You’ve probably heard that one of the best ways to make money in real estate is by purchasing distressed properties. But what exactly does that mean?
Distressed property is a property that the owner, for whatever reason, can no longer afford to own. In addition, the property may be worth less than what remains owed on the mortgage — i.e., it is “underwater.”
Another reason property becomes distressed is fraudulent activity. The lender initiates a repossession process in order to protect their asset from mortgage fraud or other claims on the property.
What makes a property “distressed”?
The term “distress” refers primarily to the hardships that affect homeownership, not to the state of the property itself. However, many distressed properties have also fallen into a state of disrepair because their owners no longer have the means to maintain them.
There might be significant physical damage deliberately inflicted on a property once the owners realize they are going to lose the property. And of course, some properties have suffered damage as a result of a natural disaster or environmental degradation.
Distressed properties can be a great investment because they can be purchased at a discount, renovated, and resold at a profit. But with foreclosure rates down nationwide to the lowest level since the first quarter of 2008, where do you find these goldmines?
The first step in finding distressed properties is understanding the conditions that produce them. Armed with this information, intrepid investors will have a better understanding of where to focus their energies when searching for properties to add to their portfolio.
5 Ways Properties Become Distressed
1. Financial Distress
The delinquency rate on single-family homes, which jumped to over 10 percent during the Great Recession, is down to just under three percent. That means out of every 100 residential properties sold in the United States, roughly three are on the road to foreclosure.
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.
Today, investors have to look harder for weaknesses in the housing market:
- An economic downturn is clearly one event that causes mortgage defaults to spike.
- Locally, delinquent mortgages may occur in areas hit by natural disasters, like fires and flooding or economic weakness in the local market.
- And just as in the Great Recession, some states are at greater risk of default, particularly states where the cost of housing has risen dramatically over the last decade, threatening to outpace incomes.
Being unable to afford to make one’s mortgage payments is one cause of default. Another is the inability to pay one’s property taxes.
For most individuals, property taxes are the second largest expense of homeownership. For people on fixed incomes, the rising cost of property tax, even where the property is fully paid off, is a significant risk.
The Tax Cuts and Jobs Act of 2017, which caps SALT tax deductions at $10,000, could have an impact on the rate of default in markets like the New York City metropolitan area, where the average property tax payment is already close to $10,000.
An estimated nine percent of households might be negatively impacted by this change, according to a report by the Tax Policy Center.
States typically use Tax Deed or Tax Lien Sales to recover taxes owed. Here’s a good table outlining how each state handles their recovery.
2. Physical Distress
The issue of physical distress — i.e., dealing with a property that has structural damage — is 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. Thus, by the time the lender foreclosures 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 are as follows:
- An infiltration of black mold.
- A fire.
- A sinkhole on the property.
- An earthquake.
- Storm damage
Sometimes a property’s physical distress results from illegal or contested activity on the part of the previous owners (think meth labs or an illegal dog fighting rings!). They might be hoarders who have allowed the property to disintegrate around them over the years for various reasons.
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
The United States has federal, state, and in some cases local codes enforcing the handling and safe disposal of dangerous chemical substances. However, some distressed properties are an environmental hazard either because the prior occupants acted in violation of existing laws or because they were engaged in a business where dangerous 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.
- The property is near a gas station and could have ground water contamination as a result of 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, such investments need to be approached with caution.
4. Vacant and Abandoned Properties
Vacant and abandoned properties can also qualify as distressed properties — provided some conditions are present. These properties are a blight on the neighborhoods that surround 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).
It’s important to understand the difference between a vacant property and one that has been abandoned, however.
Vacant properties are ones that the homeowner no longer lives in. They 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 the loan, maintenance, and taxes still need to be maintained regardless of whether or not the property is occupied or rented.
Abandoned properties, on the other hand, are ones that the owners walked away from 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 on a drive-through inspection.
As you might expect, the number of abandoned homes across the United States jumped from 9.5 to 12 million between 2005 and 2010, a predictable result of the housing collapse.
Here’s an interesting statistic, though. Despite the economic recovery, there has been a 50 percent rise in the number of vacant units; in 2005, there were 3.7 million vacant properties, and by 2016 that number jumped to 5.8 million. In some small cities, the overall vacancy rate approaches 20 percent, this is according to figures from the Lincoln Institute of Land Policy.
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 who are 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 scenarios that result in distressed properties:
- Probate/Inheritance 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.
- Divorce Financial difficulty and divorce frequently go hand in hand. In fact, 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 in order 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 the ages of 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 Bankruptcy is another means by which properties become distressed. In Chapter 11 bankruptcy, the court will assist a business or an individual to restructure and discharge their debt. In some cases, this means liquidating all assets, including any residential or commercial real estate, though 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, meaning that they continue to hold on to a property that would have been discharged as part of a liquidation bankruptcy process. That allows them to continue to operate their business until the time it can be sold.
Commercial bankruptcies frequently involve “debtor-in-possession” or DIP financing to help businesses stay afloat during the process. When the business persists in not being able to pay their debt, the property becomes distressed. You may be able to negotiate a sale directly with the property owner or else the bankruptcy trustee.
Chapter 7, or liquidation, bankruptcy 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 can do so through the trustee appointed to oversee the bankruptcy.
Since bankruptcy is a legal procedure the lender and debtor information and all that encompasses is public record. In fact, you can get a great amount of detail on the individual and company bankruptcies through PACER.
If you’re serious about investing in distressed property then boning up on the ins-and-outs of the different ways properties become distressed can help you find great deals.