I just spent several days this week inspecting South Orange County REOs. The quality, condition and pricing run the distance from “Wow – pretty nice!” to “Gag – what’s that smell?”
I saw a lot of REOs back in the mid-1990s and sold more than a few at that time. They also offered a wide range of conditions early on, but as the lenders eventually learned, most of the time they got a faster sale at a higher price by cleaning up properties before putting them on the market. More often than not, they included new carpet and neutral paint, landscape cleanup, and some minimal upgrades such as replacement of faucets, fixtures and appliances. At this point in our real estate downturn, there seems to be a reluctance to do this, although a few do. Of the 12 properties that I saw on Thursday, only 3 could be considered move-in ready, and 2 days later, all 3 of them are now in escrow!
From my experience, there are only 3 main types of buyers of foreclosed homes.
Investors who plan to fix, rent and hold for the long term. With real estate values not expected to increase in the near future, the return on investment needs to be justified based on projected cash flow, rather than appreciation. The following factors will influence the decision making for these buyers, and dictate the price that they will be willing to pay:
- Non-owner financing is generally at a higher interest rate, and requires a greater % down payment.
- Cost-to-carry during the repair period, as well as direct repair cost, needs to be added to the original investment amount.
- Tax advantages provided by depreciation.
- Cash flow should cover at least the monthly cost-to-carry.
Investors/Flippers who plan to fix and re-sell the property quickly for a profit. In addition to requiring a decent return on investment, these buyers require compensation for taking a risk that the market could deteriorate further before they can complete the repairs, find their own buyer and close the escrow. Projected cash flow is not a strong factor in this valuation, except as a fall-back position in case the market value declines below their break-even point. Factors influencing this type buyer’s decisions:
- Non-owner financing at higher rate will again be required.
- The ability to accurately estimate costs to repair, and skills or access to skilled workers who can complete the repairs quickly.
- Market knowledge to be able to estimate (guess-timate?) the final sale price.
Buyers who plan to live in the property. Many of these buyers will be current renters. Some will be move-up buyers, with savings set aside for the down payment, and the ability to rent their current home for close to monthly carrying cost. Since lenders won’t accept contingent sales, move-up buyers that can’t qualify to own 2 properties, will not be included in this group.
- First time buyers rarely have any spare money to repair after spending it on down payments and closing costs. Lenders need to include allowance for closing costs, rate buy downs.
- Emotions play a greater role for owner occupied homes. Dirty, nasty, smelly fixers will be severely discounted or totally ignored. Condition generally needs to be fairly close to “move-in ready.”
- When estimating costs to fix, most owner-occupant buyers over-estimate by about 200%!
- Many buyers are afraid of the “as-is, where-is” contract, and will need a substantial discount to overcome it.
- Monthly carrying cost must be in-line with buyer’s previous rent + tax advantage.
Lenders need to get the message, and fix or price their properties in line with the expectations and budget of their most likely buyer. For lower end, first time buyer properties, it needs to be clean, neutral and attractive so that the buyers can move in and immediately start living in their new home. For investors, if the bank won’t invest in fixing the obvious flaws, they will need to allow the fixing plus carrying cost to come off the bottom line either by pricing it substantially below other “comps,” or offering below market non-owner financing.