How to Buy a Short Sale – or a Foreclosure in King County
It’s been a while since I’ve blogged and I apologize for that. My recent preoccupation with an investment property is to blame. I’ve been in contract to purchase a short sale in Madison Valley and the negotiators are working with the bank to get final approval before the property goes to auction this Friday. Meanwhile, I thought it’d be nice to share the process as it’s fresh in my mind, and perhaps you will glean something from it for your next real estate investment project.
My Target Neighborhood
I’ve been targeting a few neighborhoods that I think will yield the best opportunities. One of them is Madison Valley in Seattle, WA. In general, if you want to find a “deal”, focus on neighborhoods where there is likely to be mispricing. This is a fundamental principal that all great investors exploit like Warren Buffett, George Soros, Peter Lynch and Julian Robertson.
New neighborhoods or cookie cutter neighborhoods usually present the least opportunities for the real estate investor. The reason is simple. If the neighborhood is new, the homogenous homes make it easy to price. The seller and the listing agent are less likely to misprice so that the property sells at deep discount. Additionally, newer neighborhoods typically don’t allow you the ability to rehab (hence, newer) and add significant value through fixing up the property.
If you live in a neighborhood and all the homes were built by the same builder in 2004, why sell your home for $200k when the guy across the street with the exact home just sold for $300k? However, if you live in a neighborhood where most homes were built in 1920 it’s a different story. Some homes likely have remodels, so don’t. In some cases brand new homes have been built on old sites. These types of scenarios allow the intelligent investor to exploit.
Furthermore, in the bank’s approval process, they request Broker Price Opinions (BPOs known as bank valuations) which are frequently subject to flaws when neighborhoods are heterogeneous and not as easy to value.
Seattle is a developed city with a wide range of neighborhoods with many homes built from the early 1900s and on. It represents an eclectic mix from early 20th century styles to post-war styles. Neighborhoods such as Leschi, Madrona, Columbia City, Wallingford, and pockets in West Seattle present great opportunities because range of homes can range widely. Gentrifying and transitional neighborhoods also create opportunity as well as it requires specific knowledge to accurately value you the property.
When investing in real estate, seventy percent of the battle lies in buying at the right price. The remaining thirty percent comprises fixup, financing, maintenance, permits, etc. The good thing about determining price is that you don’t have to be exact, but you have to be roughly right. In fact, it’s almost impossible for two different people to arrive at exactly the same valuation.
When valuing properties in Madison Valley, I looked at three groups of homes: homes sold within the last year with a heavier weight for homes within the last six; pendings sales with a heavier weight on non-short sale homes; and active comparable listings noting days on market. If possible, I try to think of the distance in terms of “blocks” as opposed to quarter-mile or half-mile radiuses (commonly used by realtors). This allows more precision and puts you in the shoes of the buyer where a quarter mile makes all the difference. During preliminary analysis, I pull up Google Street View and “walk” through the neighborhood and make mental notes of changes such as lot size, curb appeal, traffic, and blocks with curbs and blocks without.
When I determine price, I price the property where I think it would be a good deal on the market. As in, if anyone were planning on buying a home in Madison Valley – in my price range, of course – would definitely buy my property. After I determine that price, which is already conservative since they’re getting a deal, I build in a margin of safety where I can easily discount 5% and still make money. Keep in mind 5% is a ton when net margin for nationwide homebuilders is about 5%.
This project is a large project that will require more money than usual to fixup. The property is essentially a shell and just has a roof, outside walls, and some interior framing. The property needs plumbing, electrical, framing in the lower areas, windows, sheetrock, roofing, a new driveway, siding, flooring, kitchen, bathroom, and landscaping. In addition to budgeting for known items and issues, I built in a buffer for cost overruns. In this case, $30k.
