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Foreclosure investors shift to buy-and-hold strategy

April 6, 2009

At first glance, the smart way to profit from the real estate downturn seems obvious: Buy foreclosed homes, fix them up and resell them for a profit.

After all, there's no shortage of supply. In February, Marion County alone had 1,640 new foreclosure filings.

There's just one hitch. The strategy that fueled such TV programs as "Flip This House" is dead, said Bob Nice, a real estate attorney and president of the Central Indiana Real Estate Investors Association. Investors often can't finance such projects and potential purchasers can't buy them.

"It (flipping) worked five years ago, but not now," Nice said. "The model now is to buy and hold. It's a phenomenal time to acquire property, but not to sell, because there's no financing."

Pamela Smith, a real estate agent with Greenwood-based Realty World Harbert Co., experienced the market shift firsthand. Since 2003, she and her husband have purchased and flipped about a dozen foreclosed homes. But when the market went south, they were stuck with three would-be flips turned into unsellable flops. So they're renting them out and waiting for better times.

"These days, you have to be willing to hold them," Smith said. "I represent a lot of investors. I see some that are still doing it (acquiring homes), but they have cash and they're willing to hold them as rentals. That's where the market is right now. People are losing their homes and being foreclosed on. They need a place to live and they can't afford a house."

The small cadre of lawyers, real estate agents and investors who follow Indianapolis' depressingly large foreclosure market say this is the way to make money now. Instead of buying and selling, investors with ready cash are buying houses at substantial markdowns, turning them into rental properties and sitting tight until the market improves.

"I believe more millionaires will be made in the next five years in both real estate and stocks than you've seen in decades," said Matt Griffith, real estate attorney and partner with Thrasher Buschmann Griffith & Voelkel.

"If you can buy something for 20 cents on the dollar and the value really does come back, look at all the money you've made in appreciation. But you've got to have the cash because nobody's got the credit to do it."

The new reality is reflected at CIREIA's meetings, which are decidedly more subdued affairs than a few years ago, when the group's rolls soared to close to 1,000. These days, its 300 or so remaining members are more interested in maintaining their rental properties than hearing about get-rich-quick schemes. It's reflected in the subject matter of the group's seminars. Instead of talking about innovative financing, they talk about screening potential tenants.

"You don't give up your day job," Nice said of foreclosure investing. "What I tell people right now is that this is a wonderful thing to be doing to plant seeds. It's like planting a field full of pine cones. Ten years from now you'll have a forest of Christmas trees."

Foreclosure frenzy

The foreclosure field rarely has been more fertile. In the final quarter of 2008, 14 percent of the homes in the Indianapolis area were "real-estate owned," meaning they were bank or U.S. Department of Housing and Urban Development foreclosures, said Seth Payton, IUPUI urban policy analyst. That's up 8 percentage points from the far rosier, pre-meltdown days of 2004.

And nearly a third of all properties sold in the Indianapolis area during the last quarter of 2008 were REO properties—up 18 points from the last quarter of 2004.

"I know of properties that were appraised, and justifiably so, at $200,000 three years ago that can be bought now for $50,000," Nice said. "And they will generate $1,500 to $1,800 a month in revenue. That's a great return, if you have the cash."

It's also far easier than in years past to find tenants for newly purchased foreclosures. Nice and others say the rental business was devastated by the proliferation of subprime mortgages, as people with marginal credit moved into suburban starter homes. Now, those people are losing their homes and becoming renters again. And while they overextended themselves to buy homes, these renters often are excellent tenants who reliably make their monthly payments.

Money dries up

Five years ago, it seemed as if everyone got involved in real estate. Cheap money made a lot of things possible—everything from home ownership for those who clearly had no business owning homes to multiple mortgages for "investors" breathtakingly unqualified to dabble in large-scale speculation.

"People were buying apartment complexes when they knew nothing about apartment living," Griffith said. "You had individuals who had no experience in the building trades, and they were going out and acting like general contractors, buying lots and building houses themselves."

Things have changed—to say the least.

"A year ago we were putting a lot of transactions and deals and relationships together, and this year we seem to be taking them apart," said Griffith, who also serves as legal affairs counsel for CIREIA. "A lot of folks who were interested in buying or developing real estate, they still have that interest. The problem is that the market isn't there."

Companies that specialize in purchasing and selling REO properties are still doing land-office business. However, things aren't quite as hectic as in years past.

"A lot of the banks stopped doing subprime lending in 2006, so we're kind of getting through all of that product," said Mark Davis, broker/owner of IndyREO, one of about a dozen Indianapolis-area firms that handle foreclosed properties.

"The ones that are going to default have done so by now," he said. "And so that pipeline is definitely drying up."

What isn't drying up is the availability of foreclosed homes in newish, suburban starter neighborhoods—the kinds of places that real estate professionals once called "vinyl villages." These days they go by the even-more-uncharitable name of suburban ghettos.

Davis knows of some such neighborhoods where three- and four-bedroom homes can be had for $40,000 to $50,000.

Such properties are often surrounded by other foreclosures. "When you get one foreclosure in a new neighborhood, it's likely that you're going to see a lot more in that neighborhood because it's usually tied to some sort of predatory lending—a.k.a. adjustable-rate mortgages," Davis said.

"If they did that for one person in the neighborhood, it's likely that a chunk of them got into that situation."

Though the tide of foreclosures has slowed recently, a second wave is coming, said Scott Wynkoop, broker/owner of Wynkoop Brokerage Firm, which specializes in foreclosures.

In November, Fannie Mae and Freddie Mac, the giant government-controlled mortgage-financing firms, put a moratorium on foreclosures that ended April 1. Many banks followed suit. Barring further extensions, Wynkoop said, lenders soon will begin processing a deluge of foreclosures.

Not that he isn't keeping busy right now.

"We had nearly 1,000 transactions last year, all foreclosures," Wynkoop said. "Our inventory's down right now but we're still selling. And it will be replenished soon. Our inventory (of homes) is probably in the 250 range. If they hadn't placed a moratorium, we'd probably be closer to the 400 range."

These days, the people doing the buying have changed. Formerly about 80 percent of Wynkoop's properties went to investors. Now about 65 percent go to owner/ occupants.

"We used to have buyers that would buy 40 or 50 houses a year from us," he said. "That doesn't happen any longer."

It's no longer a market for amateurs—as one Indianapolis attorney (who asked to remain anonymous) learned when he purchased two west-side foreclosures to flip.

Unfortunately, he did this just after the downturn began a couple of years ago, stranding him with two homes he purchased for 50 percent of market value.

He's become a landlord out of necessity, renting out the properties until he can find someone with a credit score high enough to take them off his hands.

"I purchased with the intent of rehabbing and reselling," he said. "Unfortunately, the current market is good for buying but bad for selling."

He agrees that it's a great time to buy properties cheaply so long as you have the money and nerve to hold them long term.

"The fact is there were great deals available," he said. "And there still are. It's just a matter of what your risk tolerance is for holding while you wait for the market to come back. And mine is not really all that great."

New investors

Even in these straitened times, there seems to be a never-ending supply of newbies eager to dabble in real estate.

Wynkoop said he regularly gets e-mails from out-of-staters requesting information about Indianapolis-area investment properties. The notes are all suspiciously similar, as if they were forms downloaded from the same CD obtained from an investment seminar. He also was recently invited to speak at a Beijing seminar about how to buy inner-city houses in the United States.

"There's a lot of people from out of state and even out of country that are looking into investing in these properties," he said.

If they're interested, they better bring cash.

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