The Difference Between Foreclosures and REO’s

Foreclosure, REO, short sale—these terms can be confusing if you are a first-time real estate investor. But knowing the difference is important if you are going to sink your hard-earned money into investing. Let’s look at the differences.

In a foreclosure, the property owner has defaulted on the loan secured by the property, and the bank is exercising legal measures to take it back. Foreclosure properties are offered at auction, where the lending institution hopes to recover all or most of their losses. Depending on the condition of the property and the financial position of the bank, such properties may be priced significantly lower than their market value.

REO stands for "Real Estate Owned," although it's more common to hear such properties referred to as bank-owned. An REO property has been foreclosed by the lending institution, and has reverted to their ownership. This is not how the bank wants foreclosures to end. In most cases, the market value of the home simply does not cover the loan balance, repair costs, and other fees associated with foreclosure and sale. There's little or no equity in the property. Banks are slow to accept losses, so they keep such properties on the market at higher prices, in hopes of a sale.

Should you, as an investor, buy either of these types of properties? Yes! But you must consider several factors:

• Foreclosures often have very tempting price tags, but there's a good reason for it. Most importantly, the title is not clear. In other words, ownership of the property is not clearly established. The previous owner may have some rights. Other lenders may even have a stake. And then there's the issue of back taxes. These properties can have prior obligations to state, county and city governments totaling thousands of dollars. The next buyer could be walking into those obligations. Only thorough research will answer these questions.
• REO properties, on the other hand, have properly changed hands. All liens against the property have been addressed. Back taxes have been paid. And the title is clear. In many cases, the bank has even done any necessary repairs already. But as a result, they may expect full retail value. It depends upon the amount of money the bank has tied up in the property, but it's safe to say that the property wouldn't be an REO if it had substantial equity.

So, when do you buy these properties? Buy a foreclosure when your research indicates that its market value exceeds the loan balance plus repair costs plus any outstanding obligations. Timing can play a role here, if you're aware of a particularly likely buyer. But mostly, this just boils down to digging in and doing some extensive research. Having a good network pays off here, because you can get information much more quickly.

Buy an REO when the bank finally relents and lowers the price. And don't just wait for this to happen. Make your own luck. Find the right buyer, know when the lender is going to lose patience, and show up with the right offer at the right time. The margin can be low in REO's, but the risks are also low. And they take less of your time, if you just keep your ear to the ground for the right combination of events to converge. Again, a good network is a big plus.

The hidden gem in this arena, however, may be the pre-foreclosure. Working with a desperate homeowner and a bank that would love to avoid foreclosure costs can be a very good situation for the investor who walks in with cash at the right time. The dangers of foreclosure properties still apply, but the margins are often enough to justify significant risk.

Keep an eye out for these situations, especially now, but know what you're getting into with each property. Work your network for essential market information and buyer leads, and keep your wits about you at all times. There's a lot of money to be made in distressed properties, but getting a share of it requires hard work, market savvy, and sometimes a bit of luck.