REO or Bank Owned Homes Explained: Buying an REO Property Presents an Opportunity and a Challenge

There are many “REO” properties on the market these days. For those who understand the process, an “REO” home may present an excellent buying opportunity. But understanding the process is essential because these properties also present unique challenges.

First, an explanation of the term “REO”: it stands for “Real Estate Owned.” This term is used in a bank’s balance sheet to identify properties owned by the bank other than properties it actually uses (like a branch office). Typically, the bank becomes the owner of such a property when the bank forecloses after an owner/borrower stopped paying the mortgage. At the foreclosure auction, the bank usually bids the amount owed. If somebody bids higher, then that bidder buys the property and the bank is repaid in full. If nobody bids higher, then the bank is the winning bidder and becomes the owner.

Note also that the term “bank” isn’t really accurate. Over the last ten years, more and more mortgages have been sold to Fannie Mae or Freddie Mac, government-owned businesses that buy mortgages originally issued by private lenders. By purchasing these mortgages, the federal government makes it easier and more profitable for banks to lend money. This is one of the reasons why we experienced the housing bubble – lots of easy credit meant lots of buyers, which in turn led to rapidly increasing prices, which led to more buyers who had easy access to credit, etc. In any event, an REO property is more likely to be owned by Fannie Mae or Freddie Mac than any particular bank. But the same rules apply.

Once a bank owns a property following foreclosure, it will usually list the property for sale on the MLS. But right now there are thousands of bank-owned properties on the market. This is a problem as far as banks are concerned for two reasons. First, it’s a basic economic principle that an increase in supply will drive down prices (the ol’ “supply and demand curve” that we would have learned in college if we hadn’t skipped class that morning), and no seller, whether a bank or otherwise, wants to see prices drop. Second, bank-owned homes are generally sold for something less than full market value because the bank would prefer to sell the home quickly and recover as much of its principal as possible. Banks are in the business of lending money, not selling homes. But because of the sheer number of these properties on the market, it is not uncommon for a property to sit off the market for several months after the bank has purchased it.

Eventually, though, the bank will put the property on the market for sale. When that happens, the property will probably be listed at the low end of the market range, again because banks want to sell. Thus, for buyers, REO properties can present excellent buying opportunities.

But like most of the time in life, there is a down side to this otherwise too-good-to-be-true situation. Because banks are not in the home-selling business, but do have a lot of good lawyers, banks will only enter into a contract for the sale of a home if the contract fully protects the bank well beyond the protections of an MLS form contract (the forms used by real estate brokers). And where one side gets additional protection in a contract, it comes at the expense of the other side, i.e. the buyer.

Banks get this added protection by requiring that the contract include a bank-specific addendum. This addendum is generally non-negotiable. While the terms of these addendums can vary significantly, they all achieve the same general result: It is more difficult for a buyer to get out of the contract with a return of the earnest money.

So if you’re thinking of making an offer on an REO property, recognize that you will have fewer opportunities to get out of the contract unscathed. For example, many bank addendums require the financing contingency to expire before closing. In contrast, the standard form contract allows this contingency to remain open until closing. So if you’re buying an REO home and your financing fails on the eve of closing (say, for example, you lost your job unexpectedly), you will probably lose your earnest money, while you would have gotten the earnest money back in a “traditional” transaction without a bank addendum.

What can a buyer do to protect herself if she is thinking of buying an REO property? Well, first and foremost, read the bank addendum carefully. Make sure you know your rights under the contract and when they expire. In addition, you can hire a lawyer, who will at a minimum make sure you understand the risks you are taking. If the bank is willing to modify the terms of the addendum, a lawyer will negotiate those changes.

Posted by Marc

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