The Process

The process for foreclosing on a home mortgage usually begins when a borrower falls three months behind on payments. The lender sends a default notice to the homeowner and to the county. If the homeowner can’t pay up, a foreclosure date is set. County officials handle the auction and use the proceeds to pay off the mortgage and any other debts secured by the house. Leftover money goes to the foreclosed homeowner; leftover debt, in some cases, is the new owner’s responsibility.

The mortgage lenders typically bid up to the remaining principal amount plus any foreclosure fees. Their goal is to recoup what they are owed, either from investors bidding more or by buying the home and reselling it. Foreclosed homeowners sometimes join the bidding and win the auction, even though they don’t have the money, effectively delaying their eviction until another auction is held.

Investors can get in the game before or after auctions, too. They can try to buy directly from homeowners beforehand or from lenders who win the auction.

What’s Available?

Just about every type of home ends up at auctions: wood-frame houses in downtrodden neighborhoods, high-end homes in gated communities, condominiums, mobile homes, partially built residences and vacant land.

To find them, get free foreclosure listings from county court clerks or sheriff’s departments; some counties post them online.

Professionals specialize in niches, such as low-income housing or condominiums. Less-seasoned investors should stick with single-family homes in lower-middle- to middle-class neighborhoods, where resale likely will be easier.

Legal Issues

Hidden liens can be a big problem. If a homeowner had two mortgages and defaulted only on the second, the first is still binding. Auction officials aren’t obligated to tell you about debts outstanding, so unwary investors could be saddled with having to pay off that first mortgage, generally immediately.

A full-blown title search on a house can cost $400 or more. But for as little as $25, some title companies will do quickie “pencil searches” that detail existing liens — raw data that you weed through yourself.

In many cases, it is the property’s first mortgage in default, in which case subordinate liens are eliminated in foreclosure. But watch out for exceptions: Internal Revenue Service liens and some utility bills will need to be paid off.

Here is another pitfall: Some states give foreclosed homeowners time to reclaim their property by paying the auction price, often plus an additional percentage. In Colorado, they have 75 days (though the state is set to eliminate that grace period). So you could spend tens of thousands of dollars remodeling a house, only to have the original owner grab back the newly improved home.

Investment Stages

Many investors scour default notices in search of homeowners willing to sell cheap before auction. The competition is stiff, given the many services that report new filings to subscribers.

“There are a million investors looking to contact that homeowner with letters and phone calls and drive-bys,” says Todd Beitler, president of Real Estate Library, an online provider of foreclosure information (www.trel.com). What’s more, homeowners in preforeclosure know their home’s value, so don’t expect a big bargain.

Preforeclosure investing is medium-risk, medium-return. Executed successfully, an investor could make a 20% to 30% profit, longtime foreclosure investors say.

Buying at auction is riskier. You are typically buying “a mystery box” seen only from the outside, says Ken Kulpa, a real-estate agent specializing in foreclosures around San Jose, Calif. Sometimes, the house is a gem, but other times, there are big, costly problems — faulty plumbing, a 1950s-era kitchen or a leaky roof.

Then there is the belligerent homeowner who trashes the place on the way out or refuses to vacate, requiring a costly eviction process.

Another risk: In the excitement of bidding, many novices overpay. If you are careful, auction investors can expect to notch gains of 40% to 50% or more, professional investors say.

Most bankers won’t finance a foreclosure bid, in part because current owners aren’t likely to let them inspect the house to appraise it.

The lowest-risk option is buying foreclosed homes from banks that acquired them at auction. Most major banks list properties they own on their Web sites, and some will provide financing.

Banks often list homes in good condition near market value, so there isn’t much upside there. But banks also end up with mediocre properties and some real dogs. You can try to negotiate these houses’ prices down to less than the outstanding principal, rehab them and then resell quickly at market value or just below.

Profits on such properties can be in the 15%-to-20% range, experts say. Real Estate Library’s Mr. Beitler says this is a good place for novices to start. You won’t have title worries, because banks do that work, and you can inspect the house beforehand.

That “will help you gain confidence and experience buying and selling a property, negotiating and closing a deal, and doing the rehab work,” he says.

[Extract from an article by By Jeff D. Opdyke, Wall Street Journal]