Clients hoping to take advantage of a buyer's market in real estate essentially have three options. First, they can enter into a conventional sale with the property owner. Part or all of the purchase price will pay off any outstanding loans.

Second, buyers can negotiate short sales: deals in which even the full purchase price is insufficient to cover the outstanding debt on the property. These transactions must be approved by the lender or lenders. "Short sales are tricky," says Bob Fornatto, a senior mortgage consultant at Wintrust Mortgage in Downers Grove, Ill. "Obstacles can pop up at the last minute."

Finally, clients interested in buying a home or investment real estate can look at REO properties. These properties have been foreclosed upon by a lender and have not been acquired in a foreclosure auction. Thus, they're real estate owned (REO) by the lender.

Often lenders with REO properties-usually banks-are eager to unload them, so prices may be appealing. "There are terrific opportunities in REO properties now," says John Anderson, co-owner of Twin Oaks Realty in Minneapolis, who serves as 2010 Federal Housing Policy Chair for the National Association of Realtors. "Typically you'll get a better price on an REO property than on a straight purchase. Buyers need to know the numbers, though, because REO deals are not that simple."

NUMBERS GAME

Knowing the numbers about the REO market isn't that simple, either, as various firms collect data from around the U.S. Many markets were flooded with REO properties during the height of the financial panic in late 2008 and early 2009, as banks tried to raise cash and avoid failing. By mid-2009, 33% of all properties sold in the U.S. were REO sales, according to Clear Capital, in Truckee, Calif.

Now that things have stabilized a bit, Clear Capital puts this REO saturation rate at 26% in its latest report, released earlier this year. That's the national average, though, and market-to-market variations can be extreme. According to Clear Capital, 50% of recent sales in the Riverside, Calif. metro area were REOs, over 45% in Detroit and over 40% in Orlando, with Dallas not far behind. Typically REO saturation rates are highest in Western and Midwestern U.S. markets.

Another firm, First American CoreLogic in Santa Ana, Calif., puts the national REO rate at 0.54% in January; this rate is calculated by dividing the number of REOs by the number of housing units. A year earlier, in January 2009, that rate was 0.77%, so the data points to a drop of REO properties in the past year.

"There's a lack of inventory on the market," says Michael Krein, president of Sellstate NRES (Nevada Real Estate Services) in Henderson, Nev., who heads the National REO Brokers Association. "When a desirable property comes on the market, it may attract multiple bids."

Not everyone reports the same experience. "I imagine the REO market varies from community to community," Fornatto says. "In my market it seems there is a lot of inventory."

In the second half of 2009, First American CoreLogic estimated there was a 1.7-million-unit "shadow inventory" of residential housing, up from 1.1 million units a year earlier. The shadow inventory is not yet on the market but includes estimated REO properties held by banks and mortgage companies.

First American concluded that the large amount of shadow inventory "will impact the housing market for the next few years." Therefore, financial planners who wish to help clients buy real estate may do well to understand the process of acquiring REO properties.

COMING UP SHORT

In particular, planners may need to explain to clients the difference between buying REOs and buying in a short sale. As mentioned, a short sale takes place when the deal won't cover the mortgage debt. If John Smith bought a house for $300,000 in 2006, with a $285,000 mortgage, and he can sell the house now for $250,000, this transaction would result in a loss of more than $35,000 for the lender. In order for such a short sale to go through, the lender must agree.

"Short sales take longer to get approval and they don't always go through," says Fornatto, who was recently involved in a short sale where the lender said yes. "But before it closed, we found out about a second mortgage on the house, and the holder of that mortgage wouldn't agree," he explains. Second mortgage holders may be reluctant to approve short sales if they stand to collect nothing. As Fornatto relates, the buyer may have missed an opportunity to get an $8,000 tax credit when the purchase was thwarted.

REWARDS OF REO

Such disappointments are unlikely to take place with REOs. Here, the bank owns the property and can sell it without having to wait for anyone's permission. In some cases, a bank will drop the asking price on a property if it isn't attracting bids. The prices on REO properties have to be low enough to attract bids from buyers who are also considering conventional and short sales. "It varies," Anderson says, "but REO prices may be lower than the property's previous purchase price by 30% or more."

