Purchase a House In Poor Condition?
Many of the houses coming on the market today are
foreclosure sales, which usually sell “as is” and are often
in poor condition. This may create a buying opportunity for
some buyers, but a hazard for others.
Purchase Opportunity
A purchase opportunity arises because many potential buyers
don’t want the hassle of fixing up a house in poor
condition, which means that there are fewer competing
buyers. In addition, those who sell houses “as is” are
frequently in a hurry to get it done, which means that they
are disinclined to wait for a higher offer.
The buyers in the best position to take advantage of such
opportunities are those with the skills and knowledge
required to assess what needs to be done and how much it
will cost.
Risk of Value Uncertainty
But purchasing a house in poor condition has serious risks.
One risk is the greater uncertainty connected to its value.
The worse the condition, the more costly the improvements
required to make the house livable, and the larger the
potential error in judging in advance what these costs will
be.
The appraisal may reduce but not eliminate the uncertainty
connected to the property’s value. Appraisers mainly rely on
the sale prices of comparable properties, after adjusting
for the differences between the subject property and the
comparables. But because information on the condition of
comparables is often difficult for appraisers to obtain, the
error in making price adjustments is relatively large when
the property is in poor condition.
Risk of Not Finding a Mortgage
But today the greater risk in buying a property in poor
condition is that the buyer will be turned down for a
mortgage – or forced to find a lender who will make
the loan but at a premium price. This problem seldom arose
before the financial crisis because there were very few
foreclosure sales and lenders generally operated on the
assumption that valuation errors would be erased by property
appreciation. Today, those looking to buy a house in poor
condition need to consider this risk very carefully.
Fannie Mae, Freddie Mac, FHA and VA recently developed a
classification system for housing condition ranging from C1
(the best) to C6 (the worst). While only C6 is unacceptable
to the agencies in “as is” condition, many lenders require a
C-4 or better.
Rationale For Condition Requirement
It is understandable why the agencies that bear the risk of
default would either require that the condition of mortgaged
houses meet some minimum standard, or base their purchase
prices or insurance premiums on house condition. As noted
above, the potential error in appraisals is larger for
houses in poor condition, which would result in greater
losses on loans that default. When defaults occur early,
furthermore, the house that was in poor condition when the
loan was made is very likely to be in poor condition at
default, which increases marketing costs.
Why some lenders are stricter than the agencies, however, is
not clear. Presumably the servicing of loans on properties
in poor condition is less profitable, perhaps because these
loans have relatively short lives. It is also possible that
the cost to servicers of managing foreclosures of properties
in poor condition is relatively high. Whatever the reasons
for lender caution, home buyers looking for bargains in the
sale of distressed properties need to take it into account
in planning their purchase strategy.
A Purchase Strategy For Distressed
Properties
An inspection report from a licensed expert will help in the
decision as to whether or not to buy the house, but will not
eliminate uncertainty regarding how an appraiser will
classify the condition of the house. If the house is
classified C-5 or C-6, a loan may not be available.
If the sales contract has a mortgage contingency clause,
which is a standard provision in some states, the buyer who
can’t get a mortgage because the property is classified C-6
or C-5 will get his earnest deposit back and the deal is
cancelled. However, the thwarted buyer will not be
reimbursed for the cost of the inspection or the appraisal,
which might total about $700.
If a property is being sold “as is” and the standard sales
contract does not have a mortgage contingency clause, I
would pass unless the seller agreed to return my earnest
deposit if the property is classified C-6 by the appraiser.
You could be more conservative and require the return of
deposit with a C-5, which would avoid a mortgage problem
because most lenders will accept a C-4 or better, but it may
substantially reduce the number of sellers who will deal
with you.
While accepting a C-5 will give you access to more houses,
you must find one or more lenders who will accept a C-5. You
would be well advised to do this in advance of purchase.
Where Does the Money Come From to Fund Needed Repairs?
Assuming that a lender will accept the property as adequate collateral for the loan, the mortgage amount will be based on the lower of sale price or appraised value, both of which are based on the condition of the property as it is. While the loan amount may be large enough to cover the purchase, it will not provide funding for any of the repairs required to convert the property to a C1 condition. Furthermore, if the mortgage amount is 80% or more of the purchase price, there is not enough equity remaining to support a second mortgage. An unsecured personal loan would be extremely costly if it were available at all.
The solution to this problem is a mortgage used to acquire the property on which the loan amount is based on the value of the property after needed repairs and improvements have been made. This is future value financing, and it is available through the FHA 203k program. See Financing Home Improvements.
Thanks to Kevin Iverson, who contributed materially to this
article.