Editor’s note: With foreclosures on the rise in many parts of the country, Inman News examines the legal risks of investing in foreclosed properties at auction, describing the most common legal problems that arise and explaining how two investors had to fight in court to keep the property they purchased at auction after the former owner raised legal challenges.

Editor’s note: With foreclosures on the rise in many parts of the country, Inman News examines the legal risks of investing in foreclosed properties at auction, describing the most common legal problems that arise and explaining how two investors had to fight in court to keep the property they purchased at auction after the former owner raised legal challenges. (See Part 2 and Part 3.)

Smart real estate investors are no doubt putting two and two together. Real estate markets have cooled. In addition, foreclosures were up 33 percent in April from just 12 months before, as Inman News has reported.

Investors may add up those two facts and conclude that buying property at a foreclosure auction is the next smart move in real estate investing.

That may be true, but only for exceptionally careful investors who know the legal risks of buying property at a foreclosure sale — and there are many. Just ask me. I ran into several big ones when a friend and I bought a condo at a foreclosure auction several years ago.

Luckily, we were both recent graduates of law school and were working as litigators at law firms. Because of that, we didn’t have to sink additional money into our investment to pay for lawyers to guide us through the legal tangles we faced. However, we were forced to wait to see the property — and learn of its true condition — for six months after we’d forked over nearly $200,000 in cash for it at the auction.

Our investment turned out to be profitable, and I’d invest in another foreclosure. But I’m a lot smarter about it than I was when I operated on blind faith and paid cash for a property whose interior I’d never seen.

Bruce Bronster, a lawyer with Dreier LLP in New York City, who represents institutional clients such as lenders in foreclosure sales, says that he, too, would invest in property at a foreclosure sale, but that’s only because he considers himself fully informed about the legal risks through his legal practice. “The legal problems that can come up in foreclosure sales don’t come up often,” he says, “but when they do, they can be catastrophic to the investment.”

“There are a substantial number of experienced bidders at foreclosure sales whose business it is to buy and sell foreclosed properties and who are acutely aware of the very significant risks involved,” Bronster said. “For the foreclosure purchaser, there’s a diversification risk in that most purchasers are looking at one property. When there’s a shark who’s buying 200-300 properties a year and flipping them,” he said, that “shark” can spread the loss from one catastrophic event across all the investments.

“When you’re a single-purchase investor, you have a tremendous amount to lose,” Bronster said.

That’s exactly why I wouldn’t recommend investing in property at a foreclosure sale unless you fully understand the legal risks. You also have to build in extra time and money to cover the costs of hiring a lawyer to handle the problems that can literally turn a profitable investment into a total wipeout. If you don’t have access to legal expertise, the money to pay for it, and the time it takes to resolve the legal problems built into your investment plan, the risk of investing in foreclosures is simply too high for you.

With my investment, the legal problems that stunned my friend and I forced us to go to court to protect our investment. We couldn’t even step foot in the property for six months, even though the lender had been paid in full and the owner was trying to live there rent, mortgage, condo-assessment, and property-tax free.

We learned about the property’s availability because it was in the same building as my friend’s condo. Because the condo association had to regularly update its members on its financial status, it was no secret that one owner (I’ll call him Herman) was behind in his condo assessments and had bounced in and out of bankruptcy. When Herman’s mortgage company sued for foreclosure, the condo association was notified because of its lien for past-due assessments.

We began to investigate further. We already knew Herman’s overdue condo assessments totaled about $2,000. But we needed to know much more. Was the mortgage being foreclosed a first mortgage, a second mortgage, a home equity loan? If it was a first mortgage, and we could purchase the property at the foreclosure sale for only the amount owed to the mortgage company (typically the opening bid at a foreclosure sale), we knew that most other liens, including the one for condo association fees, would be wiped out under Illinois law.

We got copies of Herman’s bankruptcy filings, which we easily accessed and downloaded from the local bankruptcy court’s Web site for free. (Today, bankruptcy courts still allow public access to case records in person, but to view and download case information online, you’re often required to register and pay per-page for downloading, which can be a hassle.)

Because Herman was required to list all creditors on his bankruptcy petition, reviewing his petition helped us determine whether there might be additional liens on his property. It also told us that his general credit situation was bad enough that the likelihood of him being able to refinance at the last minute was low.

We also did a title search right before the foreclosure auction. Through both sources, we learned that other than the condo assessments, the only other lien on the property was for property taxes, which is typical in a foreclosure sale. If owners aren’t paying the mortgage, they’re probably also not paying the property taxes.

All of this research is important because it tells you whether you’ll buy the property free and clear or encumbered with liens. Once you’ve identified all the liens on the property, you must check your state’s law to find out which will “run” with the property and remain enforceable after the transfer. You’ll be responsible to pay every one of those liens.

Indeed, attorneys agree that one of the biggest legal risks investors run into is finding that the equity they thought was in the property doesn’t exist because of other liens they never dug deep enough to learn about. “People should have their lawyer review a title commitment before they put up their money at a foreclosure sale,” said Jon Goodman, an attorney with Frascona, Joiner, Goodman and Greenstein, P.C., in Boulder, Colo., who represents both mortgage holders and foreclosure investors.

Because we knew there were no other liens, my friend and I bought the property at the foreclosure auction. We were totally oblivious to the fact that we’d have a much bigger legal headache to resolve before we could ever take possession of the property.

Next: Due diligence can help uncover hidden liens, but other encumbrances are harder to find. Also, the legal dispute that stopped us in our tracks for six months.

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