Understanding a Short Sale
It is not difficult to understand how a short sale works. Simply stated, the lender agrees to accept less than the amount owed on the property. For example, if the borrower owes $150,000, the lender agrees to accept $120,000. You can then resell it or keep it as an income-producing property by collecting rent.
On the surface, a short-sale transaction is not hard to understand. In reality, they take a lot of work to put together. Your work can pay off by providing you with substantial profit on your investment. Too many investors think they can buy the property from the lender after the foreclosure is over. That attitude is flawed because:
There will be increased competition from other real-estate investors.
There is a possibility to make a larger profit before the pending foreclosure than afterward.
Lenders will agree to a short sale when it makes sense to do so.
In a short sale you will actually be acting as mediator between the borrower and the lender. Your job will be to negotiate a settlement of the loan made by the lender to the borrower. You will be trying to get the two sides to agree to take less money than what is actually owed.
The late-night-television investment gurus hawk cash back at settlement as one of the reasons why you should purchase their expensive CDs or real-estate courses. Short sales are one of the techniques they are using, but they don't say it in their infomercial. You get cash back by immediately flipping the property (or assigning the purchase agreement).
From the lender's viewpoint, a short sale saves the ongoing costs associated with the foreclosure process. Eliminating the growing attorney fees, the eviction process, the inevitable delays from the borrower filing bankruptcy, having to repair extensive damage to the property, and the costs associated with resale is a lofty goal.
In a short-sale opportunity, the lender gets the property back much faster from the borrower. By doing so, it is able to cut its losses on the loan that has gone bad. Your job as an active real-estate investor is to convince the lender that it will likely do better by accepting less money now than waiting for the property and sale many months later.
Why would a lender accept far less than what is owed on the property?
It's a simple strategy for the lender and is based on that old saying that “a bird in the hand is worth two in a bush.” It is better to get the money now and get rid of the property than to wait with the expectation of making more money later.
From the borrower's position, the need to do something about his pending foreclosure is pressing. A short sale is a quick answer for the defaulting borrower. It allows the borrower to put the foreclosure behind him.
The borrower has to agree first to the short sale. You'd think he would readily agree, but he probably won't. There are some problems from the borrower's point of view:
He must move immediately (or very soon).
He receives no money from the sale of the property.
He's probably in dire financial straits, and must admit it.
Most borrowers do not want to recognize their current financial situation. Their denial of the circumstances only makes it more difficult to resolve the crisis. Some defaulting borrowers will readily agree to discuss their pending foreclosure and will do whatever is necessary to get over their current loan default. They eagerly concur that their best strategy is to get the pending foreclosure over and start over.
Other defaulting borrowers will refuse to do anything, allowing the foreclosure process to move forward. As an active real-estate investor, sometimes the toughest part of the short sale will be to convince the defaulting property owner to agree to leave the property with nothing.
From the lender's position, the acceptance of the short-sale offer means the loss of money that it is owed, and lenders do not like losing money. To walk away from the property in early foreclosure is courageous. Lenders are not known to show a lot of daring when it comes to losing money, especially their own money.
Lenders usually have a strict policy when it comes to accepting a short sale. They often will publicly state that they seldom, if ever, accept any short-sale offers. In reality they will entertain any offer on a property in foreclosure and seldom accept the first short-sale offer they receive.
Don't confuse short sales in real estate with shorting in finance. Shorting is a method to profit from the decline in the price of a security. Most investors “go long” (as opposed to go short) on an investment by hoping the price of a stock or bond will rise.
Before a lender will consider a short-sale offer, a BPO (broker's price opinion) is usually ordered. The BPO is less expensive than a full appraisal.
The lender is likely to rely heavily on the BPO as to what the probable market value of the property is.
From the point of view of the loss mitigation department of the lender, it is safer to accept an offer close to the BPO than it is to accept an offer thousands of dollars less.
Some of the reasons why a lender is more likely to accept a short sale include:
The property is in poor condition.
The neighborhood has generally depreciated.
Newer homes in the market area are being chosen over existing homes.
The defaulted borrower has serious hardships and cannot afford the home payments.
In addition, there must not be a reasonable expectation that the defaulted borrower's financial situation is likely to change in the immediate future.