Always Remember: BUYERS BEWARE!


32 comments

If you buy REOs — or if you’re even considering buying REOs in the future — you’re probably going to want to keep reading. In fact, as one of my readers has already pointed out, if you’re a real estate investor of ANY kind, this is something you’re going to want to keep in mind.

This is a story about an REO property (basically, a bank owned foreclosure) that we got under contract this week, and then realized that things weren’t exactly what they seemed. The story may be a bit long, but it may save you a lot of money down the road…

As a little back-story, my wife occasionally looks through the expired listings on the MLS to see if there may be something good that slipped through the cracks and that might be worth trying to negotiate. She found a property that looked like a good deal, and was surprised it didn’t sell at the listed price prior to expiring, so she called the listing agent to get more info.

The listing agent was confused, and said, “Oh, it’s not expired…it’s still active and ready to be sold…though we haven’t gotten much activity on it recently.” Clearly, she didn’t realize the MLS listing was incorrect, which also explained why there was no activity — no other agents or buyers even realized the house was for sale.

We went to look at it, and it was even nicer than in the pictures. Clearly, since the MLS pictures were taken, the seller (the bank) had come in and painted both the interior and exterior, replaced the carpet, and obviously made some additional repairs. It went from being a decent deal to what seemed like a great deal. Thinking we found a hidden gem lost in the MLS, we quickly put in an offer, and requested 3 days of an inspection period to do a bit more investigation should our offer get accepted.

With 24 hours, we received a counter-offer just a little higher than our offer price. The agent told us that the property was scheduled for auction, so she needed a response ASAP. We quickly accepted the counter-offer, and were excited that we got gotten this practically-move-in-ready house for such a great price, and without any competition!

But, as I usually do when I get a house under contract, I immediately sent my project manager over to see if there were any issues I might have missed on the initial inspection. He was working on a house around the corner, so he went right over…

He called me when he got there, and he pointed out a little mound of dirt in the corner of the kitchen. I had seen it, and knew that it likely meant termites, but I didn’t notice any additional or obvious damage in the area, so I assumed there was a minor termite problem — something we deal with all the time. But, luckily, my project manager investigated further. When he pushed on the baseboard at the bottom of the wall near the dirt mound, his finger went right through the baseboard!

He kept looking. Apparently, the entire baseboard was destroyed by termites and was only being held together by the fresh coat of paint that had recently been applied. He checked the window sills — completely eaten by termites. He checked the steps in the center of the house — many of the steps were destroyed by termite damage. He went upstairs and found that a bunch of the wood trim on the second level had been destroyed by termites, but again, was not obvious due to the fresh paint keeping the wood from crumbling.

Once he knew what he was looking for, it only took a few minutes to realize that — best case — there was likely $10,000 or more in damage, as many of the walls would need to be ripped out, framing components would likely need to be replaced, etc. Worst case, the house could have such extensive termite damage to the structure that it could be cheaper to just knock it down. And the house was less than 15 years old!!!

Without ripping out much of the drywall in the house, there was just no way to know how much work was needed or how difficult the damage would be to repair. Needless to say, we declined to purchase the property…

Anyway, the moral of the story is that someone — likely the bank who was selling it — went into the property and did their best to cover up the damage with some fresh paint, some new trim pieces, etc. And they actually did a pretty good job — enough that I have a feeling some unsuspecting buyer will get this property at an upcoming auction and not know until too late what he is facing.

Here are some things that should have tipped us off to investigate further:

* The property had been pulled off the MLS. While this may have been a mistake, it was probably done while the bank was making “repairs”.

* The bank chose to paint and carpet the house. While this happens occasionally, the bulk of the REOs in my area are sold as-is without any work done to them. The fact that the bank decided to do any work should have alerted me to be extra cautious.

* The listing said, “Cash or conventional loans only.” This is generally done when the property has some defect that wouldn’t allow the buyer to get FHA financing. In this case, I assumed it was a mistake, as the property looked to be in great condition. After buying a couple dozen houses, I should have realized that the more likely explanation was that something was being covered up.

Anyway, I’m sure there are a lot of ethical bank sellers out there who wouldn’t go out of their way to defraud a buyer, but as this clearly indicates, there are at least some that will do just the opposite — they will attempt to hide major defects and leave it to the buyer to uncover, either before they purchase the property, or worst-case, after the deal is done.

Since REO properties (and sometimes private deals) don’t come with any warranties or even any disclosures of damage, when it comes to buying these properties, it’s truly BUYER BEWARE!