Putting in the Offer
This step requires lots of persistence and patience from the buyer’s agent. Many buyers’ agents wince when it comes to working with an investor. Some agents have investors but effectively fire their clients through lack of service. Finding investment properties requires much time and commitment on the agent’s end. The agent needs to screen, drive, analyze and value a ton of properties and neighborhoods. Finding deals requires casting a large net which in turn burns the agent’s time, their most valuable commodity.
As an investor/agent, I obviously don’t mind spending time looking for deals for myself as success pays off tremendously. When it comes to investors, I actually prefer working for them because they have a high sense of loyalty to me and my services. The truth is, investors are likely intelligent enough to do what I do, but don’t have the time nor the desire. As long as I’m helping my clients make money, this puts me in a good position because I get paid to acquire the property (as the buyer’s agent) and to dispose of it (as the listing agent).
It’s not uncommon to put in seven or eight offers until you get one acceptance. Even then with the acceptance from the seller, if you’re purchasing a short sale, you still need to wait for bank approval. I put in multiple offers on different properties in Madison Valley before one finally got mutual acceptance. Since it’s a short sale, the offer is contingent on bank approval.
To my dismay, Bank of America rejected my offer last week and responded with the following:
This short sale was submitted to your [note holder] for approval and was denied due to (insufficient offer, not willing to sign a deficiency agreement, or contributing to the loss). However, if the seller is willing to sign the deficiency agreement or contribute to the loss or have the buyer increase their offer; we may be able to reconsider the short sale. Please send us any updated documents for the short sale to be reconsidered.
This was an automated response sent by the bank which did not take into account, what I believe, as the bigger picture. The bank will likely get less since buyers have less information at the auction and tend to bid less to compensate for unknown risks. At this point it looks like the bank will not approve the offer and I will just make my trip to the auction to bid for the property.
The Right Partners
I find myself extremely blessed to have partners that I like and trust. While they say you never know what you’re made of until times are tough, I believe that we will persevere as a partnership. Why didn’t do this deal myself? Because this deal requires more than $200k in equity, and the partners bring other value to the table besides cash. While I could’ve done the project with less money, the equity cushion provides a buffer to absorb losses and decreases the private loan needed – more on that below.
In this market, financing presents the biggest hurdle. In many cases you can get funds through private loans or hard money loans. The key, however, is to get the loan and not lose your shirt in the process. Lenders typically charge you points and interest. In King County, the fees typically range from 3% to 5% for points and 10% to 12% interest. Loan terms are usually 6 to 9 months which means cost of funds are about a 20%. While this seems high, investors pay these fees because they lack alternatives.
While I know multiple sources for private lending, I also know some dentists who have money sitting in the bank earning little or no interest. Why pay high fees when you don’t have to? I put together a couple buddies that are dentists and told them I’d give them 10% interest instead of the measly 1-2% they would otherwise earn on their CDs. I drove them by the property so they could see their collateral and see what they would be loaning money on.
While, these individual lenders are my friends, business is business. This loan will be treated just as if I were getting the loan from BofA or Chase Bank. We will formalize the loan through three key documents: 1) Loan Agreement, 2) Promissory Note, and 3) Deed of Trust. The loan agreement basically states the terms of the loan, what the interest rate is, late fees, default rate (if any) and when the note is due. The promissory note is essentially the promise to pay the loan. The deed of trust is the security instrument that gives the lender their interest in the property and the right to foreclose if the borrower defaults.
Bidding at the Auction
Last week I went to the auction at 10am in Bellevue familiarize myself. I’ve been to numerous auctions in Seattle, but none in Bellevue up to that point. In King County, there are two locations you can purchase foreclosures 500 4th Ave (Seattle) and 3535 Factoria Blvd SE (Bellevue). The property is slated to auction this coming Friday at 10am.
Honestly, getting this one deal started has definitely taken more work than I expected. Every step of the process has been so rewarding, from scrubbing deals to getting into contract; from putting together the operating and subscription agreements for partners to drawing up loan documents for lenders. This serves as a great learning process, not to mention it pays the bills (hopefully).