Distressed-Property-Investing-A-Foreclosure-and-REO-Tutorial-For-New-and-Intermediate-Real-Estate-Investors

CASTLE ARCH REAL ESTATE INVESTMENT COMPANY Distressed Property Investing A foreclosure and REO snapshot for financial advisors and their clients A user guide to understanding the opportunity underneath the foreclosure crisis in America TABLE OF CONTENTS Distressed Real Estate Primer 1. Introduction 2. Real Estate Value 3. The Distressed Real Estate Market 4. The Opportunity in Distressed Real Estate Finding 5. Start With Financing and a Profile 6. Which Rocks to Look Under Due Diligence 7. Inspection 8. Professional Inspector? 9. Rehab Estimates 10. Occupancy 11. Appraisal/Valuation 12. Valuing Income Property Contract and Close 13. How Much to Offer? 14. Liens 15. Taxes 16. Creating a Holding Company 17. Financing 18. Negotiating With the Seller and Submitting an Offer 19. The REPC 20. Closing, Title and Escrow Page 1 3 3 7 10 11 19 19 20 21 22 24 31 33 35 35 36 37 39 40 COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Rehabilitation 21. Finding a Contractor 22. What You Should or Shouldn’t Do Yourself Exit 23. Lease to Own (Seller Financing) 24. Owner Occupancy 25. Sale 26. Income Property Conclusion Appendix Bank and Lender REO Resources Government Websites Additional Finding Resources Asset Management Companies Sample Home Inspection Checklist Sample REPC (State of Utah) Sample Seller’s Disclosure Form (State of Indiana) FTC Real Estate Glossary 44 47 48 48 49 50 I IV VII VI VIII X XVI XVIII COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED DISTRESSED REAL ESTATE PRIMER 1. Introduction Real Estate investing is the ultimate mixed bag. On one hand, the rich all seem to have a portion of their wealth that stems from owning property. Historically, land ownership has almost been synonymous with wealth. Likewise, home ownership has been inseparable from the American Dream since the beginning. Yet a flood of infomercials and get-rich-quick personalities have preached real estate investing to the masses … and left scores of broken failures littered in their wake. Everyone seems to know someone who got rich in real estate and someone else who went broke. How can people new to real estate investing hope to make sense of it all? Like any investment process, participants become more competent with experience. The problem is that real estate transactions are big. Stock market investors can invest almost any amount, large or small, and can tailor their risk to losses they can afford (that is not to say that they always do). With real estate, the ante is bigger. This means many players end up going “all in” on the first hand. Their first opportunity to gain COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 2 experience requires everything they have got. If they survive, they go on to play again—if not, the tuition they paid ends up being very high. I bought my first property in 1981 and have been involved in real estate development and investing for most of my life. I have done well, and I have been burned. Our company has systematized and perfected many of the techniques I discuss here. When appropriate, I will add insights about the methodologies we have developed as well as the approaches typical for individual investors. When I was a boy, one of my teachers told me, “the trick in life is to get wise before you get old.” He meant that to the extent that I could learn from the experiences of others, I would not have to pay the price to gain that experience myself. That is what this book is all about. I want to give you the opportunity to learn from my experience without paying the “dumb tax” along the way. Rather than throw you in at the deep end and watch you “sink or swim” through the various (and often very sophisticated) elements of the deal, or giving you instructions on a specific methodology that leave you helpless when the terms of a deal change in ways the methodology does not anticipate, instead, I will give you the building blocks, the tools that form a solid foundation to get you started. Now, I need to include a caveat. There is nothing that substitutes for gaining your own experience and there is no guarantee that you will profit, no safety net other than your own understanding when it comes to investing in distressed property. There are not really any shortcuts and the last thing you want is to become a foreclosure investor whose bad deals The last thing you want to do is become a foreclosure investor who is facing foreclosure yourself. have you facing foreclosure yourself. It is possible, however, to go through the process of gaining that experience prepared. You can be prepared with tools and information that increase your probability of success. I cannot guarantee that you will never get burned in a deal, but I can help you go into those deals with your eyes open. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 3 2. Real Estate Value Why is real estate valuable? Why is it an investment worth considering? Under normal circumstances, real estate appreciates, meaning it gains value over time. The reason for this is that one piece of property can be like another, but it cannot be identical. If one piece of property could be exactly similar to another, real estate values would be a function of square footage, amenities, age, and some objective measure of construction features and quality. Instead, property in the foothills is more valuable than that in the valleys, property with a view is worth more than property that is boxed in. The essential characteristic that drives real estate values is uniqueness. There is only one of any particular piece of land. In this respect, real estate is like fine art. There are only so many original Van Gogh’s and there is only so much land. The concept of uniqueness underlies the other forces at work in the real estate market. Most importantly, it is uniqueness that drives appreciation and appreciation underpins traditional real estate investing. The current real estate climate, however, is rife with distress where artificial manipulations have distorted the relationship between price and value. These distortions have caused time-tested market factors to become less reliable. 3. The Distressed Real Estate Market Real Estate Professionals call them the three Ds that drive sales: death, divorce and distress. Each of these conditions creates a “motivated seller,” a reason why sellers have a reason to place another objective over simply getting the highest possible price. Investors take advantage of that motivation by negotiating a lower price than what might otherwise be considered “fair value,” in other words, the value of the property on the open market where the equilibrium of supply and demand determine price. The motivation behind death and divorce are straightforward. These are singular life-changing events, which clearly induce a circumstance where other concerns take priority over simply getting the most money out of the sale of a property. Distress, however, can be caused by many factors. “Distress” is sometimes used as a way of describing the physical condition of a property, meaning it is run down, dilapidated, or in bad repair. For our purposes, however, we are looking at a property’s financial COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 4 condition. When we talk about distressed property, we mean property that is involved in foreclosure. Either it is at risk of foreclosure, or it has already been foreclosed. Whatever the circumstances and economics that led the owner to default on the financing of the property, foreclosure is the event that primarily indicates that this property is of interest to us. Either foreclosure is imminent, or it has already taken place. Either way, the property ends up in the hands of a motivated seller … which creates an opportunity. Foreclosures have been around as long as lending and we can probably expect that a certain number of foreclosures will always exist. The current market, however, is producing historic numbers of foreclosures, which also means we are entering a historic period of opportunity. The entire scope and ramifications of the housing crisis in the first decade of the new millennium is a topic that I expect will fill volumes and likely keep economists and historians busy for decades. Notwithstanding the enormity of the factors contributing to the state of the market, it is important for investors to have at least a basic historical context of how we got here. What follows is a brief and intentionally truncated synopsis of the critical events leading up to the current state of affairs in real estate. (For a more thorough treatment of the financial crisis, see Anatomy of a Meltdown, which can be downloaded at np-adv.com/articles/meltdown.pdf.) When the dot com bubble burst at the end of the 90’s, investment money fled the stock market looking for safer havens. As a result, investment banks orchestrated instruments called Collateralized Mortgage Obligations (CMOs) that allowed investment money to be secured by real estate. Historically, real estate in the U.S. had a stable long-term rate of appreciation (about 5.45% since the end of World War II).1 Even though this was less than the historical average rate of return on Wall Street (7.8%), investors were looking for safety after being burned by the tech stock reset. So, these CMOs offered just what they were looking for. The money that had fled Wall Street in the dot com crash, now came back into real estate securities like a tidal wave. Rating firms like S&P and Moodys gave CMOs a credit rating, which theoretically took into consideration that sub-prime mortgages (those given to borrowers with bad credit) were riskier than typical “conforming” mortgages. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 5 Now, investors could not only invest in an instrument backed by real estate, but if they were looking for a little better return (of course paired with higher risk) they could invest where the credit rating was lower. Stock market investors were used to protecting themselves against risky investments through diversification— they would spread their investments around in case one went bad—so they did the same thing with their investment in CMOs. The effect of all this new investment in real estate was an insatiable demand for mortgages, whether the borrowers had good credit or bad. In response to the demand, lenders loosened their lending criteria, offering “creative” financing through ARMs, balloon mortgages, “interest only” loans, and COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 6 the like to people with bad credit. Borrowers were getting into homes they never could afford. Cookie cutter luxury homes became so common the media began referring to them as McMansions.2 Since practically anyone could buy a home above their price range, demand on the overall housing market went up, prices started to climb; contractors started building new homes as fast as they could … and all of it was based on a lie. Homes were not really worth what people were paying, construction was not really worth what contractors were charging, borrowers were not really able to repay the mortgages they took out and the credit ratings did not truly reflect the risk of these investments. In fact, the market manipulations had created a condition for negative appreciation. In 2008, we saw the market start to unravel. The Federal Reserve had been raising interest rates to try and stop the runaway train of borrowing. In a policy bordering on irresponsible, the Fed raised interest rates 17 times and the market did not see a rate reduction for a period of 38 months. As a result, the ARMs started growing with climbing interest rates, the balloons started to mature, and the borrowers stopped being able to make their house payments. An avalanche of foreclosures started gaining momentum and the news started discussing the “housing bubble” and the “subprime mortgage crisis.” Bear Stearns, one of the five largest investment banks on Wall Street, imploded because of its heavy investment in CMOs, only to be followed by the other four. Investment banking as an industry crashed and burned, accompanied by other banks and financial institutions whose money was tied up in mortgages or mortgage backed securities. The effects were exacerbated by leverage, the term used for the ratio of dollars lent versus dollars held in deposit. Traditional banks were leveraged at a five to one ratio. In other words, for every dollar they had on deposit, they could loan five. Which meant that every dollar tied up in a foreclosure prevented five dollars from being loaned out. But that was nothing compared with the Wall Street firms. Investment banks like Lehman Brothers Holdings were leveraged as much as 35 to one. (Thus the connection between foreclosures and the “credit crunch.”) This ratio means that $2 billion in foreclosures would feel like $70 billion. With home values inflated by artificial demand, many borrowers were upside down—owing more on COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 7 their homes than they were worth— making it impossible to refinance or sell. Borrowers with bad credit often bought with little or nothing down and had virtually no “skin” in the game. It had never been easier to walk away from a mortgage, and so they did. The current market is going through a period of deleveraging— also called a “reset” where the market should eventually return to price and value equilibrium. Foreclosures are a necessary part of that reset. Even with government and private support, credit is still tighter than it was. But, who can expect lenders to return to the irresponsible lending they were doing? The market is contracting because it needs to return to the point that buyers can buy what they can afford. The only way for that to happen is for foreclosures to reset the portion of the market that is most out of line. The foreclosure solution is not quite that simple, however. Foreclosures alone do not get the market back on track. Foreclosures just return properties to the banks, and banks are not in the real estate sales business. They want to loan money, but are prevented from doing so when their money is tied up in a “nonperforming” asset, like a house with a mortgage that nobody is paying. Banks do not look at property based on its market value; they look at it based on the money they are losing by not having those dollars generating interest somewhere. That is why they are motivated sellers. They want to get the bad stuff off their books and get on to making money the way they know how. So, what is still needed in order to get the market going again? And, where is the opportunity for an investor to enter the distressed real estate picture and create value for the parties involved and make some money? That is where real estate investors come in. 4. The Opportunity in Distressed Real Estate The solution to getting the market back on track, where prices and intrinsic value are matched, requires someone to match foreclosures with new buyers. The reset means that properties need to go from their inflated rates, to fair market value. But the pendulum cannot simply swing from “overvalued” to “fair valued.” It has to overcorrect in order to get participation from those with the expertise to facilitate the transition. In other words, investors like you and me need to be able to make some money for our efforts in moving property COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 8 from the hands of the banks into a reset “fair-valued” marketplace. Where is the overcorrection going to come from? It starts with the bank as a motivated seller. Being motivated means the bank has a reason to accept a lower price than fair market value (in spite of whatever they might tell you). They have many criteria for deciding what price they are willing to accept. They are asking questions like: How much is left owing on the mortgage? What is the cost of having those dollars tied up in the property? What is our reasonable expectation for the property, in other words how much do we think we could get out in the marketplace? Properties which have been repossessed by the bank are called Real Estate Owned, or REO, properties. Often banks are willing to sell their REO pools for 80, 65, 50 cents on the dollar or less. That margin represents work that bankers are unwilling or unable to do. Bankers are not real estate professionals. They are not contractors. To them, property represents inventory—it is like shelves of unsold goods. Where a good Realtor might talk to a buyer about a home’s potential, the merits of the local schools or the realization of lifelong dreams, bankers do not think like that. They do not see the emotional component of selling someone their dream home, or selling an investment that might mean a secure retirement. Bankers live by the numbers, and as such are terribly equipped to get good value out of these properties. Add to banker’s lack of appreciation for the emotional dimension of selling, the fact that these properties are often in very poor condition. Borrowers may have been upset that the bank decided to foreclose; they may be embarrassed that they have been kicked out of their home. In any case, they often stop being interested in basic maintenance and upkeep of the property. Sometimes they intentionally take out their frustrations on the home. It is not uncommon to see things like concrete poured down toilets, dwellings left open to be ransacked and vandalized by local gangs, and everything of possible value stripped out from appliances to copper pipes. If the property is an apartment building or a rental home, the complications can be even worse as tenants try to figure out where they stand in the whole mess.3 In fact, dilapidated properties often become an issue for other community residents who resent COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 9 eyesores in their neighborhood. This is understandable. They are also victims of the market and are only trying to salvage what property value they have left. As a result, communities are passing new laws requiring banks to pay for the upkeep of properties they own; all of which simply adds more financial pressure for banks to sell.4 These market factors and motivation for banks to sell create an opportunity where savvy investors can buy real estate at less than its fair market value, add value by cleaning, making repairs, remodeling, or simply making use of better sales and marketing tactics, and finally sell the property for more than their total cost of purchase and the necessary rehab work. Because banks operate by the numbers, they often do not know whether the price they set is a good value or not. They are looking at the implication on their own finances. They consider what it costs them to retain this property versus the potential loss they take selling it cheap. Don’t fall into the trap of thinking that bankers are foolish. They are very smart, especially when it comes to making money; they are just operating from a different perspective. Because of this, you cannot count on the banker’s price to tell you anything about the property’s true value. And that means you need to go in with a system for estimating what the real value is. The story of buying a home on the cheap, cleaning and fixing it up with your own labor and selling it to the market for a killing is a little bit of a fairy tale. Is there money to be made? Absolutely. Is it as easy as it sounds? Absolutely not. If it were that easy, everybody would be doing it. There also seem to be dozens of get-rich-quick schemes built around investing in foreclosures. These schemes are really nothing more than a distraction to legitimate investors. There is a lot of risk in real estate investing and many people lose out, especially if they are unprepared. But this book is about putting probability of success in your favor. It is certainly possible to be successful, especially if you are determined and ready to put in the work required— and from here forward, I will walk you through the steps from start to finish. Steps for Investing In Distressed Property COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED FINDING Page 10 5. Start With Financing and a Profile How do you go about finding an imminent foreclosure, or an REO property? I recommend that before you start looking for properties you establish some criteria—a profile for the type of property you are interested in. When you are building your profile, Ask yourself questions like: What is my price range? What can I really afford to put in to this investment? REO deals can range from hundreds of thousands of dollars to tens or hundreds of millions and more. What locations am I willing to look at? What is my exit strategy? What type of property fits my goals and expectations? (Are you sticking with some flavor of residential property like single-family residences, multifamily condos or apartments, or do you prefer commercial property, industrial property, or raw land?) Where is your expertise and interest? For example, your background may have equipped you to be familiar with the type of repairs and refurbishment that is common for office space, but not the issues involved with an apartment building or single-family home. Ask yourself, how much rehab work am I equipped to perform? Do I need properties that require little, if any, additional work, or can I tackle major construction projects? How much can I afford in repair and refurbishment? Finally, no profile would be complete without an anticipated margin. You need a line in the sand that keeps your investment intact. If the terms of a deal fall outside the parameters you have set out for yourself, then it is time to walk away. By outlining the characteristics of your target property, you can begin looking for properties without fear of being overwhelmed by all the possibilities. Understanding the characteristics of your ideal property is cast against the backdrop of your financial options. In other words, your ability to finance the purchase must be in place before you go looking for distressed property. The reason for this is that the best opportunities are very time-sensitive. If you cannot come with the cash, the deal will go to someone else. The following checklist is designed to help you ensure that you are financially prepared to execute when the right deal presents itself: COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 11 Financing Checklist: Cash ► ow much cash do I have on H hand? ► o I need to liquidate an asset D in order to secure the necessary cash? ► oes my access to cash limit my D time frame? Cash and Debt ► Is my debt financing lined up? ► m I prequalified for the A necessary amount? ► ow long do I expect my lender H will take to fund? Partnership ► ill I partner with others to do W this deal? ► re the terms of our arrangement A clear and agreed upon by all parties? ► o I anticipate delays from my D partner(s)? With your profile and financing in order, you are ready to go hunting for deals. 