32 responses to “Always Remember: BUYERS BEWARE!”

  1. Mark in Fl says:

    We have a standard sales contract in our area that all the agents use. It was approved by the bar and local realtor assocation.

    The bank uses the standard contract but then requires an addendum that is so one sided the language supersedes just about eveything good in the local contract and allows them to not disclose known defects.

    Like you say, “buyer beware!”.

  2. Thorney Gibson says:

    Great read. Its a good idea to always have a second pair of eyes of a investment property. Glad you caught that!

  3. Luis says:

    “I’m sure there are a lot of ethical bank sellers out there who wouldn’t go out of their way to defraud a buyer…”

    Prove it! 😉

    Remember many of these are the same banks that were selling CDO’s and mortgage backed securities to pension funds with AAA ratings and then shorting the same investments because they knew they were selling crap!

  4. Mike says:

    Hey J,

    Do you get your properties inspected by an property inspector during your D.D?

  5. Tony says:

    Thanks for the post.. Very informational J!

  6. Ginny says:

    Good heads up!! Thanks!!
    Around here the banks regularly paint and carpet to attract
    homeowners and get higher prices, but it is still a good
    reminder to look under the surface.

  7. J Scott says:

    Hey Luis –

    Here’s your proof: Last week, we submitted an offer on a property in Smyrna. We noticed some potential water issues and some potential structural issues, but didn’t feel like crawling through the crawlspace to check them out (it was a tight crawl space), and there was a good chance we’d purchase it anyway depending on the scope of the issues. We asked for a few days due diligence and our plan was to get our structural engineer and our mold guy out to take a look during that time.

    Long story short, the bank came back and said, “We’ll accept this offer, but we want you to see the Inspection Report from the last buyer who had it under contract, so you have an idea of what’s wrong with the property before you commit.” Sure enough, there was a major water leak that had been poorly repaired, mold in the back of the crawl space and some structural issues that were too expensive to try to fix.

    Ultimately, the bank could have let us find these things on our own (or worse yet, hope that we didn’t find them, though we would have), but they supplied the inspection report nonetheless and saved us the time and the money. We ended up passing on the property, as the numbers didn’t work…

  8. J Scott says:

    Hey Mike –

    We used to get our properties inspected (the first three or four of them), and then we stopped, for a couple reasons:

    1. We realized that most of the inspection process was just examining very basic stuff that we could examine ourselves (do the appliances work, does the HVAC system work, does the plumbing work, are there any leaks, a visual inspection of the roof, etc);

    2. We often full rehabs anyway, so it really doesn’t matter to us if the doors, windows, toilets, faucets, appliances, etc work, as we’re going to replace them.

    Now, we still run into houses where we might be concerned about mold and/or structural issues (things we don’t have the expertise to diagnose ourselves), and when that happens, we have a mold guy and a structural engineer we can call in to give us an expert opinion. But, we don’t use general inspectors anymore, as it’s just not worth the money to us, and so far (knock on wood), there’s been nothing major that we’ve missed ourselves.

  9. Tom says:

    Very good post. You would think some banks would their act togetherw

  10. Eduardo says:

    Great insightful post.

  11. Luis says:

    Ok, ok…so you found the one honest bank out there… 🙂

    Just kidding. I always assume the worst so I end up looking for something being hidden or something being wrong when there really is not. I guess the other extreme can also be bad.

    Like you I stopped doing inspection because I noticed the exact same thing. After a couple of houses you start figuring out what is wrong and what is not. What I do instead of an inspection is a walk through with a general contractor to start putting together a list of repairs and costs. Like you say, you will be replacing it anyway so what does it matter if it’s not working or not. But figuring out what the repair/replacement is going to cost is where I still sometimes need help…

  12. Billy says:

    Hi J
    wont the bank or there real estate agent now have to disclose termite damage now that you have discovered them?

  13. J Scott says:

    Hey Billy –

    Legally, they are supposed to disclose any material information that relates to damage or other issues with the property. But, in practice, banks selling REOs tend to act as if they are above-the-law. I find this disturbing — especially considering I believe they are complicit in the whole real estate mess we’re in — but ultimately, it appears that’s the price we have to pay for the opportunity to pick up good foreclosure deal…

  14. Thanks for posting this. It really is a great reminder to have things thoroughly looked at. It’s tempting to just quickly go through a property and glance here and there, especially when you are hoping it is just a great deal that was overlooked by everyone else. After a long day, sometimes it’s hard to examine the house the way you really should. I’m am guilty of this very often.

