April 2003

With alarming regularity, I am asked about the relative merits of buying distressed properties. By distressed, we may be talking about real estate on which the property taxes or rates are so far in arrears that the relevant authorities have seized the property back from the owner as indicated on the title, and offer the real estate for sale, often for little more than the backlog of property taxes. Or, we may be talking about real estate on which the mortgage payments have fallen behind, in which case the banks will often step in, and in accordance with the mortgage document (an agreement between the lending bank and the borrowing real estate buyer which spells out, amongst other things, what to do in situations such as this) offer the real estate for sale, again often for little more than the amount outstanding on the mortgage. These latter situations are often called “foreclosure sales” or “mortgagee-in-possession sales”.

The two questions that come up most frequently regarding distressed real estate are (1) “Aren’t these properties great buying opportunities?”, and (2) “Are you actively pursuing these deals?” The answers are, respectively, maybe, and no! Let me explain.

Theoretically, distressed properties can be great deals for investors who happen to be in the proverbial right place at the right time. For example, if someone has fallen behind with their mortgage payments to the tune of $100,000, so that the total mortgage outstanding is now $320,000, and the value of the real estate is $800,000, then being able to buy the property for a little more than $320,000 would be a deal that only a fool would reject.

However, as wonderful as such a fantasy deal may seem to hopefuls with foreclosures on their mind, a deal such as this will never happen. Firstly, owners of $800,000 homes tend to have family and friends to whom they can turn in times of financial hardship to avoid them losing their equity (in this case $480,000). Secondly, even if there is no one to help them out, long before giving the property back to the bank, they would sell it for a fair market value, again to retain their substantial equity.

Consequently, foreclosure sales tend to happen to people who do not have friends or family in a position to help them out, and with real estate where there is not much difference between the market value and the amount of mortgage outstanding. In general, we are talking about real estate at the lower end of the scale of property prices for a region, and with owners who are at the lower end of the income scale. As evidence of this, get hold of a list of foreclosure properties, and check them out. They will not be in the ritzy suburbs.

Having made that bold, generalized claim, it is easy to extrapolate the reasoning that when you buy foreclosure real estate, you will tend to get tenants who will from time to time find it difficult to meet their rental obligations, just as the previous owners found it difficult to meet their mortgage obligations. If people are willing to lose what little equity they may have in a house, do you think they would have any compunction about not paying the rent for a while?

The factors which should determine the desirability of owning a piece of real estate should include the extent of the positive cash flow, the returns, the expected capital growth, and the expected management overheads. From my observations and experience, foreclosure deals tend to have acceptable returns, but lower than normal capital growth, and much higher than normal management overheads.

Buying real estate on which the property taxes (or rates, as they are called Down Under) have not been paid, is equally risky. On my last trip to Australia, I came across a couple of enthusiastic investors who were gloating over the fact that they had acquired 23 properties in the previous month for an average price of less than $3,000 each, representing the amount of rates outstanding. They clearly thought they had found the Deals of the Decade, and then asked me what they should do with them. I asked if they were rented out, and the answer was a guarded “No, there don’t seem to be many tenants around”. I asked them where these properties were located, and all of them were in dinky little towns somewhere in the outback that few people had ever heard of, fewer people were ever likely to visit, and fewer still were every likely to want to live in. Maybe their $60,000 investment would have been better made as a deposit on a single piece of real estate in a high growth area where they could easily get a tenant, have a good chance of capital growth, and not have 23 roofs, bathrooms and lavatories to maintain.

In the United States there are stories of people lining up on the steps of a courthouse, waiting for the latest list of foreclosure deals to be released to the public. Just be aware that the scrap you may have to get into to secure one of these deals could be an omen of more scraps to come to collect rent, evict non-performers and haggle over damages.

There may well be many people doing extraordinarily well out of these kinds of properties, but for me, they represent a tremendous amount of effort for relatively modest gains.

Successful investing!

Dolf de Roos