6. Which Rocks to Look Under Finding distressed property is like playing football. Imagine you are on defense and you are looking for an interception. The quarterback has the ball and is under pressure to pass it. If he does not get rid of the ball, he’s going to get sacked. The ball represents the property, of course. You need to know whose hands it is in (who owns it), and the trajectory it will travel (the process) as the owner tries to pass it. Figure 1 on the following page outlines the foreclosure process. Properties do not start out in distress. In the beginning there is a transaction between two entities: a borrower who wants to purchase a property and a bank who wants to make loans. The bank provides the funds the borrower needs to purchase the property. In return, the borrower promises to repay the bank what was borrowed, plus interest. The instrument that sets out the terms of this arrangement is a mortgage or a deed of trust (which one generally depends upon state laws and whether or not your state allows nonjudicial foreclosures). Unless I am drawing a specific distinction, I will use the term mortgage to mean both mortgages and deeds of trust. The process of foreclosure is determined by the terms of this document (and state law, but typically banks are very familiar with these laws and draft mortgage agreements in strict accordance with them.) COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 12 Figure 1: HOW PROPERTIES BECOME BANK REO COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 13 Mortgage Provisions: Will Contain ► orrower will repay the lender B ► imitations on Borrower’s use of L the property before it is paid off ► orrower will keep the property B insured ► The foreclosure agreement ► orrower agrees to receiver or B trustee control in the event of foreclosure May Contain ► repayment penalties P ► Additional default provisions ► efault remedies and foreclosure D schedule ► Due on Sale” clause “ Foreclosure is not a single event, but rather a process. In this Figure, you can see that the first phase of foreclosure is Pre-Foreclosure and the first step is Default. Mortgage agreements will spell out the terms under which the loan is repaid and what constitutes default. The most common type of default is not making scheduled payments. It is not unusual for mortgage agreements to include additional default provisions, such as if the buyer stores illegal hazardous wastes on the property or destroys the property in some way. Banks do not usually initiate foreclosure after a single missed payment. Typically foreclosure starts after two or three missed payments. In our current market, banks have been known to allow borrowers to miss their payments for six months or more. They may also implement a workout agreement or a “forbearance,” which are temporary short-term agreements between borrowers and lenders that can be used to help borrowers catch up on payments and stay in the property in order to avoid the costly foreclosure process. One source claims that banks typically lose $50,000 on every home that goes into foreclosure.5 When the bank has had enough, however, after the borrower defaults, the bank will exercise its right to accelerate the debt. This means that they notify the borrower that the entire balance of the loan must be repaid in a short period of time called the Reinstatement Period. Borrowers can try to sell the property during this period or pay the loan off with other funds, but this is often a very high hurdle for borrowers to meet. At this point, the bank will also notify the borrower of the auction schedule. The Reinstatement Period typically runs up to five days prior to the auction COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 14 date, which can be 2-3 months from the notice date. Sometimes lenders will allow a loan to be reinstated if the default is corrected, that is if the loan is merely brought current, rather than requiring the entire outstanding balance. But often the bank has exhausted its options for mending the relationship with the borrower. In that case, the bank may have made up its mind that foreclosure is the best course of action and the borrower is then subject to whatever terms in the mortgage contract govern the process of foreclosure. Depending on whether the mortgage is a Mortgage Agreement or a Deed of Trust, the bank will initiate Judicial or Non-judicial foreclosure. Judicial foreclosure is processed through the court system. Non-judicial foreclosure is handled by any “Power of Sale” terms in the mortgage as well as being governed by state law. Nonjudicial foreclosures are generally handled outside the court system. Judicial foreclosures typically take longer than Non-judicial ones. Judicial Foreclosures generally start with the filing of a Lis Pendens (a notice encumbering the title of the property in which someone claims an interest in the property and that the claim is the subject of a lawsuit). This notice of interest in the property is filed against the title of the property. A foreclosure hearing is then held by the court. No hearing is required for Nonjudicial foreclosures, but a similar Notice of Default (NOD) is filed by the trustee with the County Recorder’s Office. The bank then files a “Notice of Sale” with the county and publishes the same in the appropriate local newspaper. Getting information about properties at this stage is as simple as intercepting the property at some point in its process. During all of the aforementioned steps, the property is considered to be in Pre-Foreclosure. Which means that the owner is a buyer in trouble. If you want to intercept a property at this stage of the process, you will be dealing with both the borrower who is losing his or her home as well as a bank who is not getting paid. For individual investors, a good place to start looking for information about these properties is with public records and local publications. Anyone investing in real estate should become familiar with these resources. Public property records are typically filed with the County Clerk at the County Recorder’s Office.6 These are handled at the county COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 15 Anyone investing in real estate should become familiar with public records. level, just like property taxes. As we mentioned, certain “notices” are required to be recorded during the foreclosure process. You should be able to search for NODs, Notices of Sale, or Lis Pendens.7 There is usually no cost for searching public records and they are available to anyone. Notices filed with the Recorder’s Office are also very current. You are likely to find properties that have not yet been added to the lists compiled by listing services or online providers. The drawback is that you are limited to one county at a time, Internet resources for county records vary drastically from county to county (meaning that you will likely need to plan on visiting these offices in person), and searching these resources can be time-consuming, especially if you are unfamiliar with the process. Notices of Sale must also be published in the local newspaper. By searching local business journals and newspapers under their Public Notice sections, you can find sale notices. Pre-Foreclosure encompasses all the steps necessary to take the property to auction. Because it is so pivotal, Auction is its own phase in the foreclosure process. Again there are subtle differences between judicial and non-judicial requirements. Judicial foreclosures culminate in a Sheriff’s sale. These are the auctions that are physically held right on the courthouse steps. Non-judicial foreclosures also culminate in an auction, but it is typically held by a private auction house and is called a Public Auction or Trustees Sale. These auctions are opportunities to bid on and purchase foreclosed properties. Sales are as-is and typically buyers do not get the opportunity to get inside and inspect these properties. Auctions generally require that you bring a cashier’s check for a minimum amount (you will be asked to show this before you are allowed to bid) and then be able to close in a very short window of time—often only 24 hours. Winning bidders then receive the deed to the property, which they must then have recorded with the County Recorder’s Office. Auction prices start with an opening bid, which is typically set by the lender as a function of the COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 16 balances owed on the property plus interest, bank fees, and possibly attorney’s fees associated with the legal aspects of foreclosure. If the borrower had a significant amount of equity in the property, banks may part with it for a low price. Often, however, auctions come and go with no bids that are equal or greater than the opening bid. In this case, the auction has failed to produce a buyer for the property, or at least a buyer at the asking price. Failure to sell at auction is where REOs are born. After an auction, if there are no buyers, the property reverts to bank ownership. Failure to sell at auction is where REOs are born. One exception that investors need to be aware of is that typically judicial foreclosures have a redemption period. The redemption period is a set time where the borrower can pay off the balances owed to the bank and redeem the property. If investors are too hasty and immediately begin making repairs on a property they bought at auction in anticipation of dressing the property up for a sale, the previous owner could still redeem the property throughout the redemption period with no obligation to reimburse investors for improvements they have made. A tactic for mitigating the risk of a previous owner exercising his or her right of redemption is to buy the redemption rights, or better yet, get the owner to assign them to you. The pros here are that you take control of an unknown risk in both losing the property and waiting out the redemption period. Cons are that you may have another cost to deal with and you have to be able to negotiate for the rights with the person who holds them. Just like pre-foreclosures, when a property becomes an REO, your finding opportunity starts with identifying who owns it. The owner is typically going to be a bank or other financial institution—although various government entities also have the power to foreclose or seize properties (these entities range from the IRS and Fannie Mae to seizures made by U.S. Customs or the U.S. Marshalls Service).8 You can also check with local government offices to see if they have a list of Tax Foreclosures. All of these resources have processes they COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 17 go through when foreclosing or trying to sell the properties. The Internet can be a great resource in your search for REO properties. Many real estate brokerages compile lists of foreclosures in the areas they serve. In addition, several significant financial institutions list their REO properties on their company web sites (Countrywide, Washington Mutual, Bank of America to name a few—a more lengthy list is provided in the Appendix). Most have tools for sorting through properties to refine your search. You may be able to sort by city, price, number of bedrooms, and other criteria. There are also listing service companies who provide lists of REO properties for a fee. (A list of some of these is provided in the Appendix.) There are literally hundreds of these online.9,10 Many offer a free trial and then charge a periodic fee. There are regional and national listing services that offer information on properties in various stages of foreclosure, including the notices filed with the County as well as additional information regarding the loans on the property and sometimes even contact information. However, if you decide to use one of these, be wary of scams and deceptive marketing practices. Make sure you look for third-party validation that the company is legitimate. Ask around on Internet forums or consumer protection sites before giving anyone your money or credit card information. Sometimes you can find REO properties by going through an Asset Management Company. These companies are like listing agents for lenders with a focus on the disposition of REO properties. They tend to buy or represent bulk “REO tapes.” Typical REO tapes contain between 20 and 500 homes (although they can contain more). Bulk tapes are available at a discount that is typically unavailable to individual investors buying a single property. Just like banks these companies are motivated to sell and sometimes will do some of the tests or rehab work already in order to make the sale look more attractive.11 One of the benefits of dealing with an asset management company is that these companies have had a chance to build relationships with banks which could be impossible, or very time consuming for individual investors to cultivate. Some of them will specialize in buying REO tapes and then selling the properties off individually. Many Asset Management COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 18 companies provide REO property listings on their web sites.12 (A list of Asset Management companies can be found in the Appendix.) In our company, the relationships we have with banks and asset managers allows us to access some of the best tapes early in the process and search for the prime opportunities ahead of many other investors. Be cautious. For every legitimate company working in this trade, there are dozens of companies that are attracted by the big dollars, but who do not have the capacity to really get a deal done. Another resource for finding REO deals is local clubs or organizations. Many areas have privately organized real estate investing clubs. Joining a club like this could be an opportunity to network with others who have been down the distressed property investing road before and who may have valuable insights about dealing with local conditions, and opportunities that exist within your local market. Now let’s say you have established your profile, you have got your financing lined up, and you have successfully found a number of properties that fit your criteria. What next? Before you start making bids or submitting offers, you have some Before you start making bits or submitting offers, you have some homework to do. homework to do. It may be helpful to think of the process of investing in distressed real estate as a business venture rather than just an investment. Just like managing a company, you will need to manage these steps and the processes and people within them to maximize your chances of a return. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED DUE DILIGENCE Page 19 7. Inspection A Home Inspector once told me, “Every home has its secrets.” This is something my own experience has taught me—many times over—to be true. Not everyone performs a physical on-site inspection before purchasing a distressed property. That does not mean you should skip this step. In fact, in order to protect yourself, you need to become an expert at inspecting properties. There is an industry of professional building inspectors (and in the next section I am going to discuss using one) but remember that if the deal goes bad it is not going to be your building inspector’s money that is on the line. The person writing the check is the one who is ultimately responsible for everything—and that’s you. So, learn how to evaluate a building’s systems. Check the utilities if possible. Learn how to inspect the power, natural gas, and other heating systems. Know whether the building is connected to public sewer, or has a septic tank. Water damage is one of the most common and expensive problems in any type of building. Learn to detect signs of poor drainage, leaks, and previous plumbing problems. Call utility companies and ask for a record Inspection Checklist: Interior ► Plumbing ► lectrical E ► HVAC (Heating and Cooling) ► Structural ► urfaces (Walls, Floors, S Counters) ► oors & Windows D ► ecurity (Locks & Alarms) S Exterior ► oofing R ► Foundation ► Wall Facings ► rrigation/Water Drainage I ► Ingress/Egress ► ite Hazards S of complaints, on-site calls, and repairs. Some types of disasters require special cleanup. You need to know if the property has had a flood, fire, mold problem, has been a meth house, or is otherwise contaminated. 8. Professional Inspector? There are several types of inspections that you can pay to have performed. As a general rule it is cheaper to pay for an inspection before you own the property than it is to fix a problem that went undetected during due diligence. You need COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 20 to weigh the cost of an inspection with your stage of evaluation. You may want to reserve professional inspections as a condition of your purchase contract or use their findings as a point of negotiation (more on this in the Contract and Close section). Typically, for a few hundred dollars you can hire a professional inspector to perform an inspection. A sample home inspection checklist is included in the Appendix. Often these inspectors will provide a guarantee or even some type of limited warranty for those items included in their inspection. (Unlike homes on the regular real estate market, REO properties will generally be sold “asis” with no warranty at all. When you buy it, you are 100% responsible for anything that is wrong or goes wrong with the property.) Inspectors may also have specialized equipment to test for water damage, gas leaks, and harmful Radon gas. Look for someone who is a member of the National Institute of Building Inspectors (NIBI).13 Watch them closely in order to learn things that might help you in performing your own inspections. You will very likely need a pest inspection. You may need to factor in costs for termite treatments, repair of structural damage or exterminators for rodents or insects. 9. Rehab Estimates One of the most critical factors that will determine whether you make money or lose it will be your ability to accurately estimate the cost and value of repairs to the property. Repair costs have a way of spiraling out of control and taking longer than estimated. Both end up eating away at the return you hope to make on your investment. More than a few “house flippers” end up scrambling to get out with their skin on. You will need to quickly become a master estimator and skilled manager of the subcontractors you hire to do this work. Some repairs are deal breakers. What I mean is that some repairs can be so extensive that the risk is inordinately high that they will destroy your margin. These are especially critical when they affect the safety and structural integrity of the home. Examples of this type of problem are: cracks in the foundation, decay in bearing walls or structural members, contamination, water issues (especially those likely to recur), etc. When I see this type of problem, I generally walk away. Another acceptable option is to negotiate a COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 21 concession in price that truly reflects the risk associated with the problem. Sometimes that means you are negotiating at the value of only the land because it is cheaper to tear the house down than to fix it. It is also important to determine which repairs are important and which are not. Our company often sells its properties “as-is” because we think the return on investment for certain types of refurbishment are not worth the time and effort. On the other hand, sometimes, relatively inexpensive repairs like paint and carpeting can dramatically improve how a property shows to potential buyers. When you estimate repair costs, make sure you expect to reap a margin on those costs equal to the percentage margin you expected from the property to begin with. 10. Occupancy Just because a home has been foreclosed on, does not mean the occupants are gone. Eviction laws vary state by state, but it is not uncommon for eviction to be a lengthy and difficult process. Eviction time frames range from 30 days to over a year. Occupants (former owners or renters) are frequently informed about how to stay in the home as long as possible. You need to be aware of any occupants and the risks they represent. They may continue to deteriorate the value of the property, and be uncooperative with your due diligence efforts. If you anticipate needing to evict the occupants, allow for the legal costs and the extended time frame. Due Diligence Essentials: Valuation Data ► Property Records ► Property Tax Records ► Economic Data for the Area ► Comparable Sales ► Neighborhood Crime Rate Risks ► Required Repairs ► Hazardous Waste ► Building Code Violations ► Flood Zone Information In our company, we often take a Cash for Keys approach to limit our exposure. Cash for Keys means that we essentially offer the occupants a bribe to vacate the property. In principle, if these occupants were flush with cash, they could probably pay for lodging like everybody else. So, it is often cheaper to pay them to leave than it is to execute all the legal COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 22 proceedings to have them evicted by court order and removed. 11. Appraisal/Valuation So far our discussion of due diligence has focused on uncovering hidden costs associated with the property. Do not be surprised by something you should have caught during the early due diligence phase. As part of your due diligence, you need to establish the property’s value when you expect to sell it. This is often referred to as your After Repair Value (ARV) and reflects the realistic amount of cash you expect to walk away with when you sell. A mistake here can be just as detrimental to your investment as being blind-sided by hidden costs. Start by looking for comparables—homes that meet similar criteria to your desired property that have recently sold. The more alike they are, the better in terms of square footage, age, number of bedrooms and bathrooms, amenities, lot size, location and condition. Comparables will give you a relative ballpark estimate of the selling price you should be able to get. The idea is that the performance of similar properties in the same general location ought to be fairly accurate predictors of how your property will perform. Both high- and low-selling comparables are useful. You will want information on lowselling comparable to present to the bank when you submit your bid. The mixture of other comparables will help you get a fair sense of the price the market ought to bring. You want to be neither optimistic nor pessimistic here, but realistic. Don’t forget to consider how much price you might need to give up to meet your target sales time frame. In other words, you should expect to sell your property for less if you expect to find a buyer in 30 days, than you would if you expect to find a buyer in 90 days. There are several resources you can access to get information on comparables. You can get a general indication for residential property values from web sites like Cyberhomes.com, PropertyShark. com, and Zillow.com. If you plan on using a Realtor, they will have access to a Multiple Listing Service (MLS). An MLS is a computer database of properties listed for sale by Realtors who subscribe to it. Historical data within the MLS will tell you about the sales history of other properties in the neighborhood. What they listed for, what they sold for, and how many days they spent on the market before selling. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 23 Although not a guarantee, this information can help you determine what price you can get for your property. It can also help you estimate what you need to accept if you want a fast sale. You will want to also take a close look at the local market and make sure you understand it. Take a good look at the neighborhood, the schools, key employers nearby, and access to shopping and healthcare facilities. Look at who is living in the neighborhood. Are they mostly students, or retirees? Are they young families or empty nesters? The type of buyer the market has attracted in the past is a pretty good indicator about who will be interested in the future. In our company, we saw a property that had originally been listed for $1.8 million. It had been on the market for some time with no buyers. The price dropped to $1.5 million, then $1.3 million. It dropped to $900 thousand before entering foreclosure. It was eventually offered to us at $400 thousand. You would think that we would have jumped all over this deal. How often do you see a property that has been reduced by $1.4 million! In our due diligence process, however, we identified that the neighborhood was occupied primarily by Realtors, contractors, and mortgage brokers. The neighbors’ driveways were full of expensive cars and ski boats. This told us that the other owners were all players in the housing business and were heavily leveraged. We expected most of the neighborhood to go into foreclosure eventually, and decided that our maximum bid was about $250 thousand. This offer was not accepted, and the bank even indicated that they had accepted another offer. But, we noticed the property was simply relisted and still has not sold. Look for indicators that the market is hot or cold—commonly described as either a buyer’s market or a seller’s market. A seller’s market means that buyers are plentiful and sellers can afford to take only the best deals that come along. Signs of a seller’s market include: very little inventory (ie. relatively few homes for sale), quick sales measured in terms of “Days on the Market” (DOM). These conditions can result in multiple offers and even bidding wars where homes sell for more than the asking price A buyer’s market is the opposite. More homes are available than ready buyers to take them, so buyers are in a strong position to negotiate for what they want. You will notice that in this type of market, homes are listed and spending many more DOM, COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 24 generally over 120 days, without offers. Analysts describe the inventory in terms of how many months it will take at the current rate of sales, to absorb the inventory on the market. The current market has some areas of the country carrying a 24-month inventory or more, and that does not include new homes being listed for sale. With a clear picture of your costs, the ARV will tell you what you need to calculate the margin you expect to make on the property. It can be helpful to look at the margin on these deals in terms of percentages. For example, $50,000 in profit potential on a $550,000 home represents a much thinner margin than $50,000 in profit potential on a home worth $150,000. In our company, we specifically look for deals that have enough margin for a speedy transaction. Our typical property is under contract within 13 days or less and our average number of days to close is 42. If your margins are too tight, you won’t be free to avoid the risks of a distended holding time. Also, do not forget to figure in 6-9% of the final price toward closing costs and real estate commissions if you decide to use a Realtor. 12. Valuing Income Property Rental properties are valued differently than individual houses for sale. They also use comparables as part of their valuation process, but the valuation analysis uses terms and techniques more common for traditional investing. Income property is looked at as a business that produces income. As such, metrics for how the property produces income and return on investment (ROI) are customary. However, just like singlefamily residences, valuing rental property begins with comparables. These valuations consider comparable rents as well as the occupancy levels and value of comparable properties. For residential properties these may be a simple calculation based on bedroom and bathroom configuration and square footage. For commercial property it is likely a rate per square foot for a similar class of commercial property. For example, most office space is considered Class A (in practice this is so common that Class A has become practically meaningless as a standard for evaluating the quality of an office building). In your market it may be typical to see annual rents anywhere from $25 to $250 per square foot. In some areas of Manhattan, the rate is over $1,000 per square foot. