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 it may be 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, the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA) recently developed a classification system for housing condition ranging from C1 (the best) to C6 (the worst), but only C6 is unacceptable to the agencies in "as is" condition. Nonetheless, many lenders require a C4 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, homebuyers 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 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 C5 or C6, 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 C6 or C5 will get his earnest deposit back and the deal is canceled. 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 C6 by the appraiser. You could be more conservative and require the return of the deposit with a C5, which would avoid a mortgage problem because most lenders will accept a C4 or better, but it may substantially reduce the number of sellers who will deal with you.

While accepting a C5 will give you access to more houses, you must find one or more lenders who will accept a C5. You would be well advised to do this in advance of purchase.

Thanks to Kevin Iverson, who contributed materially to this article.

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