Fornatto tells of a recent REO transaction in which a buyer bought a "two-flat" in suburban Chicago. The buyer will live in one unit while renting out the other to bring in income. The previous owners paid over $400,000 for the property, but the new owner got it for around $265,000, Fornatto says.

Besides low prices, there may be other advantages to buying REO properties. These transactions often close fairly quickly, according to Mark Rodriquez, an attorney in Glen Ellyn, Ill., who has worked on REO transactions.

"Banks often want to sell their real estate as soon as possible," he says. "Buyers should have their loans in place or be ready to make a cash purchase. If you make a bid and then take four to six weeks to get a loan, the bank may have moved on to another buyer by then."

REO buyers are often able to obtain a property that's not encumbered by the prior owner's obligations. Banks don't want to have to deal with troublesome issues after they sell a property, so they may offer REO real estate free of title liens, judgments and other claims such as delinquent taxes and outstanding homeowners association or condo liens. In order to ease the sales process, a lender might make sure that its REO properties have running water, working electricity (including air-conditioning), and a roof that's not obviously leaking.

BUYER BEWARE

With all the advantages of buyingREO property, what's the catch? "The reason you're getting a good price on REO property is the possible condition of the house," says Anderson. "In a straight sale, the home probably has been kept up, but that's not always the case with REO properties."

An REO property may offer more challenges than buyers anticipate. They can't simply buy a three-bedroom house, spend a couple of thousands to fix it up, and sell it for $150,000, Anderson says.

In many cases, an REO home has not been occupied for a while, since the former owner had to leave. Even if the lights and showers are working, there may be other major problems that will need to be addressed. Therefore, an REO contract should have a contingency for a property inspection and buyers should bring in their own inspector, Fornatto says. It's important to remember that an appraisal is not the same as an inspection.

"REO properties are offered 'as is," Rodriquez says. "Typically there are no warranties of any sort. In most real estate transactions, the seller will make all sorts of disclosures."

After major issues are found in an inspection, a buyer can ask the bank to drop the price or make repairs. "Sometimes the bank will agree," Rodriquez says, "and sometimes it won't. Most buyers feel the deals are worth it, anyway." Moreover, informing the bank of property defects may be a good negotiating tactic because the bank can no longer say that it's ignorant of those flaws if it places the property back on the market.

If the bank agrees to make adjustments as a result of the property inspection, a buyer probably will be better off taking a price reduction, rather than letting the seller carry out renovations. Then the buyer can control what renovations will be done, who will do them and how much they'll cost. A bank might be tempted to have the work done cheaply, without focusing on quality. Rodriguez also notes that banks typically don't pay for closing costs and won't pay for a survey.

Rodriguez recommends a survey, even though it can cost a few hundred dollars. With a survey, buyers may be able to put up a home addition and know how far to go without spilling onto a neighbor's land.

As with any type of real estate these days, financing the purchase of REO property is more difficult now than it was a few years ago. Buyers need to be creditworthy and may be required to make a 20% to 25% down payment. If a mortgage is needed and the property qualifies, the buyer usually will have to get a loan from a bank other than the one holding the property.

OTHER OPPORTUNITIES

In the aftermath of the housing bust, foreclosures and the subsequent sale of REO properties are likely to remain staples of the real estate market. Nevertheless, there are additional possibilities that planners can discuss with clients seeking a principal residence, a second home or investment property.

For example, the Home Affordable Foreclosure Alternatives (HAFA) program was introduced in April. Positioning short sales as a more desirable "alternative" to foreclosures, this federal initiative provides cash incentives to gain approvals from first and second lien holders. Under HAFA, mortgage lenders must inform homeowners of the lowest price they will accept, and then respond to a homeowner's offer within 10 days.

Krein suggests yet another approach to buyers looking for investment property: Buy property involved in construction defect litigation. Such actions may be brought against developers by homeowners' associations. Financing might not be available while the litigation is ongoing, but the properties can be bought all cash, often at steep discounts, Krein says.

With no mortgage to service, such properties may yield positive cash flow if they're rented to tenants. "When the litigation is resolved, which might take a couple of years, the properties will go back to fair market value," Krein says. "Then the buyer probably will be in a position to sell at a profit or to finance the property."

Assuming this scenario plays out, an investor might be able to pull out more cash than he puts in, as tax-free loan proceeds. No matter how real estate is acquired, today's savvy buyer may be smiling tomorrow.