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 25 Rental property valuation then considers the business processes that produce income. They are valued as much for the revenue stream they produce as they are for the market value the property would bring in a sale. A quick rule of thumb is the Gross Rent Multiplier (GRM). GRM is calculated by dividing the sales price by the annual rents. In this example (Figure 2) we compare two properties based on their GRM. All things being equal, the lower the GRM, the better value the property because you earn more income for the amount of money you have to spend.14 In this case, Property #2 gives us a better GRM. Figure 2: EXAMPLE: GROSS RENT MULTIPLIER (GRM) as anything more than a simple rule of thumb. One of the most common valuation methods is determining the Capitalization Rate or “Cap” Rate. Figure 3: EXAMPLE: CAPITALIZATION “CAP” RATE GRM, however, does not take into account many of the factors that impact the profitability of an income property and so is not used Cap Rate looks at the net income of the property before taxes. To calculate the Cap Rate, first subtract your operating expenses from your gross rents and then divide the sales price by the net (Figure 3). Knowing the sources and amounts of the expenses it takes to operate the property should be considered the bare minimum information when evaluating an income property. In this example, both properties spend $500 per month per unit in operating expenses. Another way of thinking about Cap Rate is that it is an expression COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 26 of how long it will take for the investment to repay your initial capital. In other words if you received all the money you put in back in the first year, your Cap Rate would be 100, or 100%. In this respect, investors familiar with the stock market could equate Cap Rate to a P/E ratio (Price to Earnings ratio). Essentially, a higher Cap Rate is better for buyers and a lower one is better for sellers. In this example (which uses the same terms as the GRM example), Property #2 has a cap rate of 18.23, meaning that it would take us five and a half years to get our initial investment back. Property #1, however, would take a full six years to generate that much income. Since we are looking to buy, this makes Property #2 a more attractive investment. GRM did not include any information about the expenses relating to the property, but the Cap Rate approach shows us that even though Property #2 has $90,000 more in expenses each year (due to more units), the extra income offsets that risk and it continues to be the better choice of the two. Another quick-check method of evaluating rental property is the Cash on Cash Return method (Figure 4). Cash on Cash is calculated by dividing the cash flow (annual income) of the property by how much cash is required to close the deal (in Figure 4: EXAMPLE: CASH ON CASH this case, the down payment). This is sometimes shown as a percentage. The first rule of finance is never run out of cash. In this analysis, investors want to see how much cash outlay is required to complete the purchase in relation to how much cash flow the property generates. It is a method that takes into consideration the time-value of money (ie. cash flow today is worth more than cash flow tomorrow) and the impact of financing on the deal when some of the purchase is made with debt. For instance, let’s say that we again compare Property #1 and Property #2, but this time we add that we intend to pay 30% of the purchase price as a down payment, and finance the remainder. 30% of $3.5 million COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 27 is $1,050,000. With Cash on Cash, the higher the number, the better. The higher Cash on Cash Return shown for Property #2 indicates that for the amount of Cash required, this property generates the greatest amount of cash in return. Cash on Cash Return is limited like GRM in that it does not account for expenses. Its calculation only includes gross revenues, not net income. It also does not distinguish between income and Return of Capital (ROC). Nor does it take into account appreciation, depreciation, or compounding interest which all have the potential to change the desirability of a deal. These analyses all show us results over a single period; in our example that period is one year. However, these investments are typically multiyear with terms adjusting each year for inflation, appreciation, etc. By estimating each of these years, we can apply some more sophisticated investment tools to our analysis. Net Present Value (NPV) analysis is at the center of this type of valuation and essentially accounts for the time value of money. NPV calculates the current value of positive and negative cash flows over a range of periods. For our example, we are using a six-year range with revenues and expenses summed for each year. The formula for calculating NPV looks like this: Figure 5: NET PRESENT VALUE (NPV) FORMULA However, if you have not worked your way through one of these formulas since College (and frankly even if you have), you will find it much easier to use the tools built Figure 6: EXAMPLE: NPV COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 28 into Microsoft Excel, or another spreadsheet program. Using Excel, we can calculate NPV by using the discount rate (also called our Cost of Capital or our Required Rate of Return—this represents how much we might reasonably expect to get as a rate of return on an alternative investment and becomes the factor by which we measure the time value of money), and the before-tax positive and negative cash flows anticipated for each period. In this example (Figure 6), we assumed a 3% inflation factor in both our expenses and our ability to raise the rents. In addition to operating expenses, we included the down payment in year one. Both properties show a positive NPV occurring between year six and seven. At year six, however, only Property #1 has a positive NPV. If we anticipate being in the deal for less than six years, our NPV will be negative, indicating that we won’t be generating the 10% discount rate on the cash outlay. Notice that this analysis shows a higher NPV for Property #1, where the ratio of expenses to income is lower. NPV gives us what we need to calculate our Internal Rate of Return (IRR). Investors are often used to focusing on the IRR in a deal. In our NPV example, we used a 10% discount rate, which yielded a positive NPV over seven years. But, what if we just want to know what the rate of return is at breakeven? Let’s say I have a choice between two investments (in this case the two comparison properties) and I want to know which one is likely to generate the higher return. Or maybe I want to decide whether I should be investing in real estate at all and I am going to compare my returns to those I would expect when buying stocks or treasuries. Figure 7: INTERNAL RATE OF RETURN (IRR) FORMULA The idea with IRR is that you want the Net Present Value (NPV) of all the cash flows to zero out so you have an “apples to apples” comparison. Essentially, you are estimating the chances that one deal will generate returns over another. With IRR we take these cash flows and figures out at what interest rate will you equal your initial investment. The higher the rate, the better the investment. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 29 In fact, investment companies often have an established hurdle rate, which indicates the threshold at which they are willing to invest. Again, my example (Figure 8) uses Excel to calculate IRR based on the same data we used to calculate NPV. Figure 8: EXAMPLE: IRR the Modified Internal Rate of Return (MIRR). Figure 9: EXAMPLE: MODIFIED IRR (MIRR) It is common for investors to reinvest the positive cash flows and plow them back into the investment for the duration of its term. If you intend to follow this practice, you will need to modify the IRR calculation. This new calculation is called, not surprisingly, This example (Figure 9) shows the MIRR. Notice the difference between MIRR and our previous IRR example. Now that Property #2 is able to reinvest its larger cash flows, it is a much more competitive investment in relation to Property #1. It is important to remember that there is a “crystal ball” element to all valuations. We are using tools, each with its inherent limitations, to predict future performance. Predicting the future is impossible. The closest COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 30 we can get is to model the past and establish the most reasonable probability for what is to come. By using multiple analyses, you can increase your chances of seeing the deal from all angles and detecting pitfalls and risk not apparent on the surface. You should obtain your best understanding of what the property’s true current market value (your ARV) is before you decide to submit an offer. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED CONTRACT AND CLOSE Page 31 13. How Much to Offer? If the market will only yield a certain price for any given property, then it stands to reason that the opportunity to increase the margin is in the buying more than in the selling. This makes submitting the right offer the critical step, since the offer is your real opportunity to capture whatever margin is available in the property. Let’s start looking at offers by identifying what can keep you from submitting the right offer. Warren Buffet is quoted as saying, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”15 Disciplining yourself to avoid making emotional decisions that could cost you money starts right from the beginning. As we stated earlier, the reason for the opportunity in distressed real Inexperienced buyers often fall into the trap of becoming “motivated” themselves. estate starts with a motivated seller, the banks. Inexperienced buyers often fall into the trap of becoming “motivated” themselves. They develop an emotional attachment or become enamored with the possibilities that the investment represents. You need to develop the discipline to follow your game plan and be willing to walk away if the deal does not meet the terms you outlined in your profile. Do not waste time trying to justify purchasing a property if the numbers are bad. Develop the habit of setting your emotions aside and evaluating properties objectively. If there is one lesson that will help keep you from getting burned, it is that there is always another deal. Another emotional problem is the reaction to your offer. Realtors and bank sellers may thrash around and flagellate themselves about how offensive your low-ball offer is. You should be prepared to show a rationale why you think the offer makes sense, but also do not get hung up on the emotions across the negotiating table. If you are using a Realtor, make sure he or she is not afraid of submitting a low bid. Their fiduciary obligations state that they MUST submit all offers, but if you sense friction over the amount of your bid, you might as well save yourself COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 32 the brain damage—just get another Realtor. Part of the reason making an offer can be so emotional is that new investors are not used to making these deals, so the first ones have a lot riding on them. If you offer too low, your offer might not be accepted. If you offer too high, you leave profit on the table and potentially expose yourself to greater risk. In our company, we have a fairly sophisticated process for determining what we are willing to offer. The process removes any emotional component and allows us to focus on the specifics of the deal. If a deal has elements that make it more risky, that does not always mean that we will pass, but we expect the price to reflect the increased risk. Banks typically attempt to establish the Fair Market Value (FMV) of their REO properties using what is called a Broker Price Opinion (BPO), which means they have hired a Realtor to tell them what the property is worth. They do this for two reasons. First, they are not skilled at doing this work themselves—paying a fee to the Realtor is a transaction they understand. And, they have an obligation to their shareholders to make their best efforts to protect the cash in the bank. By using a third party Realtor to perform this service, they are covering their base in case anyone questions their efforts. The problem is that the Realtors hired to perform the BPOs are getting paid by the banks. Even though fees for BPOs typically only run from $50 to $150, Realtors often feel an obligation to deliver good news. As a result, they often return optimistic opinions and overvalue these properties. In order to combat this, you need to establish the value yourself and be prepared to justify it to the bank. Your best chance of getting the bank to accept a lower offer is to thoroughly justify your position. Take pictures, find comparables, and do not forget that the market is not static. Values are moving targets. If the market is falling and the BPO was done a couple of months ago, the property could have dropped in value 2-8%, a significant impact on your bottom line. Banks are fickle and they may reject your offer, they may counter your offer, they may reject it and give you an opportunity to counter, or they may accept. You want to take your best shot and provide as much information supporting your offer as you can. Many of my recommendations this far have indicated this, but just COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 33 to underscore the importance, I will say it again. Before making an offer, (especially first-time) investors you ought to make every effort to thoroughly understand the property’s actual value. This means its value to the market, not necessarily its value to you. Unless you want to end up owning the property yourself, you need to know how quickly you can turn it, and that means a sale to someone on the open market. If you first do your homework and spend some “shoe leather” looking at similar homes on the market, you will be much more confident in your bid. Take advantage of terms that may make your offer more attractive such as paying all cash, or emphasizing your capability to close quickly. Develop a systematic method for calculating your bids. For example, a common approach is to start with your ARV, multiply by 70% and subtract your repair costs. This should yield your maximum bid. Use the same process for every deal. If you cannot get the numbers to add up, it is time to pass on the deal. 14. Liens Real property is used to secure many types of obligation—the most common of these is a mortgage. The instrument securing these obligations to the property is called a lien and represents an encumbrance on the title of the property. There are two types of liens: voluntary and involuntary.16 Mortgages are considered voluntary liens because the borrower entered into the mortgage agreement voluntarily. An example of an involuntary lien is a Mechanic’s Lien filed by a contractor for work performed on the property. In customary practice, a lien makes property difficult to sell, because the new owner does not want any dispute over the ownership of the property and title companies do not want to insure titles that have potential claims or “clouds” against them. For example, if we have done our homework, estimated an ARV of $250,000 (assuming 30 DOM), with $25,000 in repairs required, we calculate our bid as follows. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 34 Liens can originate from several sources, and the order or priority in which they have a right to be repaid is called their position. A common way to look at this is a home with a first and second mortgage on it. The first mortgage is in first position on the property. That means that if the lien is foreclosed in order to produce a sale of the property and satisfy the lien, any proceeds from the sale go to the lien in first position initially, then any balance goes to the lien in second position, and so on. Lien holders or lienees, are very concerned about the position of their lien because if the proceeds of a sale are not sufficient to cover all liens with greater priority than theirs, they are left with a debt that is unsecured and therefore virtually uncollectible. Liens can be filed against a property by the government, banks and lenders, contractors (as in my example of Mechanic’s Liens), home owners’ associations (HOAs) and basically anyone who claims an interest in the property. A foreclosure affects liens. For example, liens for property taxes are typically required to be brought current by the seller at closing regardless of the foreclosure (more about these liens in the next section). Mechanic’s liens and subordinate (ie. lower in priority) liens, however, are wiped out in a foreclosure. The mortgage lien itself is typically the subject of the foreclosure and the bank resolves it through the process we are discussing. What you need to watch out for are liens that might penetrate the foreclosure. What you need to watch out for are liens that might penetrate the foreclosure. Liens that persist after you have purchased the property will become your responsibility and could be very problematic. An example of this might be an HOA lien. Properties that are part of an HOA are bound by the Codes, Covenants, and Restrictions (CC&Rs) within the association. These CC&Rs are recorded against the title of all the member properties. HOAs are typically funded by the dues paid by the members—the property owners in the association. When those dues go unpaid, the HOA typically has the right to place a lien on the property. These liens can persist through a COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 35 foreclosure, so you need to discover them before you close. You can find all liens and encumbrances recorded against a property through a title search. 15. Taxes The government always gets its share. Tax liens are always in first position on a property’s title. The same economics that cause borrowers to default on their mortgages can cause them to be delinquent in paying their property taxes. Banks typically protect themselves against this in single-family home mortgages by setting up an escrow account and collecting money for taxes and insurance. However, when borrowers default, money stops going into that account. If the process of foreclosure takes several months or the house has been on the market for some time, money for taxes quickly runs out. Transfer of title often requires that taxes be brought current. The purchase contract will typically address who is responsible for bringing taxes current (customarily the seller). That does not mean that, as the seller, a bank won’t try to pull something over on you. When it comes to who pays the taxes, make sure you know if it is you! Don’t find yourself wiped out at closing when the funds you anticipated as profits get siphoned off to pay taxes. If you are new to investing or property ownership, you may also be new to capital gains taxes. As you anticipate selling an investment property, make sure you consult with an accountant and understand the implications of capital gains taxes on your anticipated returns. Similarly, if you have never owned rental property before, you may not be aware of the tax shelter benefits of depreciating the improvements on income property. Sometimes these tax benefits can be the entire motivation for a buyer. 16. Creating a Holding Company I always recommend that investment properties be purchased in the name of a company created for the purpose of holding the property, rather than personally. This simply requires that you form a company to act as the buyer in the transaction. Your attorney should be able to help you file the necessary paperwork with the Department of Commerce in your state. Why take the extra step and incur the hassle and expense of forming a company for the transaction? I am not an attorney, and of course recommend that you consult with your own COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 36 attorney regarding all of the benefits of forming a company and the various forms that company might take. But essentially, a company provides protection for you from liability. In the worst case, a bad deal could end up in a lawsuit for any number of reasons. By forming a holding company, your risks are generally limited to your exposure in the company. In other words, as an individual you bear unlimited and unseverable personal liability. That means that if you lose a lawsuit over the deal, it is possible that you would not only lose the house you planned to invest in, but you could lose the one you are living in! You could lose not only the dollars you have invested in this deal, but the dollars you have anywhere else as well. A company essentially creates a barrier that limits your liability (in most cases) to what you have in the company. You do not want one bad deal to spread to your other deals that are performing well. 17. Financing The common logic is that REO properties are only available to buyers coming to the table with cash. This is probably a misconception that comes from trustee sales, sheriff sales and auctions, which require a cashier’s check on the spot and the remainder within 24 hours. I am a little wary of discussing alternatives to cash, because cash truly is king. Cash is certainly the strongest position for negotiation, and offers you the best chance to get the most attractive deal. But is just is not true that all foreclosures are sold for cash. Back at the beginning, we recommended that you review your financing strategy as part of your investment profile. When it comes to executing that financing strategy, your goal is to avoid letting your financing become an issue for the seller—the bank. If you can still produce the funds, timely and without excuses, you should be able to execute the sale. Just remember, the banks are motivated by the opportunity to get that money quickly and get it back into their lending pool. They will not be inclined to haggle about your lack of ability to perform. Do not take the risk of both losing a good opportunity and falling out of favor with the banks. Sometimes, you can negotiate with the bank to finance your purchase of an REO they are listing. This is tricky, because you are letting them have some control both sides of the deal, but I have seen buyers successfully negotiate with banks to convert the non-performing REO into a standard, COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 37 performing asset on their books. In the end, the most important factor is that the bank is willing to sell at a price that fits your profile. 18. Negotiating with the Seller and Submitting Your Bid Banks typically have a department responsible for the selling of their REO property. Although each bank is different, this is often the Home Loan Trading Group or the Capital Markets group. I recommend that you always try to contact the lender directly. You want to speak with the head of the Home Loan Trading Department or the department that handles the sale of assets or Asset Management for the bank’s REOs. Explain that you want to view and possibly make an offer on the property. The head of this department is who you want to submit your offer or bid to. The first step is often submitting a “Letter of Intent” or LOI. Your LOI is really just a way to tell the bank that you are interested in the property. It is a placeholder that the bank might use as it decides what to do with its REOs. If the bank knows that you are interested, they may contact you. Otherwise, this step is simply telling the bank that you understand the process. Next, you submit your bid or offer. You should plan on your offer including an Earnest Money of typically 10% of the purchase price (see the next section for more about Earnest Monies) and the bank may require you to prove that you are capable of making the purchase. They do this by requesting Proof of Funds (POF) as a way of shaking out real buyers from the Lookie Lous. One of the challenges investors find is getting banks to deal with them directly. If the bank has listed its REO properties with a real estate broker, they may want to require that contact and offers are made through the Realtor. There is also an industry of “middle men” that you may encounter. They are called intermediaries, seller’s mandates, or seller’s agents, etc. These players are trying to earn a split of the commission on the sale of the properties and claim that they have exclusive authority to represent the seller, even though this is often untrue. As a general rule, make every effort to reach out to the bank, the seller, itself. Intermediaries—even legitimate real estate professionals— just tend to get in the way of getting a deal done. Regardless of its experience in real estate, the bank is skilled at COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 38 negotiation—which means that many times they won’t. If you get to the point that they will accept your offer, and you are negotiating on certain points of the purchase contract (banks often have their attorneys draft their purchase contracts), the bank will be represented by its attorney. You should be prepared for your attorney to negotiate with the bank’s attorney after your offer is submitted, but before the purchase contract is signed. Once you sign, you are on the hook. (Technically, many states have a “buyer’s remorse” grace period in which home purchases can be voided. However, my point remains that you need to know your position going in, before you submit an offer, before you enter any type of negotiations, and definitely before you execute a contract.) The bank’s representatives will not show weakness in their position, even if both of you know it exists. You should be prepared to walk away from a deal, even if the only thing wrong with it is the banker’s attitude. Remember, emotions make for bad deals. Always be willing to walk away. You should also be prepared for the fact that, unlike individual sellers, banks sellers will most often not perform repairs (although some asset managers have done this), or allow contingencies in the purchase contract that depend upon inspection. It is possible to get inspection and repair provisions into the deal, but where this is quite common in the retail market, it is not with REOs. You should expect very little wiggle room. The property will most likely come to you “as-is” so you need to have done your due diligence ahead of time and be fully aware of what you are getting into. Any response contact from the bank after you submit your bid is typically a good sign. The “ignore play” is a favorite among banks and lenders. If you have not successfully made your case that your bid is fair, or (for any of a host of other reasons) your bid does not fit their criteria, you will be flatly rejected, if contacted at all. If you submitted a bid based upon your profile and your understanding of the property’s true value, you have given it your best shot, and still get rejected—better luck next time. Expect this to happen on deals. I do not know anyone who has been in this business a significant length of time who does not have a hefty stack of rejections. If you think you will struggle with that, you might want to reconsider getting into this type of COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 39 investing. Persistence is the name of the game. If your offer is interesting to the bank, you might get a response that sounds something like this, “We are currently considering multiple offers and the running is tight. Please present your ‘highest and best’ offer.” This is a common response whether there are any other offers on the table or not. If you can afford to give a little, that might be all it takes to get the deal. Just remember, that if it does not meet your profile, you are better off to walk away. 19. The REPC My father always told me “your word is your bond and your handshake is a contract, but if you do not get it in writing, it’s worthless.” Legally, all transfers of real property must be in writing. Although property could be sold with a simple bill of sale or even given away with a quit claim deed, the document that typically describes the terms of this transaction is a Real Estate Purchase Contract or REPC. In some states, Realtors are required by law to only use state-approved REPC forms, including state-approved addenda. (Samples of some of these forms are included in the Appendix.) In others, REPCs simply must contain all of the provisions legally required. The REPC will outline the terms of the sale. I always recommend that you retain a skilled and experienced real estate attorney to draft these contracts, along with any addenda, and represent your interests. REPC Provisions: ► Names of Buyer and Seller ► Pr perty Address & Legal o Description ► inancing Terms F ► Property Condition Provisions ► Condition of Title Provisions ► Default Provisions ► Terms of Possession ► Earnest Money Provisions You may initially have an aversion to the cost of hiring an attorney, but I encourage you to develop a good relationship with one particularly skilled in real estate for two reasons: 1. If you are serious about making your living investing in real estate, you ought to consider this an essential role in your team of professional advisors. 