How do Foreclosures and Short Sales Work?

With the real estate market as soft as it is, we are getting a lot of questions from tentative buyers about short sales and foreclosures. What is it like to buy one? Are all of them are automatically the smokin’ deals they think they are? … and if not, how can we evaluate which ones really are sound investments?

Let’s take a look at how these types of sales work.

Short Sales

Let’s say Mr. X buys a property for $500,000. Mr. X put 10% ($50,000) as a down payment, so he owes $450k on the property. Now let’s say Mr. X gets a job transfer and he has to move, but now the likely sale price for his property is only $460k. You’re thinking, hey Mr. X is ok… but you have to take into account the costs of sale – escrow fee, title insurance, termite inspection and repairs, real estate commissions, etc. So there will not be enough to pay the bank the $450k they are owed after the costs.

In this case, Mr. X may have to do a “short sale”, which means he will have to get the best price he can, convince the bank it is the best price, and then beg them to agree to take less and let him off the hook. The bank may ask Mr. X to pay in some of his personal cash to make up some or all of the difference. The bank may send Mr. X a 10-99 for the amount they end up losing, and Mr. X may have to pay taxes on that amount as though it was income (Congress’s housing relief bill passed recently does address the 10-99 issue). Or the bank may reject any offer of short sale and simply start foreclosure proceedings on Mr. X, figuring they may be able to get more for the property after they own it than Mr. X is offering them to accept now.

A good real estate agent would try to help Mr. X avoid a short sale. But in some cases, it is the best option.

Trouble is, Mr. X’s bank won’t give him ANY indication whatsoever what, if any, loss they will be willing to consider until there is a short offer on the table. So sometimes Mr. X will put his property on the market with an agent who prices the home way below where it will finally sell, way below what it is actually worth, just to get a swarm of people and a written offer to get the conversation going with the bank. At that time, the bank begins to give some teeny tiny clue as to how much less they will take, if anything.

Most of the time, when we get a frantic call from someone who has seen something on the internet priced hundreds of thousands of dollars below where it should be, we discover upon investigation that the price is somewhat “fake”. That is, maybe the bank is owed $700,000, the property is worth maybe $650k, but the asking price is $450k. No bank is going to accept a short sale of $450k or even $475k if the statistics show they might be able to get $625k after foreclosure. Technically, it’s as if those listings aren’t even really for sale since the bank isn’t likely to agree to take that big of a loss. The agent is hoping the crazy $450k price is going to get a bunch of buyers to show up, some will write offers on this property for well over $450k – perhaps even high enough that the bank would accept their offer rather than go through the legal expense of foreclosing – and others may shop with the agent for another property. Buyers who think they are going to get this property asking $450k for $399k because the “real estate market is so bad” are in for a reality check.

So buyers make offers and sit around hoping, but unless the buyer’s agent has a reasonable expectation that the bank could be convinced, and is experienced and skilled enough to present the offer in a package that is appealing not only to the seller but the bank too, it’s sort of a lot of effort for nothing. The poor buyers might wait 8 weeks or more to hear from the bank only to be told the bank is not willing to “go there”.

“Foreclosures”

So let’s say then that none of the offers on Mr. X’s property are acceptable to the bank, and if Mr. X can’t rent the property for enough to cover his payment, he might begin getting behind in his payments. The bank will eventually file a Notice of Default and finally will foreclose.
When does a property begin to be called a “foreclosure”? That term shouldn’t really be used until after the bank owns it, but some agents use it as early as when a seller starts becoming late on payments, or after the Notice of Default is filed. So “foreclosure” is a term that requires further clarification before you know what you’re dealing with. If a property has a Notice of Default on it (an “N.O.D.”), there are special legal circumstances surrounding a purchase, so please PLEASE make sure you get proper legal advice before buying a property with a N.O.D.!!

Once a bank owns the property, it is not called a short sale any more. It may be called a foreclosure, “bank-owned”, or “REO” (real estate owned). When banks sell their foreclosed homes, they – like any seller – want to get the maximum dollars they possibly can. The reason a foreclosure can sometimes be a good deal is that the bank is in a big hurry to get that maximum number, so the property may not have time to get exposed to all the buyers who might be interested. So, like the short sale “test price” scenario, they might put a price tag on a foreclosed home that is ridiculously low and then zillions of buyers will swarm over to the house and everyone will be falling over themselves writing offers for waaaaaaaaay over the asking price.

One of the worst side effects of all this “fake” pricing is perception among buyers out there. They see a home that once sold for $700k asking $450k and they think the sky is falling. They start to get the idea that these deals really exist. And in the real estate market, consumer confidence is really important for prices to stabilize. Nobody is there to explain to these buyers that there is no way on earth that property is going to sell for $450k and probably not for under $550k! It’s not going to sell for a penny less than the highest buyer out there is willing to pay! And if it sells for much below what it is worth, it likely sold to a buyer who paid all cash. (Banks favor all-cash offers because they are faster and have zero risk of falling out of escrow due to loan troubles.)

Furthermore, buyers of bank-owned properties must use extra care. Disclosure requirements are quite different since the banks have never lived in the home. Most banks will require buyers to sign an Addendum to the 8-page regular purchase contract, and this Addendum often asks the buyer to forfeit many of his protections under the regular contract. Buyers should consider getting an independent professional physical inspection – about $400 – before they accept the terms on an Addendum so they know what they are getting into and don’t end up losing their good faith deposit if a big problem is discovered later and they want to back out of the purchase.

The old adage is still true: you can’t get something for nothing.

The bottom line is that short sales, N.O.D. properties, and bank-owned properties are circumstances where it is more important than ever to have EXPERT representation. You need an agent who will help you correctly assess the value of the property completely separate from the asking price. There’s a reason the property didn’t sell in a normal sale – it’s likely the property has some challenges regarding its location or condition. You need someone who can properly investigate the status of the property with the bank – how much is owed so you’re making offers that are likely to work, and whether there is an N.O.D. necessitating special legal handling of the purchase. You need someone who can help you understand the Addendums and other curve balls. If you’re not able to pay all cash, you need a representative who can help your offer stack up against an all-cash buyer. And mainly you need someone who cares more about helping you make a healthy decision than helping themselves make a buck.

Today some internet buyer inquired on the Etheridge Team website about a bank-owned property that was on the market for 1 day. It entered escrow fully 3 days before the buyer’s inquiry. Admittedly, it most likely took an offer well over its asking price; nevertheless, this is another reason why it’s a good idea to have a real estate agent working for you to find you things rather than you relying on looking on the internet yourself. You almost have to have an advocate attending all the marketing meetings in your area of interest and lunching with other agents to get the skinny on things before they are even out. Relationships are the reason the internet will never replace good representation (key word “good”), in good markets or bad. Relationships get offers accepted and troublesome escrows closed with a win-win for both sides. Some buyers plan to call their cousin’s boyfriend’s hairdresser’s daughter who sells real estate part time to represent them after they find what they are looking for themselves… but that buyer is missing out on all the benefits of a seriously committed expert to represent them full-time. And as a buyer, having an agent costs you nothing!

At the Etheridge Team, we have sold and represented buyers on many short sales and foreclosed properties, so we are pretty experienced at judging what can to work. Even if a client wants to try something that might be a really long shot, we would always submit and aggressively negotiate any offer he/she wanted to make. We are well qualified to evaluate value and status. And most of all, it is our mission to earn your loyalty and referrals by helping you navigate the pitfalls and have an ideal experience! Give us a call and we’ll answer your specific questions on these special purchases. Maybe a short sale or bank-owned purchase is a step toward your real estate portfolio success!