an offer. Alternatively, in cases where the borrower has already defaulted on their mortgage note, you can contact the lender.
Vacant House Data Feed is a useful site that allows you to locate abandoned homes near you. The search platform allows you to select the property type, whether the lender currently owns it, and attributes like square footage and the number of bedrooms and baths. In some cases, even the owner’s phone number is available.
5. Drive-Bys (Know Your Target Neighborhoods)
You may be able to locate vacant homes in your area simply by making yourself aware of the neighborhoods in which you want to purchase a distressed property.
Houses where mail accumulates or the landscaping goes unmaintained for long periods might be abandoned. They could also belong to the children of a homeowner who has either died or gone into assisted living.
Adult children are sometimes slow to put the family home on the market, either because they can’t agree on terms or because they have an emotional attachment to the property. They may also be avoiding the need to make costly repairs in preparation for listing. Offering to take the property off their hands as-is can seem like an attractive solution to them.
Don’t forget to contact local people who may be able to give you information about vacant homes, such as mail carriers or real estate agents who specialize in your target neighborhoods. Vacant homes are a liability for real estate agents because their clients don’t want to live near them. They may be happy to share any information they have about homes not currently occupied.
A pre-foreclosure is a home where the borrower has already defaulted on their mortgage and is typically at least 90 days delinquent. Though there is a process to assist homeowners in making good on their notes, most mortgages that haven’t been paid for three consecutive months become foreclosures simply because homeowners who default cannot afford the even larger sum needed to repay past-due balances and fees.
When you locate a distressed property during the pre-foreclosure stage, you eliminate a lot of the competition and, as a result, stand a better chance of securing the property. You also have the advantage of being able to negotiate directly either with the borrower or lender while there are still options on the table.
Although you might find a delinquent homeowner who is willing to enter a short sale with you, your chances are better if you deal directly with the lender. Because the property is on the verge of repossession, they are in a greater position of power.
You can use several tools to identify properties in pre-foreclosure, including:
- The Federal Deposit Insurance Corporation (FDIC) – a free online resource that you can use to identify lenders with pre-foreclosures
- Local newspaper – most U.S. counties require notices of default to be posted
- This excellent software program – helps individuals who sign up to find information about owners whose property is in pre-foreclosure
Distressed properties come about for a variety of reasons. Foreclosure is just one of them. Consider reaching out to local attorneys to find properties in limbo due to legal issues.
- Probate Attorneys
Making friends with some of the probate attorneys in your area can give you leads on individuals who may be looking to liquidate their new inheritance.
Inheriting property isn’t always a good thing, and heirs often find themselves suddenly responsible for back taxes and costly repairs. If mortgaged, the property might be underwater or have no equity. The previous owner could have taken out a reverse mortgage.
Heirs who are not in a position to afford the property they inherited may be happy to negotiate a short sale or sell the property to someone willing to settle the tax liability.
- Family Law Attorneys
Divorce puts a financial strain on most people, and it is not uncommon for couples to be simultaneously filing for divorce and going through a foreclosure process.
Cultivating a relationship with a family law attorney in your area may help you identify properties at risk of default at the early stages. If that isn’t possible, you can still find leads by reading the divorce filings posted in your local newspaper.
One thing to remember: When a couple divorces, more may be at stake than just the family home. Sometimes, couples may have other real estate assets, such as a vacation home or inherited property. They may need to liquidate those properties quickly.
- Foreclosure Attorneys
Foreclosure attorneys work directly with the decision-makers at the banks. In fact, a workout officer or special assets manager for a bank won’t typically be able to make a move without consulting the bank’s counsel first.
Take your local foreclosure attorneys to lunch. Help them understand the value you bring to a transaction and look for referrals into the banks the attorney serves in the foreclosure process.
Joe McCall, a thought leader in real estate investment, discovered that the online real estate advertiser Zillow has been inundated with real estate listings posted by homeowners with little or no equity. These sellers are desperate because they do not have enough cash to pay the real estate fees associated with a home sale. And there are a lot of them in real estate markets across the country.
McCall or his associates approach the “sale by owner” listings of median-priced homes on Zillow to see if they are interested in a lease-to-own option. They then negotiate a wholesale price for the option and find an interested end buyer who pays McCall a fee to get the lease.
You can leverage the same principle to locate potential sellers of distressed properties.
Craigslist is a goldmine of real estate properties listed as For Sale By Owner (FSBO). Often what motivates sellers to forego using a real estate agent is they lack the standard 6% brokerage fee sellers have to pay.
These homeowners may not be on the verge of foreclosure, but they probably won’t profit from the sale, either. If possible, track listing activity, price changes, and how long or often it’s been listed to establish a seller’s urgency to offload the property.
By wading through the FSBO postings on Craigslist and contacting owners directly, you may be able to negotiate a sweet deal.
How to Buy Distressed Property
Step 1: Establish the Property Value and Potential Expenses
Once you’ve found a property, go through the preliminary due diligence steps to establish its value and estimated costs associated with it.
