Should Investors Buy Upside Down Homes?

Should Investors Buy Upside Down Homes?

A green house that is a hidden treasure Photo courtesy

Real estate investors are an opportunistic bunch, and we’re always looking for those hidden treasures that have the potential to turn the next big profit.

But it’s a balancing act.

The projects that promise the biggest rewards often come with the biggest risks, and something that a lot of real estate gurus have been pushing lately is focusing on homes where the homeowner owes more on the mortgage than the value of the property, also known as underwater or upside down homes.

There’s a number of reasons why a homeowner might be upside down. It could be anything from falling neighborhood home values to an exotic mortgage that has ballooned. What does it mean for you? Is the reward worth the risk?

Not really. Generally speaking, there is little to no profit opportunity in an upside down home.

Why?

The main tenant of real estate investing is identifying equity and then buying for less than its worth. An underwater home has no equity, so it is not possible to buy the equity at a discount.

Instead, the only way to buy a property this way is through a discount lien release, or a “short sale.” That’s when the homeowner agrees to sell the house at value and the lender forgives the outstanding balance on the loan (more on this later).

Short sales are associated with seller distress, and the common misconception is that the distress equals an opportunity for profit. But that’s often not the case.

That’s because the distress usually isn’t limited to just one homeowner. It affects the entire local market. If the homeowner went underwater as a result of falling home values, you will have to turn around and sell that home in the same poor market.

With margins already slim, it will make it incredibly difficult to sell the house quickly, and you can kiss any substantial profits goodbye.

A large brown house that could be hard to make a profitPhoto courtesy

Short sale headaches

That’s assuming that a short sale could even go through. Short sales are time consuming and a major hassle for investors, who work best when they work quickly.

It first involves contacting the seller to convince them to attempt a short sale. Short sales include some credit damage to the seller, so they will usually only consider this as a last resort.

The seller must then convince all lienholders that he or she is experiencing financial hardship, which would motivate them to accept the short sale. When we say all lienholders, we mean everybody — the mortgage, second mortgage, home equity loans and any outstanding HOA penalties.

To do this, the seller must put together a package, including financial records and independent appraisals of the home’s true value, which will be processed by each lienholder. One lienholder might accept, but a second or third might notice the amount of money going to the first lienholder and object. This will sink an entire short sale.

All it takes is one lienholder to object, and the deal is toast.

If it is successful, there are a number of levels that the application has to go through, which means this process will take months.

That’s not exactly the type of sale that a real estate investor wants to get involved in. It’s best to keep your focus on more reliable targets and taking on upside down homes if — and only if — the math adds up and it’s worth the extra work.