2. The financial consequences of legal mistakes can be devastating—a good attorney is like insurance against inexperienced mistakes that can wipe you out. I have COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 40 been in this business a long time, and I would not be without my attorney in any of my deals. You should be familiar with the elements contained in a typical REPC. REPCs will list the buyer and seller, contain a description of the property, include terms relating to financing, condition of the property, condition of title, provisions for default by buyer and seller, terms of possession, and terms regarding Earnest Money. The REPC often also requires disclosures from the seller as to the condition of the property Earnest Money is essentially a deposit, which is refundable under certain conditions and nonrefundable under others. Real Estate Brokers keep a trust account for holding Earnest Monies. It is typical for banks to accept 10% of the purchase price as Earnest Money on REO properties. If your offer is accepted, the bank will probably present you with a REPC that describes the terms as they want them. You should be prepared to thoroughly review this. Do not sign it unless you understand and accept all the terms. In our company, because we make it a practice to submit an extensive due diligence file substantiating the value of our bid, we typically submit offers that include a “Fade” provision. A fade provision means we intend to justify a lower price. The bank does not have to accept the fade, but having it in the contract gives us greater flexibility when it comes to finalizing the contract at a price we want to pay. 20. Closing, Title & Escrow Once you have a REPC signed by both you and the bank, the next step is closing. Closing, or “Settlement” is when the contract is fulfilled and the official transfer of property ownership from the seller to the purchaser takes place. Technically, there can be a few days after signatures are executed in which title can be recorded, financing can still fund, and other details can take place, but for all intents and purposes the sale is completed at closing. Closing itself typically happens at the offices of a title company and often involves a lot of paperwork and a lot of signatures. As an investor, you can prepare for the closing process by understanding what you need to have ready in order to close. Being prepared will make the entire process smoother and less stressful. Surprises that arise at closing are not fun for anyone involved. The following steps are typical. However, keep in mind that real estate COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 41 settlement laws and requirements vary from state to state. Often prior to closing, you will go through a pre-Settlement checklist: You must have your financing lined up. If you are securing a loan as part of your purchase, you must have a Loan Approval in place prior to closing. In fact, the POF may require that you have all of your financing in place earlier in the process than would be required if you were making a traditional purchase instead of buying an REO. If you are financing part of the purchase, your lender will provide you with a Truth-In-Lending statement. The Truth-In-Lending statement outlines the loan repayment terms, including the total cost of the loan if you follow the anticipated repayment schedule, including principal and Pre-Settlement Checklist: ► Financing Commitment ► Truth-In-Lending Statement ► Date, Time and Place Confirmation ► Utilities ► Insurance ► Final Walkthrough ► Settlement Statement (HUD-1) ► Certified Check interest. This is the point in which first-time home buyers are shocked and horrified to learn that their $100,000 home is actually costing them $350,000. Confirm the date, time and place of closing. It is not uncommon for banks to want to close at the offices of the title company where they do most of their business. They have typically negotiated more favorable fees due to the volume of work represented by their account. The confirmation represents agreement between the lender (if any), the title/escrow company, and the buyer and seller. Utilities are sometimes neglected and become an irritation. You should transfer utility accounts into the name of your holding company prior to closing. It is a good idea to reinspect that all utility-impacted systems in the property are working properly as part of your final walkthrough. Remember to get them transferred out of your responsibility after you sell. (We have had many buyers enjoy complimentary power and heating for a few months due to this detail being overlooked. Prepare to have the property insured from the moment you own it. Most lenders will require Homeowners, Hazard & Liability Insurance as a condition of the loan. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 42 Even if you are executing the deal in cash and expect a quick sale, do not take the risk that something could happen to the property during that period. This is simply a commonsense protection of your investment. Know whether or not flood insurance is required. Check out www. floodsmart.gov or other resource to determine if the property is located in a flood plain. Know if flood insurance has been carried on the property before. Typically sellers allow buyers to make a final walkthrough inspection a day or two before closing. This is your last chance to view the property before taking ownership of it. Make sure everything is as you remember it (no new damages). Also, if you made the contract contingent upon certain repairs, make sure the seller actually completed those repairs. Although your Earnest Money could be at risk, if you find problems during the final walkthrough, you are still free to back out of the deal. At least one business day before settlement, you should receive a Settlement Statement (also referred to as a HUD-1 statement). This document will list all the costs you are required to pay at closing. Review it carefully. If you find errors or items you do not understand, bring it up with your real estate agent, attorney or settlement agent. In most cases, you will need to bring a certified check with you to settlement to cover all the closing costs for which you are responsible. The amount of this check is based on the settlement statement. (Be sure to bring a photo ID with you as well. Title companies are typically required to verify the identities of the parties to the transaction.) Assuming all things are in order, at closing, your will be required to sign documents and make payment of your portion of closing costs and title/ escrow fees. If you are getting a loan and have not signed your loan documents prior to closing, you will be required to sign them at closing. These documents represent the agreement between you and your lender regarding the terms and conditions of the mortgage. The remaining documents represent the agreement between you and the seller transferring ownership of the property. Again, be sure to read all documents carefully before signing them, and do not sign forms with blank lines or spaces. Title companies sometimes make jokes about this type of buyer—one who is a “reader”—because most buyers do not take the time to read COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 43 the mountain of paperwork presented to them at closing. You may have felt the same way when you purchased your first home. However, you owe it to yourself to read and understand everything that could potentially impact your investment. After signing all the appropriate documents and paying the closing costs, the title company, escrow agent or attorney will record in the County Recorder’s office all documents such as the warranty and security deeds, return to the lender the completed loan package, and disburse all funds in accordance with the HUD-1 Settlement Statement. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED REHABILITATION Page 44 The nature of REOs often means these properties have taken a beating. In section 9, we discussed how essential it is to be able to estimate rehab costs as part of your due diligence and evaluate which repairs will bring the greatest ROI. In this section, we will discuss more about how to get the work done. One of the cheapest and most valuable things you can add to a property is soap and water. A good cleaning will do wonders. Beyond that, superficial cosmetic repairs and refurbishment (often called “lipstick”) like fresh paint and new carpeting can generate great returns yet keep your costs low. Typically if you need to install carpet or anything more involved, you will need to get outside help; you will need to find a contractor. 21. Finding a Contractor Contractors, like Realtors, run the gamut from trusted professionals to crooks. As a newbie, you cannot afford to choose the wrong one. A good contractor is an indispensable resource for your REO investing. Finding a good contractor requires a little homework. To start with, set up a competitive bidding process, where you request bids (for more complex work, this could be a Contractor Checklist: Request Competitive Bids from Multiple Contractors. Ensure Contractors Provide ► Active License in Good Standing ► Insurance (Bond if Necessary) ► vidence of Good Standing with E BBB & Trade Associations ► Multiple Trade References ► A Clean “Google” Protect Yourself ► ontract for a “Guaranteed C Maximum Price” (GMP) ► stablish a Firm Timeline with E Delay Penalties ► eview the Contract with Your R Attorney ► nsure You Have Included the E Entire Scope of Work ► horoughly Discuss the Process T for Change Orders ► nderstand Your Risk of U Mechanic’s Liens Request for Proposals, or RFP) from multiple contractors on the same scope of work. It is important that you understand and outline the scope of work ahead of time. Scope creep is one of the quickest ways to lose your shirt in real estate investing. Interview contractors like you would your daughter’s prom date. Do not be afraid to probe and ask COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 45 a lot of questions. Watch for signs of dishonesty. Do they look you in the eyes? Do they talk about getting ripped off? Are they complainers? Ask every bidder to go back and sharpen his pencil. It is okay for contractors to make a fair profit, but ensuring that happens is not your responsibility. After you have asked each of your bidders if that is their best price, then review the estimates and begin doing some due diligence on the contractors themselves. General Contractors and subcontractors in most trades are licensed by the state in which they operate. If your state requires a license for the type of work you are getting done, make sure you check with the state and that your contractor has a license and that it is in good standing. Check with the Consumer Protection Agency and the Attorney General’s office in your state to see if any complaints have been filed. Typically, contractors insure themselves up to a certain amount and then are able to take jobs for that amount or less. License and insurance details should be items contractors are showing potential customers all the time. Ask to see them. Depending on the type of work and its value, a bond may be required. Make sure the contractor is properly bonded and that the amount of the bond is appropriate considering the scope of the work. You should also check with the Better Business Bureau. They provide an online search function at www.bbb.org that is localized and lists complaints by consumers. Be sure to search for the name of the contractor and any variations that you are aware of. In addition to the BBB, many trades are organized into labor unions and professional associations. These organizations are usually interested in promoting the good reputation of their organization and distancing themselves from bad publicity. If your contractor is in bad standing with the appropriate trade organization, a telephone call will likely reveal it. Request references for both customers and business trade relationships and follow up on them. Find out what type of experience the contractor delivered to others who have already worked with them. Suppliers, bankers, and general contractors will help you understand the reputation of a particular contractor. Finally, perform an Internet search using Google or another search engine. Watch for entries on sites like Yelp, AngiesList, or RipoffReport COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 46 which specialize in reporting bad consumer experiences. A full vetting of your potential contractors does not guarantee that you will never have a bad experience, but you will have a shot at seeing the writing on the wall and increase your probability that this critical role does not eat up all your profits. In addition to checking up on your contractors, you should plan on adopting some “best practices” approaches to executing your contracts and overseeing the work. The estimates you received during the bidding process and the final contract for work, may be separate documents. When it comes time to execute a contract, you should let your attorney review it and you should ensure that the terms of the deal have not changed. In the end, the contract, not the estimate, will govern how much you have to pay. Whenever possible, contract for an explicit scope of work under a Guaranteed Maximum Price (GMP) contract.17 By using a GMP contract, the contractor takes responsibility for cost overruns beyond the agreed upon maximum price. This does two things. First, you have some legal protection from creeping costs. Second, the contractor has an incentive to bid thoroughly and notice potential overruns up front, before work begins. Another factor you should consider is time. Delays are notorious and costly for REO investors. Establish a time for completion in your contract, and appropriate penalties for delays. Contract work which improves real property generally gives the contractor the right to place a Mechanic’s Lien on the property as security for payment. I recommend you have your attorney draft a lien release form. Every time you pay a contractor, you should require them to sign the form. This is essentially a receipt for what you paid for and a protection against future title problems. I have seen cases where contractors filed liens but were slow to have them removed even after receiving payment and resolving any dispute. A signed lien release is often enough for you to secure a release of the lien yourself. If you pay a contractor in installments (typical only when the job is large or lengthy), I recommend your contract withhold 10-20% until the final payment. And final payments should only be made after you perform a thorough inspection, verify that all punch-list items are completed, receive signed lien- COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 47 releases, and the job is complete to your satisfaction. Remember that your leverage to get the work completed is a function of how much money you still hold. In my experience, it is always more difficult to get repairs or punch-list items completed if you have already made full payment. Frequently inspect the progress along the way and do not be afraid to ask questions if something seems wrong. The relationship with your contractor has an element of trust in it, just like any other relationship. But, trust is developed over time. Initially, a lot of checkup might seem annoying to your contractor, but then again it is not the contractor that will lose money if the deal does not go according to plan. Rehab on REO properties has the potential to bring greater returns because of its impact on perceived value. It is an overall impression that leads to the sale, not the accumulation of repair costs. If your repairs do not add to the perceived value, then they are not helping your investment returns, no matter what they cost. 22. What you should or shouldn’t do yourself Often new investors look at rehab and repair work as an opportunity to gain value by doing work themselves. They think that their sweat equity will increase the margins they get when the property sells, because the work “did not cost them anything.” While this is sometimes true, especially if the investor has a background as a contractor or tradesperson, it is also a common pitfall. Work you perform yourself is not really free. Setting aside the time you spend (which has an opportunity cost if it takes away from the time you would be spending finding the next deal), repairs have costs in materials. Are you sure that your trip to Home Depot will cost you less than a contractor’s visit to the local contractor supply yard? Do you have access to the proper equipment to ensure the job is done correctly? Are you tackling work that has related liability, like plumbing or electrical work, for which a contractor will be licensed and insured? In general, I recommend that beyond cleaning, very minor repairs, and perhaps painting, investors not COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED EXIT Page 48 perform work themselves unless they are true professionals at the type of work that needs to be done. This might require a little soul searching as you examine yourself and honestly reflect on your capabilities. Just remember that it is always cheapest to do a job once and do it right. The disposition of the property is how you get paid. All of the work you have done nurturing the investment to this point rests on your ability to exit the investment with your returns intact. Our discussion will include four typical dispositions. The first two are the least common for investors, Lease to Own, and Owner Occupancy. Then, I will cover selling and holding as income property. 23. Lease to Own (Seller Financed) Typically an investor mentality would perceive seller financing as a less than optimal exit. The reason for this is that seller financing is usually a way to create incentives for buyers who are unwilling or unable to complete a sale. If buyers are plentiful, a quick sale is preferred. Seller financing protracts the relationship between the buyer and the seller, which increases the risk. It does not yield the full return, which also creates risk and limits your opportunities to reinvest. If rental property is not your primary focus, you are now in the position of acting as a short-term landlord with full property management responsibilities. In other words, you have a new job, which will intrude into whatever your primary focus is. Even with all of the increased headache and risk, this still may be preferable to owning a property you want to sell and nobody wants to buy. Lease payments may offset or completely cover payments you are obliged to make if you financed the purchase of the property or any of the rehab work. 24. Owner Occupancy A perfectly legitimate exit strategy is owner occupancy. This means you choose to move into and live in the house yourself. As the owner, you may feel that “sweat equity” you put into the property is a good trade-off for the reduced price. Owner occupancy has limitations in terms of its investment characteristics. Discussion around this exit is limited because owner occupancy is not typically an investing or primarily moneymaking disposition of the property. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 49 25. Sale The simplest exit is a sale. In a single transaction, a buyer takes the property off your hands and your investment cashes out immediately. You always have the option of selling your property by yourself in a “For Sale by Owner” or FSBO transaction. It is worth discussing the pros and cons of a FSBO versus hiring a Realtor. The advantages of a FSBO approach are that you do not have to pay any fees to Realtors (you should still expect to have some selling costs, advertising, open houses, etc.). The disadvantages are that you do not have access to all the same tools Realtors use and you may have less expertise selling real estate. This decision requires a little introspection and honest self-assessment of your talents and abilities. Your advertising will attract as many bottom-feeding Realtors as it does prospective buyers (good Realtors get their listings by referrals from satisfied clients, not combing the classifieds). Selling the property yourself, you will still have Realtors coming to you claiming to represent buyers. These will want you to agree to pay them a commission before introducing their buyers to you. What if you decide to use a real estate broker? A Realtor can be invaluable. Unfortunately, as a group, their reputation ranks close to used car salesmen. So, how do you find a good one? Think of your relationship with your realtor like you would any other essential service provider in your life. Did you find your attorney or your doctor by where they ranked in the yellow pages? You need to do your homework. Talk to their clients and colleagues. Ask them about their track record and request examples of other properties like yours that they have sold in the area. Ask about their certifications and additional credentials. You also need to understand the legal relationship you have with your Realtor. Realtors actually practice law in a limited and heavily regulated way. They have a fiduciary responsibility to represent your interests. Do not abdicate your position as the buyer or seller. Remember that your Realtor works for you, so do not be pressured into a quick sale if you do not think you are getting the best deal. Make sure you understand the terms of any contract you sign. (It would be remiss for me not to recommend that you engage the services of a qualified attorney in COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 50 addition to your Realtor for the purposes of reviewing contracts.) Remember that even though a Realtor is required by law to use stateapproved forms when making offers on your behalf—forms which are construed to alleviate the burden on the state courts from lawsuits over real estate transactions—that you are not restricted to structuring your transaction with the language or terms included on state-approved forms. Write a deal that favors you. Know when it is time to fire your Realtor. Make sure your expectations are clear and take decisive action if they are not met. 26. Income Property Another common disposition of investment property is to rent it as income property. What is not to like about the perpetual stream of income that grows with inflation while providing a significant tax advantage? Well, for starters, income properties are more like businesses than investments. They need to be managed; they to be run for them to make money. You need to ask yourself if you are ready to be a landlord. Have you projected detailed financial models for how this business will operate? Do you know what your costs will be? Do you know what the market rents are in your area? Do you have a concept for creating a competitive advantage over other rental properties? Do you have a plan for performing the maintenance and repairs that tenants will expect? Are you comfortable collecting rent and processing evictions and collections? Rent a copy of Pacific Heights from NetFlix or Blockbuster to test your stomach for the risks of being a landlord. I am not looking to discourage you from taking on this challenge—income property can be a very rewarding and profitable investment—just keeping with the theme of helping you go into these deals with your eyes open. If the thought of being a landlord is scary to you, but the income property returns are attractive, you may want to consider hiring a professional manager or management company. This service is not free, but you may be able to find a scenario where professional management is well worth the cost and avoided COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED CONCLUSION Page 51 headaches and still lets you participate in the investment returns. Our company holds several income properties as investments— enough so that we formed our own property management company. When it comes to this type of skill set, my experience is that specialists often can outperform generalists and do it in a way that makes the associated costs very affordable. Distressed property investing can be a dynamic and exhilarating process. Many investors have been very successful working the process outlined in this book to generate very healthy returns. I am sincere in saying that shortening the reset of the bloated real estate market depends on facilitating the transfer of foreclosures back into a “fair valued” market. The volume of those transfers will be the bottleneck for much of the desperately needed economic recovery. The market is offering every indication that foreclosures and the attendant opportunities are on the rise and will be with us for at least the next several years. In fact, a recent report18 indicated that about 11% of mortgages in the U.S. are in trouble—which represents a seasonally adjusted increase of 3% over last year (2008). The 11% represents 7.9% of mortgages that are 30 days or more past due, and 3.3% which are already in the process of foreclosure. This is the highest level since these statistics began to be tracked almost 40 years ago. Like many types of investing, there is a distinct risk and reward correlation when it comes to investing in distressed property. I have made every effort to help you get a realistic perspective of both the challenges and rewards of tackling this exciting facet of real estate investing. The saying goes, a fool and his money are soon parted. I hope that the tools provided here will help you to “become wise before you get old.” Or, in more practical terms, I hope that this material will help you to avoid the pitfalls and traps that can turn a promising career investing in real estate into a nightmare that wreaks havoc with your life. To those of you ready to tackle the challenges, face the risks, and show your determination, I invite you to join the ranks of successful investors who are filling their role in getting the economy back on track. If you are hesitant, or question your ability to overcome all the risks involved (and rightly so), but still have the enthusiasm for the process that brought you this far—find a COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Page 52 way to participate. You may find that partnering with a company like mine (please excuse the shameless plug here) offers you the ability to capture some of the money to be made in this market without necessarily taking on all of the risk by yourself. If not my company, than someone else’s, but in any case, there is plenty of room for more well-prepared people to be involved. If you have read everything this far, thank you for spending your valuable time. The appendix offers many great resources to help you get started. I wish you good luck and greater prosperity as you dive in to the next chapter of your life.  COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED ABOUT THE AUTHOR Kirby Cochran is the manager of Castle Arch Opportunity Partners, a series of real estate investment funds specializing in REO acquisition and disposition. Responsible for hundreds of millions of dollars worth of real estate transactions, he has served as the CEO of Castle Arch Real Estate Investment Company for over 5 years. Mr. Cochran is also an educator, speaker and thought leader in the fields of management, finance, and real estate and is a leading expert on capital structure and shareholder value. He has been teaching new venture financing and entrepreneurship to graduate students for over a decade. Kirby currently serves as an adjunct professor in the Finance department of the David Eccles School of Business at the University of Utah. In his new series of articles entitled Leadership Insight, Mr. Cochran makes sophisticated investment methodologies used by successful investors, accessible to novice and intermediate investors with his pragmatic approach to communicating in plain English. This information has always been difficult and painful for investors to acquire, found only in the ruthless university of experience and obtained through costly tuition at the school of hard knocks. ACKNOWLEDGEMENTS Chad Jardine, my close associate and friend, was responsible for much of the leg work and physical writing of this book. His contribution allowed the principles and practices of my real estate investing process to come to life in book form and bring my insights, personal experiences and unique “voice” to a new audience via the printed page. COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED 1. Freeby50. More on Historical Home Appreciation. http://freeby50.blogspot.com/2008/05/ more-onhistorical-home-appreciation.html 2. Wikipedia. McMansions. 2009. http://en.wikipedia.org/wiki/McMansion 3. The Boston Globe. Online. Forgotten in Foreclosure, Renters Forced to Live in Decaying Homes. 2008. http://www.boston.com/business/articles/2009/02/03/forgotten_in_ foreclosures_renters_forced_to_live_in_decaying_homes/ 4. Milwaukee Rising Weblog. 2008. http://milwaukeerising.net/wordpress/2008/12/29/city-tagslenders-with-property-upkeep-duties/ 5. AARP Bulletin. 2009. Foreclosures Open Door to Disorder: Vermin, Crooks, Exploit Housing Market Crisis. http://bulletin.aarp.org/yourmoney/personalfinance/articles/foreclosures_open. html 6. Bigger Pockets. How to Find Foreclosure and Pre-Foreclosure Listings. 2009. www. biggerpockets.com/renewsblog/2006/09/01/how-to-find-foreclosure-and-pre-foreclosurelistings/ 7. Nolo. Lis Pendens. 2009. http://www.nolo.com/definition.cfm/term/BDA664CA-D50E-468E90A891295A1D404C 8. Note: web links to government foreclosed properties can be found at http://www. biggerpockets.com/government-owned-property.html 9. Mortgage News Daily. 2009. www.mortgagenewsdaily.com/wiki/REO_Database_List.asp 10. Bigger Pockets. Foreclosed Property Management. 2009. http://www.biggerpockets.com/ foreclosed_property_management.html 11. Bigger Pockets. How to Find Foreclosure and Pre-Foreclosure Listings. 2009. www. biggerpockets.com/renewsblog/2006/09/01/how-to-find-foreclosure-and-pre-foreclosurelistings/ 12. Bigger Pockets. Foreclosed Property Management. 2009. http://www.biggerpockets.com/ foreclosed_property_management.html 13. National Institute of Building Inspectors. 2009. http://www.nibi.com/ 14. Wikipedia. Gross Rent Multiplier. 2009. http://en.wikipedia.org/wiki/Gross_Rent_Multiplier 15. Morningstar. Investing Classroom: Stocks 400. 2005. http://news.morningstar.com/ classroom2/course.asp?docId=145104&page=1&CN=COM 16. Orlando, Frankie, and Marsha Ford. 2007. The Complete Guide to Locating, Negotiating, and Buying Real Estate Foreclosures: What Smart Investors Need to Know—Explained Simply. P. 45 17. Business Dictionary. Guaranteed Maximum Price. 2009. http://www.businessdictionary.com/ definition/guaranteed-maximum-price-GMP.html 18. Hagerty, James R. 2009. Overdue Mortgages Increase. The Wall Street Journal. March 6, 2009. http://online.wsj.com/article/SB123630052006746901.html COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED APPENDIX BANK & LENDER REO WEBSITES Note: Several of the major lenders are in the process of being acquired by other banks. For example, Washington Mutual is now part of JP Morgan Chase and Wachovia is part of Wells Fargo. This sector is changing so fast, we cannot claim that this list will be perpetually up to date, and you may need to do some research as entities change, restructure and enter the market. 21st Mortgage Corporation www.21stmortgage.com/web/21stSite.nsf/locating?OpenForm American Home Mortgage re.oomc.com/staticBroker/reProperties.jsp Search Criteria: State, Zip Code, Price Search Criteria: State, City, Zip, Price, Bedrooms, Bathrooms, Property Type Bank Of America bankofamerica.reo.com/search/ Search Criteria: Property Type, County, City, Price, Bedrooms, Baths, and Zip Code BB&T www.bbt.com/bbt/applications/specialassets/search.asp Search Criteria: State, City, County, Price Compass Bank www.compassbank.com/appforms/properties/index.jsp Search Criteria: State, Property Type Price Range Countrywide www.countrywide.com/purchase/f_reo.asp Search Criteria: State and City Downey Savings (Acquired by US Bank) www.downeysavings.com/bank-owned-properties Search Criteria: State, County, City, Property Type, Price, Bedrooms, Bathrooms GRP Capital www.grpcapital.com/properties/index.php Search Criteria: State, City, Zip, Price, Agent, Status COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED HSBC www.us.hsbc.com/1/2/3/personal/home-loans/properties Search Criteria: State IndyMac Bank http://apps.indymacbank.com/individuals/realestate/search.asp Integrated Asset Services www.iasreo.com/homesforsale.aspx Search Criteria: State, Bedrooms, Baths, Price Search Criteria: Property Type, City, State, Zip, Price, Bedrooms, Bathrooms JP Morgan Chase mortgage.chase.com/pages/other/co_properties_landing.jsp Search Criteria: State, County, City, Zip M&T Bank (Merging with Provident Bankshares Corporation) http://services.mandtbank.com/personal/mortgage/reomort.cfm Search Criteria: State, City, Price Ocwen Financial REO www.ocwen.com/reo/home.cfm Search Criteria: State, City, Bedrooms, Baths, Square Footage, Price, Property Type Regions Financial Corporation http://realestate.regions.com/servlet/Ore/ForeclosedPropertySearch.jsp Search Criteria: State, City, Property type Taylor Bean www.taylorbeanhomes.com/ Search Criteria: State, City, Zip, County, Price, Bedrooms, Baths, Property type US Bank www.usbankforeclosures.com/ Search Criteria: State, County, Status, Listing Type, City Zip, Bedrooms, Baths, Price COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Wachovia (Acquired by Wells Fargo) reo.wachovia.com Search Criteria: State, City, Zip, County, Bedrooms, Baths, Price, Property type Washington Mutual (Acquired by JP Morgan Chase) www.wamuproperties.com/ Search Criteria: State, City, Zip, Type of property, Bedrooms, Baths, Price Wells Fargo www.pasreo.com/pasreo/public/propertySearch.do Search Criteria: State, City, Zip, County, Bedrooms, Bathrooms, Price COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED GOVERNMENT WEBSITES Fannie Mae reosearch.fanniemae.com/research Search Criteria: State, City, Zip, Price, Bedrooms, Baths Freddie Mac www.homesteps.com/hm01_1featuresearch.htm Search Criteria: State, City, Zip, County, Price, Rooms, Bedrooms, Bathrooms Freddie Mac Appraisal Form: www.freddiemac.com/sell/forms/pdf/70.pdf GovernmentHousing.US governmenthousing.us Search Criteria: State, County, City, Zip Homeowners Assistance Program www.sas.usace.army.mil/hapinv/haphomes.htm Homesales.gov www.homesales.gov Search Criteria: State, Property type U.S. Department of Housing and Urban Development www.hud.gov/ Search Criteria: State United States Marshal Services www.treas.gov/auctions/treasury/rp/ U.S. Department of the Treasury www.treas.gov/auctions/treasury/rp/ Auction schedules for subject properties Sorted by State also includes other personal property Internal Service: www.treas.gov/auctions/irs/cat_Real7.htm Properties are listed in order of State then City COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED VA Homes for Sale https://va.reotrans.com/index.cfm? Search Criteria: State, City, Zip, Bedrooms, Bathrooms, Price, COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED ASSET MANAGEMENT COMPANIES Corporate Asset Management, LLC www.camreo.com Search Criteria: Zip, Bedrooms, Baths, Property Type Grasha Real Estate www.grasha.com/html/reo.lasso?-search=REO Keystone Asset Management www.keystonebest.com/ LAMCO www.lendersreo.com/listings.aspx Search Criteria: State, City, Price, property type Mortgage Lenders Network USA mlnusa.com OakTree Reo Asset Management www.gotooaktree.com/ASSET_20_MANAGEMENT.html Search Criteria: City, County, Bedrooms, Baths, Property Type TREO www.treonet.com/ TriMont Real Estate trimontrea.com/html/properties/properties_for_sale.asp COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED ADDITIONAL FINDING RESOURCES Bid 4 Assets www.bid4assets.com/ Properties are listed by property type and when auction is closing Buy Bank Homes www.buybankhomes.com Search Criteria: State, City, Zip, County Default Research Inc www.defaultresearch.com/ Listings available for purchase Foreclosurenet.net www.foreclosurenet.net/ Search Criteria: State, Zip Foreclosure.com www.foreclosure.com/ Search Criteria: State, Zip Foreclosures.com www.foreclosures.com/ Search Criteria: State, County, Zip Hudson and Marshall www.hudsonandmarshall.com/AuctionSchedule.aspx Search Criteria: State, City, Zip Realtor.com www.realtor.com/FindHome/default.asp?mode=Map Realty Trac www.realtytrac.com Search Criteria: State, City, Zip COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED SAMPLE HOME INSPECTION CHECKLIST 1. Roofing Roofing material Flashings Plumbing Stacks Ventilation Covers Rain Gutters/Eavestroughs Downspouts/Roof Drains Fascia/Soffits Chimneys 2. Exterior Elements Siding (Brick, Vinyl, Aluminum, Stucco, Stone, Composite, Other) Windows Entry Doors Stairs/Stoops Porch(es) Deck(s) Railings Electrical Outlets 3. Site Elements Patios Walkways Driveways Retaining Walls Window Wells Ground Slope at Foundation Site Grading Irrigation Systems 4. Garage(s) Roofing Floor Slab Foundation Attic Ventilation Walls/Ceilings Siding Vehicle Doors Door Operators Electrical House/Service Doors 5. Attics Roof Framing Roof Deck/Sheathing Ventilation Provisions Insulation 6. Bathroom(s) Sink(s) Toilet Bathtub Shower Surround/Enclosure Flooring Walls/Ceiling Ventilator Electrical/GFCI 7. Kitchen Plumbing/Sink Floor Walls/Ceiling Electrical/GFCI Oven Range Dishwasher Disposal COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED Ventilator Cabinetry Countertops Refrigerator 8. Interior Elements Ceilings Walls Floors Stairs Railings Windows Room Doors Slider/Patio Doors Smoke/CO Detectors Fireplaces 9. Foundation/Substructure Foundation Walls Floor Framing Basement Floor Slab Stairs/Railings 10. Foundation Area Water Penetration Exterior Features/Water Intrusion Factors Interior Conditions/Signs of Water Intrusion 11. Electric System Service/Entrance Line Grounding Provisions Main Disconnect(s) Distribution Panel Source: HouseMaster Home Inspections Devices Wiring/Conductors GFCI Test 12. Cooling System Outdoor Units Indoor Blower/Fan Condensation Provisions Thermostat(s) 13. Heating System Heating Unit Burner Fuel Line at Unit Combustion Air Provisions Vent Connector Blower Thermostat(s) 14. Plumbing System Water Supply Piping Water Flow at Fixtures Drain/Waste Piping Fixture Drainage Exterior Faucet(s) Gas Piping 15. Hot Water Piping Water Heater Vent Connector Gas/Fuel Lines at Unit Safety Valve Provisions COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED SAMPLE REPC STATE OF UTAH REAL ESTATE PURCHASE CONTRACT This is a legally binding Real Estate Purchase Contract (“REPC”). Utah law requires real estate licensees to use this form. Buyer and Seller, however, may agree to alter or delete its provisions or to use a different form. If you desire legal or tax advice, consult your attorney or tax advisor. OFFER TO PURCHASE AND EARNEST MONEY DEPOSIT On this _____ day of ____________, 20____ (“Offer Reference Date”) (“Buyer”) offers to purchase from __________________________________________ (“Seller”) the Property described below and [ ] delivers to the Buyer’s Brokerage with this offer, or [ ] agrees to deliver no later than four (4) calendar days after Acceptance (as defined in Section 23), Earnest Money in the amount of $_______________ in the form of___________________________________. After Acceptance of the REPC by Buyer and Seller, and receipt of the Earnest Money by the Brokerage, the Brokerage shall have four (4) calendar days in which to deposit the Earnest Money into the Brokerage Real Estate Trust Account. Buyer’s Brokerage ___________________________________________ Phone:_________________________________ Received by: (Signature above acknowledges receipt of Earnest Money) on (Date) 1. PROPERTY: also described as: OTHER PROVISIONS , County of , State of Utah, Zip ___________ (the "Property"). City of Any reference below to the term “Property” shall include the Property described above, together with the Included Items and water rights/water shares, if any, referenced in Sections 1.1, 1.2 and 1.4. 1.1 Included Items. Unless excluded herein, this sale includes the following items if presently owned and in place on the Property: plumbing, heating, air conditioning fixtures and equipment; ovens, ranges and hoods; cook tops; dishwashers; ceiling fans; water heaters; light fixtures and bulbs; bathroom fixtures and bathroom mirrors; curtains, draperies, rods, window blinds and shutters; window and door screens; storm doors and windows; awnings; satellite dishes; affixed carpets; automatic garage door openers and accompanying transmitters; security system; fencing and any landscaping. 1.2 Other Included Items. The following items that are presently owned and in place on the Property have been left for the convenience of the parties and are also included in this sale (check applicable box): [ ] washers [ ] dryers [ ] refrigerators [ ] water softeners [ ] microwave ovens [ ] other (specify)________________________________ __________________________________________________________________________________________________ The above checked items shall be conveyed to Buyer under separate bill of sale with warranties as to title. 1.3 Excluded Items. The following items are excluded from this sale: _____________________________________ __________________________________________________________________________________________________ 1.4 Water Service. The Purchase Price for the Property shall include all water rights/water shares, if any, that are the legal source for Seller’s current culinary water service and irrigation water service, if any, to the Property. The water rights/water shares will be conveyed or otherwise transferred to Buyer at Closing by applicable deed or legal instruments. The following water rights/water shares, if applicable, are specifically excluded from this sale: ________________________ __________________________________________________________________________________________________ 2. PURCHASE PRICE. The Purchase Price for the Property is $ ____________________. Except as provided in this Section, the Purchase Price shall be paid as provided in Sections 2(a) through 2(d) below. Any amounts shown in 2(b) and 2(d) may be adjusted as deemed necessary by Buyer and the Lender. $ $ $________________ $ $ (a) Earnest Money Deposit. Under certain conditions described in the REPC, this deposit may become totally non refundable. (b) New Loan. Buyer may apply for mortgage loan financing (the “Loan”) on terms acceptable to Buyer: If an FHA/VA loan applies, see attached FHA/VA Loan Addendum. (c) Seller Financing (see attached Seller Financing Addendum) (d) Balance of Purchase Price in Cash at Settlement PURCHASE PRICE. Total of lines (a) through (d) Page 1 of 6 pages Buyer’s Initials ________ Date Seller’s Initials ________ Date COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED 3. SETTLEMENT AND CLOSING. 3.1 Settlement. Settlement shall take place no later than the Settlement Deadline referenced in Section 24(d), or as otherwise mutually agreed by Buyer and Seller in writing. “Settlement" shall occur only when all of the following have been completed: (a) Buyer and Seller have signed and delivered to each other or to the escrow/closing office all documents required by the REPC, by the Lender, by the title insurance and escrow/closing offices, by written escrow instructions (including any split closing instructions, if applicable), or by applicable law; (b) any monies required to be paid by Buyer or Seller under these documents (except for the proceeds of any new loan) have been delivered by Buyer or Seller to the other party, or to the escrow/closing office, in the form of cash, wire transfer, cashier’s check, or other form acceptable to the escrow/closing office. 3.2 Prorations. All prorations, including, but not limited to, homeowner’s association dues, property taxes for the current year, rents, and interest on assumed obligations, if any, shall be made as of the Settlement Deadline referenced in Section 24(d), unless otherwise agreed to in writing by the parties. Such writing could include the settlement statement. The provisions of this Section 3.2 shall survive Closing. 3.3 Special Assessments. Any assessments for capital improvements as approved by the HOA (pursuant to HOA governing documents) or as assessed by a municipality or special improvement district, prior to the Settlement Deadline ____ shall be paid for by: [ ] Seller [ ] Buyer [ ] Split Equally Between Buyer and Seller [ ] Other (explain) _ _____ __. The provisions of this Section 3.3 shall survive Closing. 3.4 Fees/Costs/Payment Obligations. Unless otherwise agreed to in writing, Seller and Buyer shall each pay onehalf (1/2) of the fee charged by the escrow/closing office for its services in the settlement/closing process. Tenant deposits (including, but not limited to, security deposits, cleaning deposits and prepaid rents) shall be paid or credited by Seller to Buyer at Settlement. Buyer agrees to be responsible for homeowners’ association and private and public utility service transfer fees, if any, and all utilities and other services provided to the Property after the Settlement Deadline. The escrow/closing office is authorized and directed to withhold from Seller’s proceeds at Closing, sufficient funds to pay off on Seller’s behalf all mortgages, trust deeds, judgments, mechanic's liens, tax liens and warrants. The provisions of this Section 3.4 shall survive Closing. 3.5 Closing. For purposes of the REPC, “Closing” means that: (a) Settlement has been completed; (b) the proceeds of any new loan have been delivered by the Lender to Seller or to the escrow/closing office; and (c) the applicable Closing documents have been recorded in the office of the county recorder. The actions described in 3.5 (b) and (c) shall be completed within four calendar days after Settlement. 4. POSSESSION. Seller shall deliver physical possession of the Property to Buyer as follows: [ ] Upon Closing; Calendar Days after Closing. Any contracted rental of the Property prior to or after [ ] ___Hours after Closing; [ ] Closing, between Buyer and Seller, shall be by separate written agreement. Seller and Buyer shall each be responsible for any insurance coverage each party deems necessary for the Property including any personal property and belongings. Seller agrees to deliver the Property to Buyer in broom-clean condition and free of debris and personal belongings. Any Seller or tenant moving-related damage to the Property shall be repaired at Seller's expense. The provisions of this Section 4 shall survive Closing. 5. CONFIRMATION OF AGENCY DISCLOSURE. Buyer and Seller acknowledge prior written receipt of agency disclosure provided by their respective agent that has disclosed the agency relationships confirmed below. At the signing of the REPC: , represents [ ] Seller [ ] both Buyer and Seller as a Limited Agent; Seller’s Agent Seller’s Brokerage Buyer’s Agent Buyer’s Brokerage 6. , represents [ ] Seller [ ] both Buyer and Seller as a Limited Agent; , represents [ ] Buyer [ ] both Buyer and Seller as a Limited Agent; , represents [ ] Buyer [ ] both Buyer and Seller as a Limited Agent. TITLE & TITLE INSURANCE. 6.1 Title to Property. Seller represents that Seller has fee title to the Property and will convey marketable title to the Property to Buyer at Closing by general warranty deed. Buyer does agree to accept title to the Property subject to the contents of the Commitment for Title Insurance (the “Commitment”) provided by Seller under Section 7, and as reviewed and approved by Buyer under Section 8. Buyer also agrees to accept title to the Property subject to any existing leases, rental and property management agreements affecting the Property not expiring prior to Closing which were provided to Buyer pursuant to Section 7(e). The provisions of this Section 6.1 shall survive Closing. 6.2 Title Insurance. At Settlement, Seller agrees to pay for and cause to be issued in favor of Buyer, through the title insurance agency that issued the Commitment (the “Issuing Agent”), the most current version of the ALTA Homeowner’s Policy of Title Insurance (the “Homeowner’s Policy”). If the Homeowner’s Policy is not available through the Issuing Agent, Buyer and Seller further agree as follows: (a) Seller agrees to pay for the Homeowner’s Policy if available Page 2 of 6 pages Buyer’s Initials ________ Date Seller’s Initials ________ Date COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED through any other title insurance agency selected by Buyer; (b) if the Homeowner’s Policy is not available either through the Issuing Agent or any other title insurance agency, then Seller agrees to pay for, and Buyer agrees to accept, the most current available version of an ALTA Owner’s Policy of Title Insurance (“Standard Coverage Owner’s Policy”) available through the Issuing Agent. 7. SELLER DISCLOSURES. No later than the Seller Disclosure Deadline referenced in Section 24(a), Seller shall provide to Buyer the following documents in hard copy or electronic format which are collectively referred to as the "Seller Disclosures": (a) a written Seller property condition disclosure for the Property, completed, signed and dated by Seller as provided in Section10.3; (b) a Commitment for Title Insurance as referenced in Section 6; (c) a copy of any restrictive covenants (CC&R’s), rules and regulations affecting the Property; (d) a copy of the most recent minutes, budget and financial statement for the homeowners’ association, if any; (e) a copy of any lease, rental, and property management agreements affecting the Property not expiring prior to Closing; (f) evidence of any water rights and/or water shares referenced in Section 1.4; (g) written notice of any claims and/or conditions known to Seller relating to environmental problems and building or zoning code violations; and ____________ ______ (h) Other (specify) 8. BUYER’S CONDITIONS OF PURCHASE. 