This question, “Which is better, an REO or a foreclosure auction?” It is very common and investors seem to confuse the problems of these two ways of buying properties in bulk. The REOs are already owned by the banks and have been through the foreclosure auction. The other properties that must go through the foreclosure auction will need to be purchased in an open auction environment.
Foreclosure auction properties are generally not available for viewing by a prospective buyer prior to the auction. An investigation must be conducted to determine any and all liens (mortgages, code violations, code liens, judgments, or other liens) that are against the property. Secondary mortgages and personal judgments will be extinguished in the foreclosure sale, but city or county liens and IRS liens will not be extinguished in the sale. Due to the open bidding nature of the foreclosure auction, first-time investors often overbid the properties they want.
The REO properties are already owned by the bank and the minor liens have been extinguished. Additionally, properties can be viewed whenever the buyer wishes, so a full assessment of interior and exterior repairs can be made. This unique ability to inspect the property before purchasing makes it worth buying REOs over foreclosures at auction.
However, if an investor understands the risks associated with the auction and controls their bid, there is the possibility of deals at the auction. Even better, once the property has been checked for title liens and if there is a second lien on the property, there is another possibility. This opportunity would be where a second mortgage note exists and the note holder realizes that his note will be fully extinguished on sale.
Secondary and subsequent liens will have no value after the auction. Many times, the first lien holder forecloses and there is equity in the property if there are no second lien holders. If you approach the second holder of the note to purchase the note at a significant discount of 5% of the face value of the note, you can use this note as credit to bid in the auction.
The way this works is that the second note holder will transfer the note to you and either release the link or cancel the note as is the normal way a note is paid for. You will now own this note for its full face value, not just what you paid. So an original face amount of $50,000 plus any unpaid payments could likely be purchased for $2,500 or less, in some cases just $500. If the second note holder doesn’t sell the note before the auction, they get nothing after sale.
Armed with the $50,000 bill, you can go to the auction and bid on the property. The first offer must be for the minimum allowed by the county, usually $100. This offer means the amount of the final judgment the court awarded to the first mortgage holder plus $100. If there are any bidders beyond this point, the proceeds will go to the second note holder (you) for a total amount of $50,000. If there are aggressive bidders for the property, you should bid to keep the price moving.
For example, if the final purchase price at the auction is $150,000 and the first mortgage was $100,000, the net result is that you will receive approximately $50,000 for the note you paid $2,500 for. This is not only a great return on your investment, it is likely to be a bigger profit than selling the property wholesale. Your competitors for these notes are the professional investors who buy properties at auction daily.
In short, buying an REO is simpler than buying a property at a foreclosure auction and should fetch a better price for the investor-buyer. You will also have less or no linking problems like with auction properties. Every property is different, and if the investor can buy a second note at a discount, research the lien and title, and control his bid at auction, he may be able to get a better offer than an REO. The key is to do his homework on the property and determine its reasonable ARV (After Repair Value) so he can formulate an exit strategy before buying it.