How to Determine a Distressed Property’s Value
- Verify the property condition and occupancy
- Estimate necessary repair costs
- Use Zillow for value estimates
- Find three “after repaired value” similar comps in the area
- Search county property records for assessments, permits, deeds, and property tax history
Step 2: Make an Offer
You’ve figured out the distressed property’s value,. Now it’s time to make an offer.
How Much Should I Offer on a Distressed Property?
It depends on who owns the property, how costly it will be to make any necessary repairs, and how quickly the owner needs to sell it.
When you’re making an offer to purchase bank-owned property, you should be very aggressive in your discount. REO asset managers aren’t going to be offended and don’t have any “skin in the game.” The thing that matters most, in my experience, to an asset manager is that you perform, and there’s no “re-trade” or re-negotiation.
When you’re buying a distressed property from a private seller who’s in trouble, that’s a different story. In some scenarios, you’ll want to go in with almost your best offer upfront and justify your price with facts.
For example, document repair cost estimates or factors (sometimes unbeknownst to the homeowner) that could impact the value and present the information with your offer to show how you arrived at the price.
Most importantly, make sure you satisfy the seller’s needs when making an offer on a distressed property. Often this has nothing to do with the top-line purchase offer price at all.
A private individual may be most worried about having time and money to move.
A bank is normally concerned with the net proceeds and a definitive timeline.
Step 3: Complete Due Diligence
Once your offer’s been approved, you can move on to the formal due diligence process to expose important facts and histories about the property before you finalize the sale.
Distressed property can have surprises.
Your due diligence process will be the difference between buying very profitable distressed properties and finding yourself underwater on your deals. The due diligence process can be split into two parts: the preliminary due-diligence (done before you make an offer) and the formal due diligence process (starts after you have made the offer).
Here are a few due diligence aspects to pursue:
- Pull the property file at the town or city hall (the building department has one for every property)
- In the case of private sellers, you may want to perform title due diligence to expose existing liens and other title issues
- Check PACER for bankruptcy when dealing with private sellers
- Have the property professionally inspected and assessed
Don’t skimp on your due diligence. Investing some time and money before purchasing the property is the only way to ensure you’re making the best investment.
Step 4: Fund and Close
There are many investment funding and financing options for distressed properties. However, most options aren’t traditional since properties in short sale or foreclosure status are typically in rough shape and won’t pass lender requirements.
A few distressed property financing options include:
Hard Money – private, short-term money that is typically lent on the deal’s merits rather than relying on more traditional factors like a credit score. You can easily find hard money lenders here. Terms will vary from lender to lender.
Credit Lines – Can be used for difficult acquisitions
203(K) Rehab Loan – For homebuyers rather than investors, it can be an excellent option if you plan to live in the home
Advantages & Disadvantages of Distressed Properties
Advantages of Distressed Properties
- Below-Market Prices
Distressed properties are an excellent way for first-time real estate investors to gain instant equity and increase fix-and-flip profits.
- Better Property for Less Money
Buying distressed properties allows investors to acquire higher-quality assets for less capital than they’d spend on a similar property for sale on the traditional market.
- Financing Flexibility
Some lenders offer financing on their distressed properties, making it easy for buyers to close the deal.
- Often More Negotiable than Other Properties
Private sellers and lenders may be more willing and able to work with investors buying them out than they would be in a traditional selling scenario.
Disadvantages of Distressed Properties
- As-Is Property Purchase
Most distressed properties are sold as-is, primarily because owners can’t afford fixes or concessions and lenders don’t want the hassle of coordinating inspections and repairs.
- Costly and Unexpected Repairs
Lots of abandoned or vacant properties require major updates and renovations to make them marketable (and livable) and distressed property repair costs can add up fast.
- Delayed Closings
Distressed property circumstances vary and each purchase process will be different. Lenders not equipped to manage a distressed property purchase may be delayed in paperwork processing and approvals, and private sellers may be slow to move forward with the sale for numerous reasons.
- Auction Dynamics
Investors buying a distressed property at an auction face multiple challenges and risks, including losing the deal to a higher bidder or potentially overpaying for a property due to the high-pressure buying conditions.
Distressed Property FAQs
What is a Distressed Mortgage?
A mortgage becomes distressed when a borrower can no longer afford the payments and stops paying the lender in accordance with mortgage terms.
Can I Finance My Purchase of Distressed Houses?
Yes, though non-traditional methods may be necessary. Some lenders specialize in distressed property loans, and you can also source funds from other investors.
If you’re planning to finance the purchase traditionally, acquire a mortgage preapproval from your lender. This process verifies what a bank is willing to lend a borrower, so when the right deal comes along, a buyer has the confidence and lender backing to pursue it.
Time is of the essence during these transactions, and having funds ready when you need them is key to a successful short sale or distressed property purchase.
Should I Buy a Distressed Property?
You should consider it. Not all buyers are equipped to deal with investing in distressed property right away but with some research, expert insights, and the right tools, most can earn substantial profits and build strong portfolios.
Gain control of the distressed property buying process and go bank direct. By reaching out to decision-makers before a property hits the foreclosure stage, you can get better deals, avoid competitive auction scenarios, and negotiate directly with the seller.
Check out BankProspector, and start searching for distressed property today.