8.1 DUE DILIGENCE CONDITION. Buyer's obligation to purchase the Property: [ ] IS [ ] IS NOT conditioned upon Buyer’s Due Diligence as defined in this Section 8.1(a) below. This condition is referred to as the “Due Diligence Condition.” If checked in the affirmative, Sections 8.1(a) through 8.1(c) apply; otherwise they do not. (a) Due Diligence Items. Buyer’s Due Diligence shall consist of Buyer’s review and approval of the contents of the Seller Disclosures referenced in Section 7, and any other tests, evaluations and verifications of the Property deemed necessary or appropriate by Buyer, such as: the physical condition of the Property; the existence of any hazardous substances, environmental issues or geologic conditions; the square footage or acreage of the land and/or improvements; the condition of the roof, walls, and foundation; the condition of the plumbing, electrical, mechanical, heating and air conditioning systems and fixtures; the condition of all appliances; the costs and availability of homeowners’ insurance and flood insurance, if applicable; water source, availability and quality; the location of property lines; regulatory use restrictions or violations; fees for services such as HOA dues, municipal services, and utility costs; convicted sex offenders residing in proximity to the Property; and any other matters deemed material to Buyer in making a decision to purchase the Property. Unless otherwise provided in the REPC, all of Buyer’s Due Diligence shall be paid for by Buyer and shall be conducted by individuals or entities of Buyer's choice. Seller agrees to cooperate with Buyer’s Due Diligence. Buyer agrees to pay for any damage to the Property resulting from any such inspections or tests during the Due Diligence. (b) Buyer’s Right to Cancel or Resolve Objections. If Buyer determines, in Buyer’s sole discretion, that the results of the Due Diligence are unacceptable, Buyer may either: (i) no later than the Due Diligence Deadline referenced in Section 24(b), cancel the REPC by providing written notice to Seller, whereupon the Earnest Money Deposit shall be released to Buyer without the requirement of further written authorization from Seller; or (ii) no later than the Due Diligence Deadline referenced in Section 24(b), resolve in writing with Seller any objections Buyer has arising from Buyer’s Due Diligence. (c) Failure to Cancel or Resolve Objections. If Buyer fails to cancel the REPC or fails to resolve in writing any objections Buyer has arising from Buyer’s Due Diligence, as provided in Section 8.1(b), Buyer shall be deemed to have waived the Due Diligence Condition. 8.2 APPRAISAL CONDITION. Buyer's obligation to purchase the Property: [ ] IS [ ] IS NOT conditioned upon the Property appraising for not less than the Purchase Price. This condition is referred to as the “Appraisal Condition.” If checked in the affirmative, Sections 8.2(a) and 8.2(b) apply; otherwise they do not. (a) Buyer’s Right to Cancel. If after completion of an appraisal by a licensed appraiser, Buyer receives written notice from the Lender or the appraiser that the Property has appraised for less than the Purchase Price (a “Notice of Appraised Value”), Buyer may cancel the REPC by providing written notice to Seller (with a copy of the Notice of Appraised Value) no later than the Financing & Appraisal Deadline referenced in Section 24(c); whereupon the Earnest Money Deposit shall be released to Buyer without the requirement of further written authorization from Seller. (b) Failure to Cancel. If the REPC is not cancelled as provided in this section 8.2, Buyer shall be deemed to have waived the Appraisal Condition. 8.3 FINANCING CONDITION. Buyer’s obligation to purchase the property: [ ] IS [ ] IS NOT conditioned upon Buyer obtaining the Loan referenced in Section 2(b). This condition is referred to as the “Financing Condition.” If checked in the affirmative, Sections 8.3(a) and 8.3(b) apply; otherwise they do not. If the Financing Condition applies, Buyer agrees to work diligently and in good faith to obtain the Loan. Page 3 of 6 pages Buyer’s Initials ________ Date Seller’s Initials ________ Date COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED (a) Buyer’s Right to Cancel Before the Financing & Appraisal Deadline. If Buyer, in Buyer’s sole discretion, is not satisfied with the terms and conditions of the Loan, Buyer may cancel the REPC by providing written notice to Seller no later than the Financing & Appraisal Deadline referenced in Section 24(c); whereupon the Earnest Money Deposit shall be released to Buyer without the requirement of further written authorization from Seller. (b) Buyer’s Right to Cancel After the Financing & Appraisal Deadline. If after expiration of the Financing & Appraisal Deadline referenced in Section 24(c), Buyer fails to obtain the Loan, meaning that the proceeds of the Loan have not been delivered by the Lender to Seller or to the escrow/closing office as required under Section 3.5 of the REPC, then Buyer or Seller may cancel the REPC by providing written notice to the other party; whereupon the Earnest Money Deposit, or Deposits, if applicable (see Section 8.4 below), shall be released to Seller without the requirement of further written authorization from Buyer. In the event of such cancellation, Seller agrees to accept as Seller’s exclusive remedy, the Earnest Money Deposit, or Deposits, if applicable, as liquidated damages. Buyer and Seller agree that liquidated damages would be difficult and impractical to calculate, and the Earnest Money Deposit, or Deposits, if applicable, is a fair and reasonable estimate of Seller’s damages in the event Buyer fails to obtain the Loan. 8.4 ADDITIONAL EARNEST MONEY DEPOSIT. If the REPC has not been previously canceled by Buyer as provided in Sections 8.1, 8.2 or 8.3(a), then no later than the Due Diligence Deadline referenced in Section 24(b), or the Financing & Appraisal Deadline referenced in Section 24(c), whichever is later, Buyer: [ ] WILL [ ] WILL NOT deliver to the Buyer’s Brokerage, an Additional Earnest Money Deposit in the amount of $_________________. The Earnest Money Deposit and the Additional Earnest Money Deposit, if applicable, are sometimes referred to herein as the “Deposits”. The Earnest Money Deposit, or Deposits, if applicable, shall be credited toward the Purchase Price at Closing. 9. ADDENDA. There [ ] ARE [ ] ARE NOT addenda to the REPC containing additional terms. If there are, the terms of the following addenda are incorporated into the REPC by this reference: [ ] Addendum No. ___ _____ [ ] Seller Financing Addendum [ ] FHA/VA Loan Addendum [ ] Lead-Based Paint Disclosure & Acknowledgement (in some transactions this disclosure is required by law) [ ] Other (specify) 10. HOME WARRANTY PLAN / AS-IS CONDITION OF PROPERTY. 10.1 Home Warranty Plan. A one-year Home Warranty Plan [ ] WILL [ ] WILL NOT be included in this transaction. If included, the Home Warranty Plan shall be ordered by [ ] Buyer [ ] Seller and shall be issued by a company selected and shall be paid for at by [ ] Buyer [ ] Seller. The cost of the Home Warranty Plan shall not exceed $ Settlement by [ ] Buyer [ ] Seller. 10.2 Condition of Property/Buyer Acknowledgements. Buyer acknowledges and agrees that in reference to the physical condition of the Property: (a) Buyer is purchasing the Property in its “As-Is” condition without expressed or implied warranties of any kind; (b) Buyer shall have, during Buyer’s Due Diligence as referenced in Section 8.1, an opportunity to completely inspect and evaluate the condition of the Property; and (c) if based on the Buyer’s Due Diligence, Buyer elects to proceed with the purchase of the Property, Buyer is relying wholly on Buyer’s own judgment and that of any contractors or inspectors engaged by Buyer to review, evaluate and inspect the Property. 10.3 Condition of Property/Seller Acknowledgements. Seller acknowledges and agrees that in reference to the physical condition of the Property, Seller agrees to: (a) disclose in writing to Buyer defects in the Property known to Seller that materially affect the value of the Property that cannot be discovered by a reasonable inspection by an ordinary prudent Buyer; (b) carefully review, complete, and provide to Buyer a written Seller property condition disclosure as stated in section 7(a); and (c) deliver the Property to Buyer in substantially the same general condition as it was on the date of Acceptance, as defined in Section 23, ordinary wear and tear excepted. The provisions of Sections 10.2 and 10.3 shall survive Closing. 11. FINAL PRE-SETTLEMENT WALK-THROUGH INSPECTION. 11.1 Walk-Through Inspection. No earlier than seven (7) calendar days prior to Settlement, and upon reasonable notice and at a reasonable time, Buyer may conduct a final pre-Settlement walk-through inspection of the Property to determine only that the Property is “as represented,” meaning that the items referenced in Sections 1.1, 1.2 and 8.1(b)(ii) ("the items") are respectively present, repaired or corrected as agreed. The failure to conduct a walk-through inspection or to claim that an item is not as represented shall not constitute a waiver by Buyer of the right to receive, on the date of possession, the items as represented. If the items are not as represented, Seller agrees to cause all applicable items to be corrected, repaired or replaced (the “Work”) prior to the Settlement Deadline referenced in Section 24(d). 11.2 Escrow to Complete the Work. If, as of Settlement, the Work has not been completed, then Buyer and Seller agree to withhold in escrow at Settlement a reasonable amount agreed to by Seller, Buyer (and Lender, if applicable), sufficient to pay for completion of the Work. If the Work is not completed within thirty (30) calendar days after the Settlement Deadline, the amount so escrowed may, subject to Lender’s approval, be released to Buyer as liquidated damages for failure to complete the Work. The provisions of this Section 11.2 shall survive Closing. 12. CHANGES DURING TRANSACTION. Seller agrees that from the date of Acceptance until the date of Closing, none of the following shall occur without the prior written consent of Buyer: (a) no changes in any leases, rental or property Page 4 of 6 pages Buyer’s Initials ________ Date Seller’s Initials ________ Date COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED management agreements shall be made; (b) no new lease, rental or property management agreements shall be entered into; (c) no substantial alterations or improvements to the Property shall be made or undertaken; (d) no further financial encumbrances to the Property shall be made, and (e) no changes in the legal title to the Property shall be made. 13. AUTHORITY OF SIGNERS. If Buyer or Seller is a corporation, partnership, trust, estate, limited liability company or other entity, the person signing the REPC on its behalf warrants his or her authority to do so and to bind Buyer and Seller. 14. COMPLETE CONTRACT. The REPC together with its addenda, any attached exhibits, and Seller Disclosures (collectively referred to as the “REPC”), constitutes the entire contract between the parties and supersedes and replaces any and all prior negotiations, representations, warranties, understandings or contracts between the parties whether verbal or otherwise. The REPC cannot be changed except by written agreement of the parties. 15. MEDIATION. Any dispute relating to the REPC arising prior to or after Closing: [ ] SHALL [ ] MAY AT THE OPTION OF THE PARTIES first be submitted to mediation. Mediation is a process in which the parties meet with an impartial person who helps to resolve the dispute informally and confidentially. Mediators cannot impose binding decisions. The parties to the dispute must agree before any settlement is binding. The parties will jointly appoint an acceptable mediator and share equally in the cost of such mediation. If mediation fails, the other procedures and remedies available under the REPC shall apply. Nothing in this Section 15 prohibits any party from seeking emergency legal or equitable relief, pending mediation. The provisions of this Section 15 shall survive Closing. 16. DEFAULT. 16.1 Buyer Default. If Buyer defaults, Seller may elect one of the following remedies: (a) cancel the REPC and retain the Earnest Money Deposit, or Deposits, if applicable, as liquidated damages; (b) maintain the Earnest Money Deposit, or Deposits, if applicable, in trust and sue Buyer to specifically enforce the REPC; or (c) return the Earnest Money Deposit, or Deposits, if applicable, to Buyer and pursue any other remedies available at law. 16.2 Seller Default. If Seller defaults, Buyer may elect one of the following remedies: (a) cancel the REPC, and in addition to the return of the Earnest Money Deposit, or Deposits, if applicable, Buyer may elect to accept from Seller, as liquidated damages, a sum equal to the Earnest Money Deposit, or Deposits, if applicable; or (b) maintain the Earnest Money Deposit, or Deposits, if applicable, in trust and sue Seller to specifically enforce the REPC; or (c) accept a return of the Earnest Money Deposit, or Deposits, if applicable, and pursue any other remedies available at law. If Buyer elects to accept liquidated damages, Seller agrees to pay the liquidated damages to Buyer upon demand. 17. ATTORNEY FEES AND COSTS/GOVERNING LAW. In the event of litigation or binding arbitration to enforce the REPC, the prevailing party shall be entitled to costs and reasonable attorney fees. However, attorney fees shall not be awarded for participation in mediation under Section 15. This contract shall be governed by and construed in accordance with the laws of the State of Utah. The provisions of this Section 17 shall survive Closing. 18. NOTICES. Except as provided in Section 23, all notices required under the REPC must be: (a) in writing; (b) signed by the Buyer or Seller giving notice; and (c) received by the Buyer or the Seller, or their respective agent, or by the brokerage firm representing the Buyer or Seller, no later than the applicable date referenced in the REPC. 19. NO ASSIGNMENT. The REPC and the rights and obligations of Buyer hereunder, are personal to Buyer. The REPC may not be assigned by Buyer without the prior written consent of Seller. Provided, however, the transfer of Buyer’s interest in the REPC to any business entity in which Buyer holds a legal interest, including, but not limited to, a family partnership, family trust, limited liability company, partnership, or corporation (collectively referred to as a “Permissible Transfer”), shall not be treated as an assignment by Buyer that requires Seller’s prior written consent. Furthermore, the inclusion of “and/or assigns” or similar language on the line identifying Buyer on the first page of the REPC shall constitute Seller’s written consent only to a Permissible Transfer. 20. INSURANCE & RISK OF LOSS. 20.1 Insurance Coverage. As of Closing, Buyer shall be responsible to obtain casualty and liability insurance coverage on the Property in amounts acceptable to Buyer and Buyer’s Lender, if applicable. 20.2 Risk of Loss. If prior to Closing, any part of the Property is damaged or destroyed by fire, vandalism, flood, earthquake, or act of God, the risk of such loss or damage shall be borne by Seller; provided however, that if the cost of repairing such loss or damage would exceed ten percent (10%) of the Purchase Price referenced in Section 2, either Seller or Buyer may elect to cancel the REPC by providing written notice to the other party, in which instance the Earnest Money Deposit, or Deposits, if applicable, shall be returned to Buyer. 21. TIME IS OF THE ESSENCE. Time is of the essence regarding the dates set forth in the REPC. Extensions must be agreed to in writing by all parties. Unless otherwise explicitly stated in the REPC: (a) performance under each Section of the REPC which references a date shall absolutely be required by 5:00 PM Mountain Time on the stated date; and (b) the term "days" and “calendar days” shall mean calendar days and shall be counted beginning on the day following the event which triggers the timing requirement (e.g. Acceptance). Performance dates and times referenced herein shall not be Page 5 of 6 pages Buyer’s Initials ________ Date Seller’s Initials ________ Date COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED binding upon title companies, lenders, appraisers and others not parties to the REPC, except as otherwise agreed to in writing by such non-party. 22. ELECTRONIC TRANSMISSION AND COUNTERPARTS. Electronic transmission (including email and fax) of a signed copy of the REPC, any addenda and counteroffers, and the retransmission of any signed electronic transmission shall be the same as delivery of an original. The REPC and any addenda and counteroffers may be executed in counterparts. 23. ACCEPTANCE. "Acceptance" occurs only when all of the following have occurred: (a) Seller or Buyer has signed the offer or counteroffer where noted to indicate acceptance; and (b) Seller or Buyer or their agent has communicated to the other party or to the other party’s agent that the offer or counteroffer has been signed as required. 24. CONTRACT DEADLINES. Buyer and Seller agree that the following deadlines shall apply to the REPC: (a) Seller Disclosure Deadline (b) Due Diligence Deadline (c) Financing & Appraisal Deadline (d) Settlement Deadline (Date) (Date) (Date) (Date) 25. OFFER AND TIME FOR ACCEPTANCE. Buyer offers to purchase the Property on the above terms and conditions. If [ ] AM [ ] PM Mountain Time on Seller does not accept this offer by: _______ (Date), this offer shall lapse; and the Brokerage shall return any Earnest Money Deposit to Buyer. (Buyer’s Signature) (Buyer’s Names) (PLEASE PRINT) (Buyer’s Names) (PLEASE PRINT) (Offer Date) (Buyer’s Signature) (Notice Address) (Notice Address) (Zip Code) (Zip Code) (Offer Date) (Phone) (Phone) ACCEPTANCE/COUNTEROFFER/REJECTION CHECK ONE: [ ] ACCEPTANCE OF OFFER TO PURCHASE: Seller Accepts the foregoing offer on the terms and conditions specified above. [ ] COUNTEROFFER: Seller presents for Buyer’s Acceptance the terms of Buyer’s offer subject to the exceptions or . modifications as specified in the attached ADDENDUM NO. [ ] REJECTION: Seller rejects the foregoing offer. (Seller’s Signature) (Date) (Time) (Seller’s Signature) (Notice Address) (Notice Address) (Zip Code) (Zip Code) (Date)(Time) (Phone) (Phone) (Seller’s Names) (PLEASE PRINT) (Seller’s Names) (PLEASE PRINT) THIS FORM APPROVED BY THE UTAH REAL ESTATE COMMISSION AND THE OFFICE OF THE UTAH ATTORNEY GENERAL, EFFECTIVE AUGUST 27, 2008. AS OF JANUARY 1, 2009, IT WILL REPLACE AND SUPERSEDE THE PREVIOUSLY APPROVED VERSION OF THIS FORM. Page 6 of 6 pages Buyer’s Initials ________ Date Seller’s Initials ________ Date COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED SAMPLE SELLER DISCLOSURE FORM State Form 46234 (R4 / 1-07) SELLER'S RESIDENTIAL REAL ESTATE SALES DISCLOSURE Date (month, day, year) Seller states that the information contained in this Disclosure is correct to the best of Seller's CURRENT ACTUAL KNOWLEDGE as of the above date. The prospective buyer and the owner may wish to obtain professional advice or inspections of the property and provide for appropriate provisions in a contract between them concerning any advice, inspections, defects, or warranties obtained on the property. The representations in this form are the representations of the owner and are not the representations of the agent, if any. This information is for disclosure only and is not intended to be a part of any contract between the buyer and the owner. Indiana law (IC 32-21-5) generally requires sellers of 1-4 unit residential property to complete this form regarding the known physical condition of the property. An owner must complete and sign the disclosure form and submit the form to a prospective buyer before an offer is accepted for the sale of the real estate. Property address (number and street, city, state, and ZIP code) 1. The following are in the conditions indicated: A. APPLIANCES Built-in Vacuum System Clothes Dryer Clothes Washer Dishwasher Disposal Freezer Gas Grill Hood Microwave Oven Oven Range Refrigerator Room Air Conditioner(s) Trash Compactor TV Antenna / Dish Other: None/Not Defective Not Included Defective Do Not Know C. WATER & SEWER SYSTEM Cistern Septic Field / Bed Hot Tub Plumbing Aerator System Sump Pump Irrigation Systems Water Heater / Electric Water Heater / Gas Water Heater / Solar Water Purifier Water Softener Well Septic & Holding Tank/Septic Mound Geothermal and Heat Pump Other Sewer System (Explain) None/Not Defective Not Included Defective Do Not Know Yes Are the improvements connected to a public water system? Are the improvements connected to a public sewer system? None/Not Not Included Defective Defective Do Not Know Are there any additions that may require improvements to the sewage disposal system? If yes, have the improvements been completed on the sewage disposal system? Are the improvements connected to a private/community water system? Are the improvements connected to a private/community sewer system? No Do Not Know B. ELECTRICAL SYSTEM Air Purifier Burglar Alarm Ceiling Fan(s) Garage Door Opener / Controls Inside Telephone Wiring and Blocks / Jacks Intercom Light Fixtures Sauna Smoke / Fire Alarm(s) Switches and Outlets Vent Fan(s) 60 / 100 / 200 Amp Service (Circle one) NOTE: "Defect" means a condition that would have a significant adverse effect on the value of the property, that would significantly impair the health or safety of future occupants of the property, or that if not repaired, removed or replaced would significantly shorten or adversely affect the expected normal life of the premises. D. HEATING & COOLING SYSTEM Attic Fan Central Air Conditioning Hot Water Heat Furnace Heat / Gas Furnace Heat / Electric Solar House-Heating Woodburning Stove Fireplace Fireplace Insert Air Cleaner Humidifier Propane Tank Other Heating Source None/Not Not Included Defective Defective Do Not Know The information contained in this Disclosure has been furnished by the Seller, who certifies to the truth thereof, based on the Seller’s CURRENT ACTUAL KNOWLEDGE. A disclosure form is not a warranty by the owner or the owner’s agent, if any, and the disclosure form may not be used as a substitute for any inspections or warranties that the prospective buyer or owner may later obtain. At or before settlement, the owner is required to disclose any material change in the physical condition of the property or certify to the purchaser at settlement that the condition of the property is substantially the same as it was when the disclosure form was provided. Seller and Purchaser hereby acknowledge receipt of this Disclosure by signing below. Signature of Seller: Signature of Seller: Signature of Seller: Date (mm/dd/yy): Date (mm/dd/yy): Date (mm/dd/yy): Signature of Buyer: Signature of Buyer: Signature of Buyer: Date (mm/dd/yy): Date (mm/dd/yy): Date (mm/dd/yy): The Seller hereby certifies that the condition of the property is substantially the same as it was when the Seller’s Disclosure form was originally provided to the Buyer. Page 1 of 2 Property address (number and street, city, state, and ZIP code) 2. ROOF Age, if known: ___________ Years. Does the roof leak? Is there present damage to the roof? Is there more than one roof on the house? If so, how many layers? ____________ 3. HAZARDOUS CONDITIONS Have there been or are there any hazardous conditions on the property, such as methane gas, lead paint, radon gas in house or well, radioactive material, landfill, mineshaft, expansive soil, toxic materials, mold, other biological contaminants, asbestos insulation, or PCB's? Explain: YES NO DO NOT KNOW 4. OTHER DISCLOSURES Do improvements have aluminum wiring? Are there any foundation problems with the improvements? Are there any encroachments? Are there any violations of zoning, building codes, or restrictive covenants? YES NO DO NOT KNOW YES NO DO NOT KNOW Is the present use a non-conforming use? Explain: Is the access to your property via a private road? Is the access to your property via a public road? Is the access to your property via an easement? Have you received any notices by any governmental or quasi-governmental agencies affecting this property? E. ADDITIONAL COMMENTS AND/OR EXPLANATIONS: (Use additional pages, if necessary) Are there any structural problems with the building? Have any substantial additions or alterations been made without a required building permit? Are there moisture and/or water problems in the basement, crawl space area, or any other area? Is there any damage due to wind, flood, termites or rodents? Have any improvements been treated for wood destroying insects? Are the furnace/woodstove/chimney/flue all in working order? Is the property in a flood plain? Do you currently pay flood insurance? Does the property contain underground storage tank(s)? Is the homeowner a licensed real estate salesperson or broker? Is there any threatened or existing litigation regarding the property? Is the property subject to convenants, conditions and/or restrictions of a homeowner's association? Is the property located within one (1) mile of an airport? The information contained in this Disclosure has been furnished by the Seller, who certifies to the truth thereof, based on the Seller's CURRENT ACTUAL KNOWLEDGE. A disclosure form is not a warranty by the owner or the owner's agent, if any, and the disclosure form may not be used as a substitute for any inspections or warranties that the prospective buyer or owner may later obtain. At