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   ARTICLE   |   From Scotsman Guide Residential Edition   |   February 2011

Fill the Distressed-Property Niche

As more buyers tap depressed home prices, a growing market segment awaits brokers

Fill the Distressed-Property Niche

Although economic uncertainty is approaching its fourth consecutive spring, opportunities exist that can help mortgage brokers and their clients get past the doom-and-gloom mentality they may have about the housing market and the economy.

In fact, mortgage brokers who create a niche of working with residential-property investors may uncover a bright future for themselves, as well as for their clients, particularly when focusing on distressed and real estate-owned (REO) properties.

Brokers entering the distressed-property-investment market should know — and advise clients about — the market's realities. 

•  •  •

One in five U.S. consumers believes the housing market won't recover until at least 2015, according to a recent survey by RealtyTrac Inc. and Trulia Inc. This mentality and today's market realities present a prime opportunity for property-investors — big and small, experienced and rookie — to tap depressed real estate prices by buying into the foreclosure and REO-property markets.

"Today's property-investors have an opportunity to take maximum advantage of changing market dynamics. In many ways, conditions couldn't be better for purchasing investment properties, especially when it comes to two key elements: prices and interest rates."

Acquiring distressed properties for eventual resale can be a sound and profitable investment strategy. In fact, many investors consider REO properties to be nothing short of a sure bet.

Today's property-investors have an opportunity to take maximum advantage of changing market dynamics. In many ways, conditions couldn't be better for purchasing investment properties, especially when it comes to two key elements: prices and interest rates.

According to RealtyTrac, foreclosure sales accounted for 25 percent of all U.S. residential sales this past third quarter. Moreover, the average sales price for properties that sold while in some stage of foreclosure was almost one-third less than the average price for nonforeclosure properties. That discount increased to almost 41 percent for REO properties.

Interest rates, meanwhile, might not be as low as they once were, but the 30-year-fixed rate was hovering around 5 percent as of press time. The 15-year-fixed rate was about 4.4 percent, and 5/1 adjustable-rate mortgages had rates close to 3.75 percent.

National employment struggles also benefit distressed-property investors. With U.S. unemployment at 9.4 percent this past December — its 20th consecutive month greater than 9 percent — hundreds of thousands of Americans who once owned a home or who can't get financing in today's strict-underwriting environment continue to sign monthly rent checks.

Investors who can tap this strong rental market after purchasing property at steep discounts position themselves for short- and long-term success.

Example scenario

Mortgage brokers and their clients must consider many factors when deciding to enter the property-investment game. These include financing requirements and REO-property attributes.

The choices you and your clients make today can build a foundation for sustained returns and a profitable portfolio. Brokers who distinguish themselves by specializing in this budding market could find their services in high demand this year and for years to come.

To better understand the factors a property-investor must consider, let's look at the economics of purchasing an REO property using an example with some of the figures already discussed:

  • 30-year, fixed-rate mortgage: 5-percent interest
  • REO-property discount: 41 percent

Let's also credit the investor in this scenario with enough money to make a 25-percent downpayment — the minimum required for many investment loans.

Using these figures without some additional knowledge, however, won't tell the entire story. Brokers also must understand that rental income from an investment property is offset by depreciation expenses over 25 years, as well as deductions for interest, property management, taxes, insurance and maintenance.

In addition, improvements can be added to the basis to offset a taxable gain upon the sale of the property. (Note: When a taxable gain on a property is calculated at the time of sale, the original purchase price plus any improvements that added value to the property — together referred to as the basis — are subtracted from the selling price.)

Using this information, let's pencil out a possible investment scenario for an REO property with a market value of $280,000. Because the property is an REO, we'll presume it sells for $165,200 — a 41-percent discount. With a 25-percent downpayment ($41,300), the investor must finance $123,900. Using a 30-year, fixed-rate mortgage with a 5-percent interest rate, the monthly payment would be $665.

In many U.S. markets, this type of house may rent for $1,500 or more per month. That would more than cover the mortgage and additional payments, which would include the following monthly estimates:

  • Property taxes: $200
  • Property management: $150
  • Insurance: $150
  • Maintenance: $100

Including these costs and a $665 mortgage payment, the monthly expenses for this investment would total about $1,265, yielding monthly cash flow of $235.

When you consider the initial 41-percent discount on the purchase price, even modest appreciation in the first two to three years of ownership could lead to more-substantial returns upon future sale.

Key points

There are some additional items to consider when working with property-investors. Running through this list before a purchase can help your clients choose their properties wisely.

Length of property-ownership: How long do your clients intend to keep the investment property? The differences between three-, five-, 10- and 30-year strategies can be dramatic. For most REO-investment purchases, clients hope to resell — or at least refinance — within five to seven years. For those hoping to refinance, an ARM could be a smart choice. By tapping lower interest rates and putting less money down, clients can yield higher upfront returns and save more cash for other possible investments.

Percentage of income needed to qualify: Per Fannie Mae guidelines, mortgage brokers can only consider 75 percent of a property's rental income as part of qualifying a borrower for an investment-property mortgage. This is a good thing, especially considering the expenses that go hand-in-hand with owning investment property and the potential for extended and unplanned vacancy.

Purpose of investment: For people invested primarily in stocks and bonds, a real estate purchase can make sense and can be a way to diversify a retirement portfolio. Savvy investors can even purchase property using a retirement account such as a 401(k). As part of a federally approved retirement account, rental-property income may be tax-deferred.

Choosing a property

Mortgage brokers who work with property-investors must gain insights about the aforementioned items to help clients secure the proper financing, a pivotal decision in leveraged investing. Choosing a property can be equally challenging.

Investors will typically use a real estate agent in their property search, but knowing some general tips can help you advise clients, as well. When offering insights — without crossing the line of dispensing financial advice — consider the following:

  • Neighborhood selection: Investors should choose an area with a relatively stable economic environment or one predicted to become stable soon. They should research local unemployment rates and current and future job opportunities. Areas poised to rebound — or already in recovery — likely will offer better appreciation and higher returns on investment.
  • Property diversification: Investors should avoid putting all their money into one property type. When possible, their property portfolios should include a mix of higher-end, midrange and lower-end properties. Longer-term security comes through investment diversity.
  • Geographical spread: If possible, property-buyers should make investments with national considerations. Many areas in the U.S. provide stable REO investments. By casting a wide net, investors create greater potential for higher returns overall.

•  •  •

As property-investors look to tap today's distressed-property and REO markets, mortgage brokers can position themselves to help.

By studying the variables involved in investment purchases, brokers can help investor clients find the right financing and make smart purchases that yield short- and long-term success. Striking the right balance between market conditions, financing options and inventory selection requires delicacy and dedication.

If managed correctly, however, the rewards can be phenomenal — for property-investors and for those who help them secure the leveraged purchasing power they seek.


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