How to Evaluate a Pre-Foreclosure Deal

Screening relied on recorded loan amounts. Evaluation starts with the actual figures. With the owner's signed authorization, you or a title company can request a written payoff statement from each lender. A payoff statement typically shows the principal balance, accrued interest, late charges, foreclosure fees and costs, and a per-day interest amount, and it is valid only through a stated date.

Keep two numbers apart. The reinstatement amount is what the owner would pay to bring the loan current and keep the home. The payoff amount is what it takes to retire the loan entirely, and that is what a sale must cover.

Expect the payoff to rise while you negotiate, because interest and foreclosure costs keep accruing. Build that growth into your numbers rather than relying on today's figure.

If there is more than one loan, request a payoff from each servicer and compare the figures with the owner's recent statements. A balance that looks wrong, or a loan the owner did not mention, is worth resolving now rather than at the closing table.

The foreclosing loan is rarely the only lien on a property. Order a preliminary title report or a full title search before you agree on a price, and look for:

• Second mortgages and home equity lines of credit.
• Delinquent property taxes and tax liens, which generally take priority over mortgages.
• HOA or condo association liens, which can carry their own fees and, in some states, priority.
• Judgment liens, federal tax liens, mechanic's liens and child support liens.
• Municipal liens for code violations, utilities or demolition, which do not appear in every search.

Each lien must be paid in full at closing, or the lienholder must agree in writing to accept less. In a short sale, junior lienholders often ask for a payment in exchange for a release. Some releases, such as for federal tax liens, follow their own process and can take time, so start early.

Owners under financial strain often put off maintenance, so assume repairs until an inspection shows otherwise. Ask the owner for permission to tour the home, then make your offer contingent on a professional home inspection.

Turn the findings into costs:

• Get written contractor bids for major items such as the roof, foundation, HVAC, plumbing, electrical system and sewer line.
• Order specialist inspections where the general inspection flags a concern, such as a structural engineer or a sewer scope.
• Check with the local building department for unpermitted work and open code violations.
• Add a reserve for problems you cannot see. Many investors add a percentage of the repair budget, and a larger one for older homes.

Repair costs matter even if you plan to live in the home. Some loan programs require certain repairs before closing, and whatever is left becomes your budget after you move in.

You need two values. The as-is value is what the home would sell for today in its current condition. The after-repair value (ARV) is what it would likely sell for once your planned repairs are done.

Estimate both from comparable sales: recent closed sales of similar homes nearby. For ARV, use comparables that were updated to the standard you plan. Adjust for differences in size, bedrooms, lot, parking and location, and be conservative when there are few recent sales.

Common errors include using list prices instead of sale prices, picking the best sales in the neighborhood and assuming a renovation will add more value than the area supports. A local agent's opinion can test your estimate, and if you finance the purchase, your lender's appraisal has the final word on value for the loan.

If you plan to rent the home rather than resell it, also estimate market rent from similar rentals nearby. For a long-term hold, rent and operating costs matter as much as resale value.

The 70% rule is a quick screening formula used by many investors who buy to renovate and resell. It sets a maximum purchase price of 70% of ARV minus repair costs. For example, with an ARV of $250,000 and repairs of $40,000, the formula gives $175,000 minus $40,000, or $135,000.

The remaining 30% is meant to cover costs and profit, but it is a rule of thumb, not a guarantee. In higher-priced markets, with long holding periods or with expensive financing, it may leave too little margin. Many investors adjust the percentage to their own costs, and a buyer who will live in the home or hold it as a rental will use different math.

Either way, check the result against a full cost list:

• Purchase closing costs, including title insurance and recording fees.
• Financing costs, such as points, interest and the fees on a hard money loan.
• Holding costs during repairs: taxes, insurance, utilities and HOA dues.
• Selling costs if you will resell, including commissions and seller closing costs.
• A margin for profit and risk.

Now compare your maximum price with the total payoffs. If your price covers the foreclosing loan, every other lien, past-due taxes and the owner's own selling costs, with something left for the owner, the deal can close as an equity sale. If it does not, it can only work as a short sale, and the lender's own valuation, not your formula, decides whether your price is acceptable. How to buy a pre-foreclosure compares the two paths.

In an equity sale, a fair price leaves the owner with their remaining equity at closing. Several states have equity purchaser or home equity sales laws that give owners in foreclosure specific protections, and deals priced far below value draw scrutiny from regulators and courts. Show the owner how you reached your number, as described in approaching distressed homeowners ethically, and have a real estate attorney review the contract.

A simple illustration helps both of you. For example, if your price is $200,000, the payoffs total $170,000 and the owner's selling costs are $12,000, about $18,000 would remain for the owner before any other liens are paid. Put that estimate in writing alongside your offer.

Before you negotiate, write down the highest price you will pay and the assumptions behind it: ARV, repair budget, costs and margin. That is your walk-away number. Decide in advance which changes would move it, such as a higher payoff, a newly found lien or a worse inspection report, and which would not.

Revisit the number whenever the facts change. Payoffs grow, repair bids come in and short sale lenders counter. If the deal no longer works at your walk-away price, step back and tell the owner promptly so they can pursue other options. A deal that only works if everything goes right is usually one to pass on.

Share the relevant figures with anyone advising you, such as your lender, partner or attorney, and keep a copy with your offer. If the owner asks how you reached your price, the same written assumptions let you explain it clearly and consistently.