or before settlement, the owner is required to disclose any material change in the physical condition of the property or certify to the purchaser at settlement that the condition of the property is substantially the same as it was when the disclosure form was provided. Seller and Purchaser hereby acknowledge receipt of this Disclosure by signing below: Signature of Seller: Signature of Seller: Signature of Seller: Date (mm/dd/yy): Date (mm/dd/yy): Date (mm/dd/yy): Signature of Buyer: Signature of Buyer: Signature of Buyer: Date (mm/dd/yy): Date (mm/dd/yy): Date (mm/dd/yy): The Seller hereby certifies that the condition of the property is substantially the same as it was when the Seller’s Disclosure form was originally provided to the Buyer. Page 2 of 2 FTC REAL ESTATE GLOSSARY Federal Trade Commission ftc.gov The Real Estate Marketplace Glossary: How to Talk the Talk Buying a home can be exciting. It also can be somewhat daunting, even if you’ve done it before. You will deal with mortgage options, credit reports, loan applications, contracts, points, appraisals, change orders, inspections, warranties, walk-throughs, settlement sheets, escrow accounts, recording fees, insurance, taxes...the list goes on. No doubt you will hear and see words and terms you’ve never heard before. Just what do they all mean? The Federal Trade Commission, the agency that promotes competition and protects consumers, has prepared this glossary to help you better understand the terms commonly used in the real estate and mortgage marketplace. A Annual Percentage Rate (APR): The cost of a loan or other financing as an annual rate. The APR includes the interest rate, points, broker fees and certain other credit charges a borrower is required to pay. Annuity: An amount paid yearly or at other regular intervals, often at a guaranteed minimum amount. Also, a type of insurance policy in which the policy holder makes payments for a fixed period or until a stated age, and then receives annuity payments from the insurance company. Application Fee: The fee that a mortgage lender or broker charges to apply for a mortgage to cover processing costs. Appraisal: A professional analysis used to estimate the value of the property. This includes examples of sales of similar properties. Appraiser: A professional who conducts an analysis of the property, including examples of sales of similar properties in order to develop an estimate of the value of the property. The analysis is called an “appraisal.” Appreciation: An increase in the market value of a home due to changing market conditions and/or home improvements. Arbitration: A process where disputes are settled by referring them to a fair and neutral third party (arbitrator). The disputing  Glossary parties agree in advance to agree with the decision of the arbitrator. There is a hearing where both parties have an opportunity to be heard, after which the arbitrator makes a decision. Asbestos: A toxic material that was once used in housing insulation and fireproofing. Because some forms of asbestos have been linked to certain lung diseases, it is no longer used in new homes. However, some older homes may still have asbestos in these materials. Assessed Value: Typically the value placed on property for the purpose of taxation. Assessor: A public official who establishes the value of a property for taxation purposes. Asset: Anything of monetary value that is owned by a person or company. Assets include real property, personal property, stocks, mutual funds, etc. Assignment of Mortgage: A document evidencing the transfer of ownership of a mortgage from one person to another. Assumable Mortgage: A mortgage loan that can be taken over (assumed) by the buyer when a home is sold. An assumption of a mortgage is a transaction in which the buyer of real property takes over the seller’s existing mortgage; the seller remains liable unless released by the lender from the obligation. If the mortgage contains a due-on-sale clause, the loan may not be assumed without the lender’s consent. Assumption: A homebuyer’s agreement to take on the primary responsibility for paying an existing mortgage from a home seller. Assumption Fee: A fee a lender charges a buyer who will assume the seller’s existing mortgage. Automated Underwriting: An automated process performed by a technology application that streamlines the processing of loan applications and provides a recommendation to the lender to approve the loan or refer it for manual underwriting. B Balance Sheet: A financial statement that shows assets, liabilities, and net worth as of a specific date. Balloon Mortgage: A mortgage with monthly payments often based on a 30-year amortization schedule, with the unpaid balance due in a lump sum payment at the end of a specific period of time (usually 5 or 7 years). The mortgage may contain an option to “reset” the interest rate to the current market rate and to extend the due date if certain conditions are met. Balloon Payment: A final lump sum payment that is due, often at the maturity date of a balloon mortgage. Bankruptcy: Legally declared unable to pay your debts. Bankruptcy can severely impact your credit and your ability to borrow money. Before-tax Income: Income before taxes are deducted. Also known as “gross income.” Biweekly Payment Mortgage: A mortgage with payments due every two weeks (instead of monthly). Bona fide: In good faith, without fraud. Bridge Loan: A short-term loan secured by the borrower’s current home (which is usually for sale) that allows the proceeds to be used for building or closing on a new house before the current home is sold. Also known as a “swing loan.” Glossary  Broker: An individual or firm that acts as an agent between providers and users of products or services, such as a mortgage broker or real estate broker. See also “Mortgage Broker.” Building Code: Local regulations that set forth the standards and requirements for the construction, maintenance and occupancy of buildings. The codes are designed to provide for the safety, health and welfare of the public. Buydown: An arrangement whereby the property developer or another third party provides an interest subsidy to reduce the borrower’s monthly payments typically in the early years of the loan. Buydown Account: An account in which funds are held so that they can be applied as part of the monthly mortgage payment as each payment comes due during the period that an interest rate buydown plan is in effect. Certificate of Deposit: A document issued by a bank or other financial institution that is evidence of a deposit, with the issuer’s promise to return the deposit plus earnings at a specified interest rate within a specified time period. Certificate of Eligibility: A document issued by the U.S. Department of Veterans Affairs (VA) certifying a veteran’s eligibility for a VA-guaranteed mortgage loan. Chain of Title: The history of all of the documents that have transferred title to a parcel of real property, starting with the earliest existing document and ending with the most recent. Change Orders: A change in the original construction plans ordered by the property owner or general contractor. Clear Title: Ownership that is free of liens, defects, or other legal encumbrances. Closing: The process of completing a financial transaction. For mortgage loans, the process of signing mortgage documents, disbursing funds, and, if applicable, transferring ownership of the property. In some jurisdictions, closing is referred to as “escrow,” a process by which a buyer and seller deliver legal documents to a third party who completes the transaction in accordance with their instructions. See also “Settlement.” Closing Agent: The person or entity that coordinates the various closing activities, including the preparation and recordation of closing documents and the disbursement of funds. (May be referred to as an escrow agent or settlement agent in some jurisdictions.) Typically, the closing is conducted by title companies, escrow companies or attorneys. Closing Costs: The upfront fees charged in connection with a mortgage loan transaction. Money paid by a buyer (and/or seller or other third party, if applicable) C Cap: For an adjustable-rate mortgage (ARM), a limitation on the amount the interest rate or mortgage payments may increase or decrease. See also “Lifetime Payment Cap,” “Lifetime Rate Cap,” “Periodic Payment Cap,” and “Periodic Rate Cap.” Capacity: Your ability to make your mortgage payments on time. This depends on your income and income stability (job history and security), your assets and savings, and the amount of your income each month that is left over after you’ve paid for your housing costs, debts and other obligations. Cash-out Refinance: A refinance transaction in which the borrower receives additional funds over and above the amount needed to repay the existing mortgage, closing costs, points, and any subordinate liens.  Glossary to effect the closing of a mortgage loan, generally including, but not limited to a loan origination fee, title examination and insurance, survey, attorney’s fee, and prepaid items, such as escrow deposits for taxes and insurance. Closing Date: The date on which the sale of a property is to be finalized and a loan transaction completed. Often, a real estate sales professional coordinates the setting of this date with the buyer, the seller, the closing agent, and the lender. Closing Statement: See “HUD-1 Settlement Statement.” Co-borrower: Any borrower other than the first borrower whose name appears on the application and mortgage note, even when that person owns the property jointly with the first borrower and shares liability for the note. Collateral: An asset that is pledged as security for a loan. The borrower risks losing the asset if the loan is not repaid according to the terms of the loan agreement. In the case of a mortgage, the collateral would be the house and real property. Commission: The fee charged for services performed, usually based on a percentage of the price of the items sold (such as the fee a real estate agent earns on the sale of a house). Commitment Letter: A binding offer from your lender that includes the amount of the mortgage, the interest rate, and repayment terms. Common Areas: Those portions of a building, land, or improvements and amenities owned by a planned unit development (PUD) or condominium project’s homeowners’ association (or a cooperative project’s cooperative corporation) that are used by all of the unit owners, who share in the common expenses of their operation and maintenance. Common areas include swimming pools, tennis courts, and other recreational facilities, as well as common corridors of buildings, parking areas, means of ingress and egress, etc. Comparables: An abbreviation for “comparable properties,” which are used as a comparison in determining the current value of a property that is being appraised. Concession: Something given up or agreed to in negotiating the sale of a house. For example, the sellers may agree to help pay for closing costs. Condominium: A unit in a multiunit building. The owner of a condominium unit owns the unit itself and has the right, along with other owners, to use the common areas but does not own the common elements such as the exterior walls, floors and ceilings or the structural systems outside of the unit; these are owned by the condominium association. There are usually condominium association fees for building maintenance, property upkeep, taxes and insurance on the common areas and reserves for improvements. Construction Loan: A loan for financing the cost of construction or improvements to a property; the lender disburses payments to the builder at periodic intervals during construction. Contingency: A condition that must be met before a contract is legally binding. For example, home purchasers often include a home inspection contingency; the sales contract is not binding unless and until the purchaser has the home inspected. Conventional Mortgage: A mortgage loan that is not insured or guaranteed by the federal government or one of its agencies, such as the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs (VA), or the Glossary  Rural Housing Service (RHS). Contrast with “Government Mortgage.” Conversion Option: A provision of some adjustable-rate mortgage (ARM) loans that allows the borrower to change the ARM to a fixed-rate mortgage at specified times after loan origination. Convertible ARM: An adjustable-rate mortgage (ARM) that allows the borrower to convert the loan to a fixed-rate mortgage under specified conditions. Cooperative (Co-op) Project: A project in which a corporation holds title to a residential property and sells shares to individual buyers, who then receive a proprietary lease as their title. Cost of Funds Index (COFI): An index that is used to determine interest rate changes for certain adjustable-rate mortgage (ARM) loans. It is based on the weighted monthly average cost of deposits, advances, and other borrowings of members of the Federal Home Loan Bank of San Francisco. Counter-offer: An offer made in response to a previous offer. For example, after the buyer presents their first offer, the seller may make a counter-offer with a slightly higher sale price. Credit: The ability of a person to borrow money, or buy goods by paying over time. Credit is extended based on a lender’s opinion of the person’s financial situation and reliability, among other factors. Credit Bureau: A company that gathers information on consumers who use credit. These companies sell that information to lenders and other businesses in the form of a credit report. Credit History: Information in the files of a credit bureau, primarily comprised of a list of individual consumer debts and a record of whether or not these debts were paid back on time or “as agreed.” Your credit history is called a credit report when provided by a credit bureau to a lender or other business. Credit Life Insurance: A type of insurance that pays off a specific amount of debt or a specified credit account if the borrower dies while the policy is in force. Credit Report: Information provided by a credit bureau that allows a lender or other business to examine your use of credit. It provides information on money that you’ve borrowed from credit institutions and your payment history. Credit Score: A numerical value that ranks a borrower’s credit risk at a given point in time based on a statistical evaluation of information in the individual’s credit history that has been proven to be predictive of loan performance. Creditor: A person who extends credit to whom you owe money. Creditworthy: Your ability to qualify for credit and repay debts. D Debt: Money owed from one person or institution to another person or institution. Debt-to-Income Ratio: The percentage of gross monthly income that goes toward paying for your monthly housing expense, alimony, child support, car payments and other installment debts, and payments on revolving or open-ended accounts, such as credit cards. Deed: The legal document transferring ownership or title to a property Deed-in-Lieu of Foreclosure: The transfer of title from a borrower to the lender to satisfy the mortgage debt and avoid foreclosure. Also called a “voluntary conveyance.”  Glossary Deed of Trust: A legal document in which the borrower transfers the title to a third party (trustee) to hold as security for the lender. When the loan is paid in full, the trustee transfers title back to the borrower. If the borrower defaults on the loan the trustee will sell the property and pay the lender the mortgage debt. Default: Failure to fulfill a legal obligation. A default includes failure to pay on a financial obligation, but also may be a failure to perform some action or service that is non-monetary. For example, when leasing a car, the lessee is usually required to properly maintain the car. Delinquency: Failure to make a payment when it is due. The condition of a loan when a scheduled payment has not been received by the due date, but generally used to refer to a loan for which payment is 30 or more days past due. Depreciation: A decline in the value of a house due to changing market conditions or lack of upkeep on a home. Discount Point: A fee paid by the borrower at closing to reduce the interest rate. A point equals one percent of the loan amount. Down Payment: A portion of the price of a home, usually between 3-20%, not borrowed and paid up-front in cash. Some loans are offerend with zero downpayment. Due-on-Sale Clause: A provision in a mortgage that allows the lender to demand repayment in full of the outstanding balance if the property securing the mortgage is sold. cepts your offer, unless one of the sales contract contingencies is not fulfilled. Easement: A right to the use of, or access to, land owned by another. Employer-Assisted Housing: A program in which companies assist their employees in purchasing homes by providing assistance with the down payment, closing costs, or monthly payments. Encroachment: The intrusion onto another’s property without right or permission. Encumbrance: Any claim on a property, such as a lien, mortgage or easement. Equal Credit Opportunity Act (ECOA): A federal law that requires lenders to make credit equally available without regard to the applicant’s race, color, religion, national origin, age, sex, or marital status; the fact that all or part of the applicant’s income is derived from a public assistance program; or the fact that the applicant has in good faith exercised any right under the Consumer Credit Protection Act. It also requires various notices to consumers. Equity: The value in your home above the total amount of the liens against your home. If you owe $100,000 on your house but it is worth $130,000, you have $30,000 of equity. Escrow: An item of value, money, or documents deposited with a third party to be delivered upon the fulfillment of a condition. For example, the deposit by a borrower with the lender of funds to pay taxes and insurance premiums when they become due, or the deposit of funds or documents with an attorney or escrow agent to be disbursed upon the closing of a sale of real estate. Escrow Account: An account that a mortgage servicer establishes on behalf of a borrower to pay taxes, insurance E Earnest Money Deposit: The deposit to show that you’re committed to buying the home. The deposit usually will not be refunded to you after the seller ac- Glossary  premiums, or other charges when they are due. Sometimes referred to as an “impound” or “reserve” account. Escrow Analysis: The accounting that a mortgage servicer performs to determine the appropriate balances for the escrow account, compute the borrower’s monthly escrow payments, and determine whether any shortages, surpluses or deficiencies exist in the account. Eviction: The legal act of removing someone from real property. Exclusive Right-to-Sell Listing: The traditional kind of listing agreement under which the property owner appoints a real estate broker (known as the listing broker) as exclusive agent to sell the property on the owner’s stated terms, and agrees to pay the listing broker a commission when the property is sold, regardless of whether the buyer is found by the broker, the owner or another broker. This is the kind of listing agreement that is commonly used by a listing broker to provide the traditional full range of real estate brokerage services. If a second real estate broker (known as a selling broker) finds the buyer for the property, then some commission will be paid to the selling broker. Exclusive Agency Listing: A listing agreement under which a real estate broker (known as the listing broker) acts as an exclusive agent to sell the property for the property owner, but may be paid a reduced or no commission when the property is sold if, for example, the property owner rather than the listing broker finds the buyer. This kind of listing agreement can be used to provide the owner a limited range of real estate brokerage services rather than the traditional full range. As with other kinds of listing agreements, if a second real estate broker (known as a selling broker) finds the buyer for the property, then some commission will be paid to the selling broker. Executor: A person named in a will and approved by a probate court to administer the deposition of an estate in accordance with the instructions of the will. F Fair Credit Reporting Act (FCRA): A consumer protection law that imposes obligations on (1) credit bureaus (and similar agencies) that maintain consumer credit histories, (2) lenders and other businesses that buy reports from credit bureaus, and (3) parties who furnish consumer information to credit bureaus. Among other provisions, the FCRA limits the sale of credit reports by credit bureaus by requiring the purchaser to have a legitimate business need for the data, allows consumers to learn the information on them in credit bureau files (including one annual free credit report), and specifies procedure for challenging errors in that data. Fair Market Value: The price at which property would be transferred between a willing buyer and willing seller, each of whom has a reasonable knowledge of all pertinent facts and is not under any compulsion to buy or sell. Fannie Mae: A New York stock exchange company. It is a public company that operates under a federal charter and is the nation’s largest source of financing for home mortgages. Fannie Mae does not lend money directly to consumers, but instead works to ensure that mortgage funds are available and affordable, by purchasing mortgage loans from institutions that lend directly to consumers. Fannie Mae-Seller/Servicer: A lender that Fannie Mae has approved to sell loans to it and to service loans on Fannie Mae’s behalf. Fannie Mae/Freddie Mac Loan Limit: The current 2006 Fannie Mae/Freddie  Glossary Mac loan limit for a single-family home is $417,000 and is higher in Alaska, Guam, Hawaii, and the U.S. Virgin Islands. The Fannie Mae loan limit is $533,850 for a two-unit home; $645,300 for a three-unit home; and $801,950 for a four-unit home. Also referred to as the “conventional loan limit.” Federal Housing Administration (FHA): An agency within the U.S. Department of Housing and Urban Development (HUD) that insures mortgages and loans made by private lenders. FHA-Insured Loan: A loan that is insured by the Federal Housing Administration (FHA) of the U.S. Department of Housing and Urban Development (HUD). First Mortgage: A mortgage that is the primary lien against a property. First-Time Home Buyer: A person with no ownership interest in a principal residence during the three-year period preceding the purchase of the security property. Fixed-Period Adjustable-Rate Mortgage: An adjustable-rate mortgage (ARM) that offers a fixed rate for an initial period, typically three to ten years, and then adjusts every six months, annually, or at another specified period, for the remainder of the term. Also known as a “hybrid loan.” Fixed-Rate Mortgage: A mortgage with an interest rate that does not change during the entire term of the loan. Flood Certification Fee: A fee charged by independent mapping firms to identify properties located in areas designated as flood zones. Flood Insurance: Insurance that compensates for physical property damage resulting from flooding. It is required for properties located in federally designated flood hazard zones. Foreclosure: A legal action that ends all ownership rights in a home when the homebuyer fails to make the mortgage payments or is otherwise in default under the terms of the mortgage. Forfeiture: The loss of money, property, rights, or privileges due to a breach of a legal obligation. Fully Amortized Mortgage: A mortgage in which the monthly payments are designed to retire the obligation at the end of the mortgage term. G General Contractor: A person who oversees a home improvement or construction project and handles various aspects such as scheduling workers and ordering supplies. Gift Letter: A letter that a family member writes verifying that s/he has given you a certain amount of money as a gift and that you don’t have to repay it. You can use this money towards a portion of your down payment with some mortgages. Good-Faith Estimate: A form required by the Real Estate Settlement Procedures Act (RESPA) that discloses an estimate of the amount or range of charges, for specific settlement services the borrower is likely to incur in connection with the mortgage transaction. Government Mortgage: A mortgage loan that is insured or guaranteed by a federal government entity such as the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs (VA), or the Rural Housing Service (RHS). Government National Mortgage Association (Ginnie Mae): A government-owned corporation within the U.S. Department of Housing and Urban De- Glossary  velopment (HUD) that guarantees securities backed by mortgages that are insured or guaranteed by other government agencies. Popularly known as “Ginnie Mae.” Gross Monthly Income: The income you earn in a month before taxes and other deductions. It also may include rental income, self-employed income, income from alimony, child support, public assistance payments, and retirement benefits. Ground Rent: Payment for the use of land when title to a property is held as a leasehold estate (that is, the borrower does not actually own the property, but has a long-term lease on it). Growing-Equity Mortgage (GEM): A fixed-rate mortgage in which the monthly payments increase according to an agreed-upon schedule, with the extra funds applied to reduce the loan balance and loan term. to an amount that represents a specified percentage of the borrower’s equity in the property. Home Inspection: A professional inspection of a home to determine the condition of the property. The inspection should include an evaluation of the plumbing, heating and cooling systems, roof, wiring, foundation and pest infestation. Homeowner’s Insurance: A policy that protects you and the lender from fire or flood, which damages the structure of the house; a liability, such as an injury to a