    Reminds me of an REO I looked at a couple years ago. I was rushing through it because I had been through several that day. It seemed like a really good deal and as I was heading out, I looked back and noticed a 1 inch hole in a baseboard. Upon further examination, it appeared to have been chewed through by rats. I then went looking through the house for more signs and they were everywhere. I had missed them before but noticed them all now that I was really looking. The neighbor was outside and informed me (after asking) that they have been having some serious rat problems. LOTS of RATS! Chewing wires inside the walls is what concerns me most. Not to mention the smell when you kill them.

    Danny

  15. Mark in Fl says:

    People,
    Just for grins, read the bank’s contract or the addendums to the standard contract in your area on your next deal.

  16. Mark in Fl says:

    For instance, focus on your remedies for say termites or rats discovered after the inspection period that you might have missed that they knew or should have known about.

  17. J Scott says:

    Mark –

    I’m going to have to disagree with you on this one (though I certainly see your point). According to GA real estate law, sellers and their agents (including banks and REO listing agents) are NOT allowed to sign away their responsibility to inform buyers of adverse conditions known about the property. In other words, if a bank or their agents knows about a defect with a property, they legally need to disclose it, and signing an addendum can’t legally change that.

    And banks know this.

    That is why the addendum essentially says, “All parties agree that the seller has no knowledge of any defects though those defects may exist.” If banks thought they could get away with it, their addendum would say, “We might have knowledge of defects, but we don’t have to tell you.” They don’t say this because it’s not legal for them to hide defects, and they can’t make it legal no matter they do.

    The reason banks can generally get away with not telling buyers about defects is that there is plausible deniability — in other words, while the banks may know (or the listing agents may know), there is no good way to prove they know. It’s the buyer’s word against the bank’s word, and the bank’s have much better lawyers than most buyers if it ever went to court.

    In this case, someone (either the bank or the listing agent) sent a contractor into the property to cover up issues. It’s reasonable to assume that the contractor was asked to cover up those issues, or at very least, the contractor noticed those issues and reported them back to whomever hired him. So, it’s pretty impossible for the bank and the listing agent to argue that they didn’t know about the problems, since they clearly tried to cover them up. This is fraud, plain and simple, and no addendum can legally protect them against that.

    Btw, I’ve noticed that on many occasions, an REO property will change hands from one listing agent to another, and during the hand-off, some work will be done on the property. My guess is that this is the bank’s way of circumventing the disclosure laws — by having the previous agent order the work, the new agent can plausibly deny that they had any knowledge of the issue, as they were hired after the issue was addressed. Just a guess on that one, based on a few years worth of observation…

    Let me finish with a reiteration of the fact that I believe it’s completely the buyer’s responsibility to do their due diligence, and I don’t expect a seller or a listing agent for an REO property to tell me anything about a property. That said, I also don’t expect for them to pay money to try to hide issues from me or my inspectors/contractors.

  18. Greg Harris says:

    The last few REO properties I’ve dealt with have had some kind of crazy cover up attempt for major issues that without thorough inspection no one would ever know about until it was way too late… I am not a fan of these “3,000 dollar tricks” just to dump inventory at a much higher price than anyone should pay for it

  19. Mark in Fl says:

    It’s a good post and I believe you are correct. Georgia and Florida law are probably very similar. Here, the courts require disclosure for “anything that materially affects the value of the property”.

    However unless the bank just concedes to us once the defect is discovered we may have to hire an attorney to fight the bank’s corporate legal staff and go through the process of trying to prove who had actual knowledge of the defect.

    In the meantime, we’d be lying in bed at night thinking about the addendum that states in bold print how we accepted the property as is and how the losing party has to pay all attorney fees and litigation costs and how our attorney just won’t guarantee that we’ll win.

    Having said all that, I have an unorthodox opinion on all this that I’ll follow up with shortly.

  20. J Scott says:

    Mark –

    You’re absolutely correct, and I 100% agree. When it comes to fighting banks (and especially fighting FNMA), it really doesn’t matter if you’re right, as the cost to win in court will far exceed any loss you might take on the property. And, from what I’ve seen, the banks are pretty good about covering up defects in ways that provide pretty good deniability for themselves and their agents; so even if you had the money (and the inclination) to fight, it may be hard to prove your case, even if common sense tells you you’re right. I definitely can’t argue with you on that…

    Ultimately, we either have to deal with the crap thrown at us or stop playing the REO game. Personally, the deals are still good enough that it’s worth dealing with all the ridiculous stuff in the addendum (rekey fees, seller-defined extensions, no return of EM for seller default, covering up defects, etc)…

    I just wanted to make sure my readers were aware of some of the unscrupulous things that go on that they should be wary of…because as you say, once you own the property, there’s not much recourse, no matter how fraudulent the bank may have been.

