REO Property Investment: How It Works for Commercial Foreclosures

An example of an REO property.

If you’re in the market for commercial property, but you know you’re crafty and well-connected enough to make do with a less-than-loved property, then it makes sense that you’re looking into commercial REO properties.

What Is an REO Property?

REO stands for real estate owned, meaning the property is currently in possession of the lender. You’ll also hear them called banked-owned properties and foreclosures. What this means is that the previous property owner has defaulted on the mortgage, and the bank has foreclosed on the property.

In an effort to liquidate the loss, the bank will typically list the property for sale. This process is frequently managed by a company or subsidiary of the lender whose sole purpose is to minimize losses of this nature.

Commercial Foreclosures vs Residential REOs

Overall, commercial foreclosures are pretty similar to residential foreclosures, but the terms of the original loan may be different.

For example, a commercial foreclosure could happen because the borrower defaulted on the mortgage, or for breaking a term of their commercial loan. If the borrower isn’t paying property taxes or meeting their debt service coverage ratio (DSCR), the lender may attempt to foreclose.

You’ll also want to research the laws regarding commercial foreclosures in your state. Depending on your state’s laws, the foreclosure could be nonjudicial or judicial.

Nonjudicial Commercial Foreclosure

Also known as a power of sale foreclosure, this process takes place out of court. Typically, commercial loans contain a power of sale clause that allows the lender to take possession of the property outside of court.

Find the power of sale clause in your deed of trust or mortgage note.

Judicial Commercial Foreclosures

In the event of a judicial foreclosure, the lender files a lawsuit against the borrower. The petition for foreclosure filed by the lender asks for permission to foreclose on the borrower and an order for sale of the REO property.

How Do Commercial REO Property Purchases Work?

The sale of a commercial REO property is much different than a typical retail sale. First, buyers have the opportunity to bid on them at auction. However, the foreclosing bank can make a credit bid. To recoup the amount lost on the defaulted mortgage, a credit bid allows banks to bid the total amount of the debt, plus any fees or costs associated with the foreclosure process.

As an investor, you must bid in cash or a cash equivalent depending on your state and the terms of the lender.

Often, the lender is the highest bidder at the foreclosure sale. Now that property is officially an REO property. Next, the loan servicer secures the property, replacing locks and making emergency repairs. If the property is still occupied, the bank or an REO management company will make attempts to remove the tenant, such as offering cash for keys. Finally, the bank that owns the REO or its REO management company markets and lists the property.

Be aware that in the case of an REO sale, the seller calls all the shots. Frequently, terms normally included in the normal Offer to Purchase will be deleted. In all cases, the terms dictated by the REO seller supersede the buyer’s offer. The seller will not normally negotiate after they accept an offer. To acceptance to minimize problems during escrow, both parties should be sure all terms are negotiated prior.

Pros and Cons of Buying Commercial Foreclosures

As a CRE investor, you’re already in the mindset of weighing the costs of benefits of every investment. Foreclosures require even more risk. Here are some pros and cons to help you decide if an REO investment is right for you.

REO Pros

  • You may find a deal – This is the biggest reason people invest in REO properties. REOs are often much cheaper than retail properties.
  • Clean title – Often, the bank will clear the title of REO properties.

REO Cons

  • Distressed property sold as-is – You really won’t know the extent of the damage until you get your inspector inside after you make your offer. When an owner knows they are going to default, they have no incentive to maintain the upkeep of the property, which can result in structural or other major damage.
  • Redemption periods – The previous owner may be entitled to a redemption period in which they are able to reclaim the property. Regulations around redemption periods are state by state.
  • Closing costs – Depending on the bank and your area, closing costs may not be covered by the seller. You may be responsible.

You’ll also want to consider other issues that may come with a commercial REO purchase. There are issues of commercial litigation, and the distinctions between commercial and residential nonjudicial foreclosures: unified foreclosures, and judicial foreclosures. And buyers must consider creditor’s rights issues, including obtaining relief from stay in various bankruptcy courts.

Then there are mechanics’ lien lawsuits; stop notice claims and abatement issues. And possible municipality disputes; transfer tax contingencies; property tax problems; short sales; loan purchase and sale agreements; predatory lending claims; discriminatory lending claims; Fair Debt Collection Practices Act claims; and many other issues.

That’s why it’s important to have a trustworthy commercial inspector, to perform your due diligence, and to have an experienced attorney and broker on hand.

How to Make an Offer on a Commercial REO Property

Before making your offer, you want to get the loan process started to show the bank that you’re serious. Start by getting a pre-approval letter from your lender and a proof of funds statement from your bank. These two items are typically required before you can even present an offer to the seller.

It’s up to the loan servicer or REO management company to develop their marketing strategy and obtain an appraisal to set their price. Bear in mind that these are often distressed properties sold as-is. You won’t be able to negotiate repairs like a regular retail property.

This is why due diligence is especially important for REO properties. When you submit your offer to the bank, be sure to include a contingency clause for the due diligence period. A contingency clause will allow you to safely back out of the deal with minimal expense should you or your inspector find major issues with the property.

Buyers must consider that the sales price combined with the anticipated expense of repairs and upgrades will be less than the stabilized value of the property. Some lenders may offer commercial bridge loans to help you pay off an existing property to fund repairs to your REO.

Where to Find Commercial REO Properties

If you’ve read the pros and cons and are ready to start investing, check out these resources for REO property listings.

  • LoopNet – As the premier commercial real estate listings site, it’s only natural that LoopNet offers a dedicated search engine for bank owned properties.
  • HUD’s Multifamily Property Disposition Mailing List – Get new REO multifamily listings sent straight to your inbox.
  • HomePath by Fannie Mae – Are you a single-family home investor or house flipper? Check out thousands of foreclosed listings at HomePath.
  • Your Preferred Bank – Do you have a preferred lender? Search their website for REO properties. Major lenders like BB&T and Chase usually list their REOs, or you can inquire with them.
  • Your Network – Of course, you don’t need us to tell you that. But you might need a reminder to ask your network about REOs, so here it is.

REO Properties Can Be a Beautiful Deal

As long as you’ve done your due diligence, an REO property could be a lucrative investment. Don’t let the “what-ifs” discourage you. Issues come up in any deal, so don’t throw in the towel before you run the numbers.

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