visitor to your home; or damage to your personal property, such as your furniture, clothes or appliances Homeowner’s Warranty (HOW): Insurance offered by a seller that covers certain home repairs and fixtures for a specified period of time. Homeowners’ Association: An organization of homeowners residing within a particular area whose principal purpose is to ensure the provision and maintenance of community facilities and services for the common benefit of the residents. Housing Expense Ratio: The percentage of your gross monthly income that goes toward paying for your housing expenses. HUD-1 Settlement Statement: A final listing of the closing costs of the mortgage transaction. It provides the sales price and down payment, as well as the total settlement costs required from the buyer and seller. Hybrid Loan: An adjustable-rate mortgage (ARM) that offers a fixed rate for an initial period, typically three to ten years, and then adjusts every six months, annually, or at another specified period, for the remainder of the term. H Hazard Insurance: Insurance coverage that compensates for physical damage to a property from fire, wind, vandalism, or other covered hazards or natural disasters. Home Equity Conversion Mortgage (HECM): A special type of mortgage developed and insured by the Federal Housing Administration (FHA) that enables older home owners to convert the equity they have in their homes into cash, using a variety of payment options to address their specific financial needs. Sometimes called a “reverse mortgage.” Home Equity Line of Credit (HELOC): A type of revolving loan, that enables a home owner to obtain multiple advances of the loan proceeds at his or her own discretion, up 10 Glossary I Income Property: Real estate developed or purchased to produce income, such as a rental unit. Index: A number used to compute the interest rate for an adjustable-rate mortgage (ARM). The index is generally a published number or percentage, such as the average interest rate or yield on U.S. Treasury bills. A margin is added to the index to determine the interest rate that will be charged on the ARM. This interest rate is subject to any caps on the maximum or minimum interest rate that may be charged on the mortgage, stated in the note. Individual Retirement Account (IRA): A tax-deferred plan that can help you build a retirement nest egg. Inflation: An increase in prices. Initial Interest Rate: The original interest rate for an adjustable-rate mortgage (ARM). Sometimes known as the “start rate.” Inquiry: A request for a copy of your credit report by a lender or other business, often when you fill out a credit application and/or request more credit. Too many inquiries on a credit report can hurt your credit score; however, most credit scores are not affected by multiple inquiries from auto or mortgage lenders within a short period of time. Installment: The regular periodic payment that a borrower agrees to make to a lender. Installment Debt: A loan that is repaid in accordance with a schedule of payments for a specified term (such as an automobile loan). Interest: The cost you pay to borrow money. It is the payment you make to a lender for the money it has loaned to you. Interest is usually expressed as a percentage of the amount borrowed. Interest Accrual Rate: The percentage rate at which interest accumulates or increases on a mortgage loan. Interest Rate Cap: For an adjustablerate mortgage (ARM), a limitation on the amount the interest rate can change per adjustment or over the lifetime of the loan, as stated in the note. Interest Rate Ceiling: For an adjustable-rate mortgage (ARM), the maximum interest rate, as specified in the mortgage note. Interest Rate Floor: For an adjustablerate mortgage (ARM), the minimum interest rate, as specified in the mortgage note. Investment Property: A property purchased to generate rental income, tax benefits, or profitable resale rather than to serve as the borrower’s primary residence. Contrast with “second home.” J Judgment Lien: A lien on the property of a debtor resulting from the decree of a court. Jumbo Loan: A loan that exceeds the mortgage amount eligible for purchase by Fannie Mae or Freddie Mac. Also called “non-conforming loan.” Junior Mortgage: A loan that is subordinate to the primary loan or first-lien mortgage loan, such as a second or third mortgage. K Keogh Funds: A tax-deferred retirement-savings plan for small business owners or self-employed individuals who Glossary 11 have earned income from their trade or business. Contributions to the Keogh plan are tax-deductible. Loan Origination: The process by which a loan is made, which may include taking a loan application, processing and underwriting the application, and closing the loan. Loan Origination Fees: Fees paid to your mortgage lender or broker for processing the mortgage application. This fee is usually in the form of points. One point equals one percent of the mortgage amount. Loan-To-Value (LTV) Ratio: The relationship between the loan amount and the value of the property (the lower of appraised value or sales price), expressed as a percentage of the property’s value. For example, a $100,000 home with an $80,000 mortgage has an LTV of 80 percent. Lock-In Rate: A written agreement guaranteeing a specific mortgage interest rate for a certain amount of time. Low-Down-Payment Feature: A feature of some mortgages, usually fixed-rate mortgages, that helps you buy a home with a low down payment. L Late Charge: A penalty imposed by the lender when a borrower fails to make a scheduled payment on time. Lease-Purchase Option: An option sometimes used by sellers to rent a property to a consumer, who has the option to buy the home within a specified period of time. Typically, part of each rental payment is put aside for the purpose of accumulating funds to pay the down payment and closing costs. Liabilities: A person’s debts and other financial obligations. Liability Insurance: Insurance coverage that protects property owners against claims of negligence, personal injury or property damage to another party. LIBOR-Index: An index used to determine interest rate changes for certain adjustable-rate mortgage (ARM) plans, based on the average interest rate at which international banks lend to or borrow funds from the London Interbank Market. Lien: A claim or charge on property for payment of a debt. With a mortgage, the lender has the right to take the title to your property if you don’t make the mortgage payments. Lifetime Cap: For an adjustable-rate mortgage (ARM), a limit on the amount that the interest rate or monthly payment can increase or decrease over the life of the loan. Liquid Asset: A cash asset or an asset that is easily converted into cash. M Manufactured Housing: Homes that are built entirely in a factory in accordance with a federal building code administered by the U.S. Department of Housing and Urban Development (HUD). Manufactured homes may be singleor multi-section and are transported from the factory to a site and installed. Homes that are permanently affixed to a foundation often may be classified as real property under applicable state law, and may be financed with a mortgage. Homes that are not permanently affixed to a foundation generally are classified as personal property, and are financed with a retail installment sales agreement. 1 Glossary Margin: A percentage added to the index for an adjustable-rate mortgage (ARM) to establish the interest rate on each adjustment date. Market Value: The current value of your home based on what a purchaser would pay. An appraisal is sometimes used to determine market value. Maturity Date: The date on which a mortgage loan is scheduled to be paid in full, as stated in the note. Merged Credit Report: A credit report issued by a credit reporting company that combines information from two or three major credit bureaus. Modification: Any change to the terms of a mortgage loan, including changes to the interest rate, loan balance, or loan term. Money Market Account: A type of investment in which funds are invested in short-term securities. Mortgage: A loan using your home as collateral. In some states the term mortgage is also used to describe the document you sign (to grant the lender a lien on your home). It also may be used to indicate the amount of money you borrow, with interest, to purchase your house. The amount of your mortgage often is the purchase price of the home minus your down payment. Mortgage Broker: An individual or firm that brings borrowers and lenders together for the purpose of loan origination. A mortgage broker typically takes loan applications and may process loans. A mortgage broker also may close the loan. Mortgage Insurance (MI): Insurance that protects lenders against losses caused by a borrower’s default on a mortgage loan. MI typically is required if the borrower’s down payment is less than 20 percent of the purchase price. Mortgage Insurance Premium (MIP): The amount paid by a borrower for mortgage insurance, either to a government agency such as the Federal Housing Administration (FHA) or to a private mortgage insurance (PMI) company. Mortgage Lender: The lender providing funds for a mortgage. Lenders also manage the credit and financial information review, the property and the loan application process through closing. Mortgage Life Insurance: A type of insurance that will pay off a mortgage if the borrower dies while the loan is outstanding; a form of credit life insurance. Mortgage Rate: The interest rate you pay to borrow the money to buy your house. Mortgagee: The institution or individual to whom a mortgage is given. Mortgagor: The owner of real estate who pledges property as security for the repayment of a debt; the borrower. Multifamily Mortgage: A mortgage loan on a building with five or more dwelling units. Multifamily Properties: Typically, buildings with five or more dwelling units. Multiple Listing Service (MLS): A clearinghouse through which member real estate brokerage firms regularly and systematically exchange information on listings of real estate properties and share commissions with members who locate purchasers. The MLS for an area is usually operated by the local, private real estate association as a joint venture among its members designed to foster real estate brokerage services. Mutual Funds: A fund that pools the money of its investors to buy a variety of securities. Glossary 1 N Negative Amortization: An increase in the balance of a loan caused by adding unpaid interest to the loan balance; this occurs when the payment does not cover the interest due. Net Monthly Income: Your take-home pay after taxes. It is the amount of money that you actually receive in your paycheck. Net Worth: The value of a company or individual’s assets, including cash, less total liabilities. Non-Liquid Asset: An asset that cannot easily be converted into cash. Note: A written promise to pay a specified amount under the agreed upon conditions. Note Rate: The interest rate stated on a mortgage note, or other loan agreement. part of the financing for the buyer’s purchase of the property. Owner-Occupied Property: A property that serves as the borrower’s primary residence. P Partial Payment: A payment that is less than the scheduled monthly payment on a mortgage loan. Payment Change Date: The date on which a new monthly payment amount takes effect, for example, on an adjustable-rate mortgage (ARM) loan. Payment Cap: For an adjustable-rate mortgage (ARM) or other variable rate loan, a limit on the amount that payments can increase or decrease during any one adjustment period. Personal Property: Any property that is not real property. PITI: An acronym for the four primary components of a monthly mortgage payment: principle, interest, taxes, and insurance (PITI). PITI Reserves: A cash amount that a borrower has available after making a down payment and paying closing costs for the purchase of a home. The principal, interest, taxes, and insurance (PITI) reserves must equal the amount that the borrower would have to pay for PITI for a predefined number of months. Planned Unit Development (PUD): A real estate project in which individuals hold title to a residential lot and home while the common facilities are owned and maintained by a homeowners’ association for the benefit and use of the individual PUD unit owners. Point: One percent of the amount of the mortgage loan. For example, if a loan O Offer: A formal bid from the home buyer to the home seller to purchase a home. Open House: When the seller’s real estate agent opens the seller’s house to the public. You don’t need a real estate agent to attend an open house. Original Principal Balance: The total amount of principal owed on a mortgage before any payments are made. Origination Fee: A fee paid to a lender or broker to cover the administrative costs of processing a loan application. The origination fee typically is stated in the form of points. One point is one percent of the mortgage amount. Owner Financing: A transaction in which the property seller provides all or 1 Glossary is made for $50,000, one point equals $500. Power of Attorney: A legal document that authorizes another person to act on one’s behalf. A power of attorney can grant complete authority or can be limited to certain acts and/or certain periods of time. Pre-Approval: A process by which a lender provides a prospective borrower with an indication of how much money he or she will be eligible to borrow when applying for a mortgage loan. This process typically includes a review of the applicant’s credit history and may involve the review and verification of income and assets to close. Pre-Approval Letter: A letter from a mortgage lender indicating that you qualify for a mortgage of a specific amount. It also shows a home seller that you’re a serious buyer. Pre-Qualification: A preliminary assessment by a lender of the amount it will lend to a potential home buyer. The process of determining how much money a prospective home buyer may be eligible to borrow before he or she applies for a loan. Pre-Qualification Letter: A letter from a mortgage lender that states that you’re pre-qualified to buy a home, but does not commit the lender to a particular mortgage amount. Predatory Lending: Abusive lending practices that include making mortgage loans to people who do not have the income to repay them or repeatedly refinancing loans, charging high points and fees each time and “packing” credit insurance onto a loan. Prepayment: Any amount paid to reduce the principal balance of a loan before the scheduled due date. Prepayment Penalty: A fee that a borrower may be required to pay to the lender, in the early years of a mortgage loan, for repaying the loan in full or prepaying a substantial amount to reduce the unpaid principle balance. Principal: The amount of money borrowed or the amount of the loan that has not yet been repaid to the lender. This does not include the interest you will pay to borrow that money. The principal balance (sometimes called the outstanding or unpaid principal balance) is the amount owed on the loan minus the amount you’ve repaid. Private Mortgage Insurance: Insurance for conventional mortgage loans that protects the lender from loss in the event of default by the borrower. See Mortgage Insurance Promissory Note: A written promise to repay a specified amount over a specified period of time. Property Appreciation: See “Appreciation.” Purchase and Sale Agreement: A document that details the price and conditions for a transaction. In connection with the sale of a residential property, the agreement typically would include: information about the property to be sold, sale price, down payment, earnest money deposit, financing, closing date, occupancy date, length of time the offer is valid, and any special contingencies. Purchase Money Mortgage: A mortgage loan that enables a borrower to acquire a property. Q Qualifying Guidelines: Criteria used to determine eligibility for a loan. Glossary 1 Qualifying Ratios: Calculations that are used in determining the loan amount that a borrower qualifies for, typically a comparison of the borrower’s total monthly income to monthly debt payments and other recurring monthly obligations. Quality Control: A system of safeguards to ensure that loans are originated, underwritten and serviced according to the lender’s standards and, if applicable, the standards of the investor, governmental agency, or mortgage insurer. but are generally not involved in the lending process. Real Estate Settlement Procedures Act (RESPA): A federal law that requires lenders to provide home mortgage borrowers with information about transaction-related costs prior to settlement, as well as information during the life of the loan regarding servicing and escrow accounts. RESPA also prohibits kickbacks and unearned fees in the mortgage loan business. Real Property: Land and anything permanently affixed thereto — including buildings, fences, trees, and minerals. Recorder: The public official who keeps records of transactions that affect real property in the area. Sometimes known as a “Registrar of Deeds” or “County Clerk.” Recording: The filing of a lien or other legal documents in the appropriate public record. Refinance: Getting a new mortgage with all or some portion of the proceeds used to pay off the prior mortgage. Rehabilitation Mortgage: A mortgage loan made to cover the costs of repairing, improving, and sometimes acquiring an existing property. Remaining Term: The original number of payments due on the loan minus the number of payments that have been made. Repayment Plan: An arrangement by which a borrower agrees to make additional payments to pay down past due amounts while still making regularly scheduled payments. Replacement Cost: The cost to replace damaged personal property without a deduction for depreciation. R Radon: A toxic gas found in the soil beneath a house that can contribute to cancer and other illnesses. Rate Cap: The limit on the amount an interest rate on an adjustable-rate mortgage (ARM) can increase or decrease during an adjustment period. Rate Lock: An agreement in which an interest rate is “locked in” or guaranteed for a specified period of time prior to closing. See also “Lock-in Rate.” Ratified Sales Contract: A contract that shows both you and the seller of the house have agreed to your offer. This offer may include sales contingencies, such as obtaining a mortgage of a certain type and rate, getting an acceptable inspection, making repairs, closing by a certain date, etc. Real Estate Professional: An individual who provides services in buying and selling homes. The real estate professional is paid a percentage of the home sale price by the seller. Unless you’ve specifically contracted with a buyer’s agent, the real estate professional represents the interest of the seller. Real estate professionals may be able to refer you to local lenders or mortgage brokers, 1 Glossary Rescission: The cancellation or annulment of a transaction or contract by operation of law or by mutual consent. Borrowers have a right to cancel certain mortgage refinance and home equity transactions within three business days after closing, or for up to three years in certain instances. Revolving Debt: Credit that is extended by a creditor under a plan in which (1) the creditor contemplates repeated transactions; (2) the creditor may impose a finance charge from time to time on an outstanding unpaid balance; and (3) the amount of credit that may be extended to the consumer during the term of the plan is generally made available to the extent that any outstanding balance is repaid. Right of First Refusal: A provision in an agreement that requires the owner of a property to give another party the first opportunity to purchase or lease the property before he or she offers it for sale or lease to others. Rural Housing Service (RHS): An agency within the U.S. Department of Agriculture (USDA), which operates a range of programs to help rural communities and individuals by providing loan and grants for housing and community facilities. The agency also works with private lenders to guarantee loans for the purchase or construction of singlefamily housing. Second Mortgage: A mortgage that has a lien position subordinate to the first mortgage. Secondary Mortgage Market: The market in which mortgage loan and mortgage-backed securities are bought and sold. Secured Loan: A loan that is backed by property such as a house, car, jewelry, etc. Security: The property that will be given or pledged as collateral for a loan. Securities: Financial forms that shows the holder owns a share or shares of a company (stocks) or has loaned money to a company or government organization (bonds). Seller Take-Back: An agreement in which the seller of a property provides financing to the buyer for the home purchase. See also “Owner Financing.” Servicer: A firm that performs servicing functions, including collecting mortgage payments, paying the borrower’s taxes and insurance and generally managing borrower escrow accounts. Servicing: The tasks a lender performs to protect the mortgage investment, including the collection of mortgage payments, escrow administration, and delinquency management. Settlement: The process of completing a loan transaction at which time the mortgage documents are signed and then recorded, funds are disbursed, and the property is transferred to the buyer (if applicable). Also called closing or escrow in different jurisdictions. See also “Closing” Settlement Statement: A document that lists all closing costs on a consumer mortgage transaction. S Securities: A financial form that shows the holder owns a share or shares of a company (stock) or has loaned money to a company or government organization (bond). Sale-Leaseback: A transaction in which the buyer leases the property back to the seller for a specified period of time. Glossary 1 Single-Family Properties: One- to four-unit properties including detached homes, townhouses, condominiums, and cooperatives, and manufactured homes attached to a permanent foundation and classified as real property under applicable state law. Soft Second Loan: A second mortgage whose payment is forgiven or is deferred until resale of the property. Servicemembers Civil Relief Act: A federal law that restricts the enforcement of civilian debts against certain military personnel who may not be able to pay because of active military service. It also provides other protections to certain military personel. Subordinate Financing: Any mortgage or other lien with lower priority than the first mortgage. Survey: A precise measurement of a property by a licensed surveyor, showing legal boundaries of a property and the dimensions and location of improvements. Sweat Equity: A borrower’s contribution to the down payment for the purchase of a property in the form of labor or services rather than cash. Third-Party Origination: A process by which a lender uses another party to completely or partially originate, process, underwrite, close, fund, or package a mortgage loan. See also “Mortgage Broker.” Title: The right to, and the ownership of, property. A title or deed is sometimes used as proof of ownership of land. Title Insurance: Insurance that protects lenders and homeowners against legal problems with the title. Title Search: A check of the public records to ensure that the seller is the legal owner of the property and to identify any liens or claims against the property. Trade Equity: Real estate or assets given to the seller as part of the down payment for the property. Transfer Tax: State or local tax payable when title to property passes from one owner to another. Treasury Index: An index that is used to determine interest rate changes for certain adjustable-rate mortgage (ARM) plans. It is based on the results of auctions by the U.S. Treasury of Treasury bills and securities. Truth-In-Lending Act (TILA): A federal law that requires disclosure of a truth-in-lending statement for consumer credit. The statement includes a summary of the total cost of credit, such as the annual percentage rate (APR) and other specifics of the credit. Two- to Four- Family Property: A residential property that provides living space (dwelling units) for two to four families, although ownership of the structure is evidenced by a single deed; a loan secured by such a property is considered to be a single-family mortgage. T Taxes and Insurance: Funds collected as part of the borrower’s monthly payment and held in escrow for the payment of the borrower’s, or funds paid by the borrower for, state and local property taxes and insurance premiums. Termite Inspection: An inspection to determine whether a property has termite infestation or termite damage. In many parts of the country, a home must be inspected for termites before it can be sold. 1 Glossary U Underwriting: The process used to determine loan approval. It involves evaluating the property and the borrower’s credit and ability to pay the mortgage. Uniform Residential Loan Application: A standard mortgage application you will have to complete. The form requests your income, assets, liabilities, and a description of the property you plan to buy, among other things. Unsecured Loan: A loan that is not backed by collateral. V Veterans Affairs (U.S. Department of Veterans Affairs): A federal government agency that provides benefits to veterans and their dependents, including health care, educational assistance, financial assistance, and guaranteed home loans. VA Guaranteed Loan: A mortgage loan that is guaranteed by the U.S. Department of Veterans Affairs (VA). W Walk-Through: A common clause in a sales contract that allows the buyer to examine the property being purchased at a specified time immediately before the closing, for example, within the 24 hours before closing. Warranties: Written guarantees of the quality of a product and the promise to repair or replace defective parts free of charge. Federal Trade Commission ftc.gov Castle Arch Lease-To-Own Income Fund: Executive Summary, March 3, 2009 12 © 2009 Castle Arch Real Estate Investment Company, LLC