  21. Mark in Fl says:

    J Scott,
    You don’t have to explain yourself to me. You provide more cogent information on real estate investing than anyone I can think of.

    Mark

  22. Mark in Fl says:

    A Lis Pendens popped up in a great neighborhood and we planned to bid at the courthouse steps. The ARV was about $140,000 minimum. I looked all around the outside of the all brick vacant home and peered through the windows at what appeared to be minimal work.

    I had planned to bid $80,000 but got wrapped up in something else and missed the auction.

    Later, I saw where it sold on the MLS to another investor for $44,000. We found out it was infested with termites even though it was undectable from the outside.

    The investor got a good deal since it was just the studs and not into the roof.

    Lessons learned: The investor was able to get an inspection, title insurance, repair estimates and could back out during the inspection period. My point being that as bad as dealing with the banks are, the risk is significantly less than the courthouse auctions. I would have lost money without those basic protections that the bank sales offer.

    Do we need government regulation to keep the banks from defrauding investors? I don’t think so, I know the risks, accept the terms of their contracts, and pay accordingly. .

    We all know that high rates of return brings high risk. I’m reminded of what the Supreme Court of Florida said when they took a hard line against tax deed investors which applies to bank foreclosures as well: “Tax deed investing is not for the faint of heart, caveat emptor applies in the utmost vigor”.

  23. Larry says:

    I know Wells Fargo almost always paint over interior and put carpets.. Scott, that REO might own by WF.

  24. Carol in CA says:

    I am a Realtor in California and both the Realtor and the Seller, ie, Private Seller or Investor Seller must disclose any changes or problems that they know about. Something as simple as changing out a faucet or a toilet must be disclosed or you are liable. Maybe the banks can get away with it but not a regular Seller they would get sued to the moon for hiding a material fact from the buyer.

  25. J Scott says:

    Hi Carol,

    Unfortunately, for some reason, REO sellers aren’t held to the same standards as retail sellers. It’s sad, but true…

  26. Ted C says:

    I came upon this as I was looking for somebody that had the guts/craziness to stand up to the banks and do something about cover ups. I am a real estate investor and I accept the risk of buying REO inventory but I struggle w the fact that most Fannie homes are sold to first time home buyers that are so desperate to get a nice house for a good price that they overlook basic steps to safeguard themselves and end up moving their young children in houses infested w mold and other issues.
    I have seen plenty of houses and I find it criminal for the banks and Asset Manager to do the best in hiding things. After couple of years in this they are getting pretty good at it and not that many inspectors are catching up.
    I think we should do something about it especially since we know how it works. I plan on contacting some tv anchors and get them interested.

  27. J Scott says:

    Hey Ted,

    I certainly commend you for this. I wish I were optimistic that anything significant could be done about it (they have deep pockets and lots of lawyers), but perhaps a bunch of negative press could go a long way!

  28. Jake says:

    J,

    What would be your recommendations on buying a home with sections of the house that were finished without permits? I’m looking at a deal now where the house is listed at 2,045 sq ft but the tax records only show 1,352. The listing specifies that the entire second floor was finished without permits, so I’m assuming this is the 700 sq ft difference. Have you dealt with this before? What is involved? Etc. Keep up the great work!

    Jake

  29. J Scott says:

    Hey Jake,

    Be very cautious with this. Unless you get the addition properly permitted, you’ll find it very hard to ever resell the house to an owner occupant. If you want to get it permitted, you’ll need to go to the building department and pull permits retroactively. They’ll likely require you to open up the walls so they can check electrical, plumbing, framing, insulation, etc. Depending on how much they require you to open up, what they find and what they require you to fix/redo, it could end up being pretty expensive.

    Make sure you factor this into your price if you choose to purchase…

  30. Eve says:

    I like the story very much!

    I am starting and have very little knowledge on the rehab cost. Do you think I should hire a structural engineer, termite expert and general contractors to know the rehab cost? That looks like a lot of ppl to work with, what are your suggestions?

  31. J Scott says:

    Hi Eve,

    I spend the better part of an entire chapter discussing this topic in one of my books (“The Book on Flipping Houses”) and then have an entire second book devoted to the subject (“The Book on Estimating Rehab Costs”).

    I highly recommend you check them out: http://www.biggerpockets.com/flippingbook

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