What is a Short Sale (Real Estate)
A short sale in real estate is when a financially distressed homeowner sells his or her property for less than the amount due on the mortgage. The buyer of the property is a third party (not the bank), and all proceeds from the sale go to the lender. The lender either forgives the difference or gets a deficiency judgment against the borrower requiring him or her to pay the lender all or part of the difference between the sale price and the original value of the mortgage. In some states, this difference must legally be forgiven in a short sale.
In investing, a short sale is a transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future.
BREAKING DOWN Short Sale (Real Estate)
The term short sale refers to the fact that the home is being sold for less than the balance remaining on the mortgage, for example, a person selling a home for $150,000 when there is still $175,000 remaining on the mortgage. In this example, the difference of $25,000, minus closing costs and other costs of selling, is considered the deficiency.
Before the process can begin, the lender that holds the mortgage must sign off on the decision to execute a short sale, also known as a pre-foreclosure sale. Additionally, the lender, typically a bank, needs documentation that explains why a short sale makes sense; after all, the lending institution could lose a lot of money in the process. No short sale may occur without lender approval.
Short sales tend to be lengthy and paperwork-intensive transactions, sometimes taking up to a full year to process. However, short sales are not as detrimental to a homeowner's credit rating as a foreclosure.
Differences Between a Short Sale and a Foreclosure
Short sales and foreclosures are two financial options available to homeowners who are behind on their mortgage payments, have a home that is underwater or both. The owner, in both cases, is forced to part with the home, but the timeline and consequences are different in each situation.
A foreclosure is the act of the lender seizing the home after the borrower fails to make payments. It is the last option for the lender, since the home is used as collateral on the note. Unlike a short sale, foreclosures are initiated by lenders only. The lender moves against the delinquent borrowers to force the sale of a home, hoping to make good on its initial investment of the mortgage. Also, unlike most short sales, many foreclosures take place when the homeowner has abandoned the home. If the occupants have not yet left the home, they are evicted by the lender in the foreclosure process.
Once the lender has access to the home, it orders an appraisal and proceeds with trying to sell the home. Foreclosures do not normally take as long to complete as a short sale because the lender is concerned with liquidating the asset quickly. Foreclosed homes may also be auctioned off at a trustee sale, where buyers bid on homes in a public process.
A homeowner who has gone through a short sale may, with certain restrictions, be eligible to purchase another home immediately. In most circumstances, homeowners who experience foreclosure need to wait a minimum of five years to purchase another home. A foreclosure is kept on a person's credit report for seven years.
While a foreclosure essentially lets you walk away from your home, albeit with grave consequences for your financial future, such as having to declare bankruptcy and destroying your credit, completing a short sale is labor-intensive. However, the payoff for the extra work involved in a short sale may be worth it.
Things to Know About a Short Sale
Even though a short sale hurts a person's credit score less than a foreclosure, it is still a negative mark on credit. Any type of property sale that is denoted by a credit company as "not paid as agreed" is a ding on a credit score. Therefore, short sales, foreclosures and deeds-in-lieu of foreclosure all negatively impact a person's credit.
Short sales don't always negate the remaining mortgage debt after a property is sold. This is because there are two parts to all mortgages: a promise to repay the lender and a lien against the property used to secure the loan. The lien protects the lender in case a borrower can't repay the loan. It gives the lending institution the right to sell the property for repayment. This part of the mortgage is waived in a short sale.
The second part of the mortgage is the promise to repay, and lenders can still enforce this portion, either through a new note or through the collection of the deficiency. Regardless, lending institutions must approve the short sale, and borrowers are sometimes at their whim.
How to Go About the Short Sale Process
Before beginning the short sale process, the struggling homeowner should consider the likelihood that the lender will want to work with them on a short sale by understanding the lender's perspective. The lender is not required to do a short sale; it will be allowed at the lender's discretion. The source of the financial trouble should be new, such as a health problem, the loss of a job or a divorce, not something that was not disclosed when the homebuyer originally applied for the loan. The lender won't be sympathetic to a dishonest borrower. However, if you feel you were a victim of predatory lending practices, you may be able to talk the lender into a short sale even if you have not had any major financial catastrophes since purchasing the home.
Also, be aware of other circumstances that may prevent the lender from wanting to do a short sale. Unfortunately, if you are not actually in default on your mortgage payments yet, the lender probably won't be willing to work with you. Also, if the lender thinks it can get more money from foreclosing on your home than from allowing a short sale, the lender may not allow you to exercise this option. Finally, if someone cosigned on the mortgage, the lender may want to hold that person responsible for payment rather than doing a short sale.
If you think your situation is ripe for a short sale, talk to a decision-maker at the bank about the possibility of engaging in this type of transaction. Don't just talk to a customer service representative, who is often more like a spokesperson and has no real authority. To work your way up the phone ladder, immediately ask to speak with the lender's loss mitigation department. If you don't like what the first decision-maker says, try talking to another one on another day and see if you get a different answer. If the lender is willing to consider a short sale, you're ready to move forward with creating the short sale proposal and finding a buyer.
At this point, you should consult an attorney, a tax professional and a real estate agent. While these are high-priced professional services, if you make a mistake by trying to handle a complex short sale transaction yourself, you may find yourself in even bigger financial trouble. You may be able to pay for these service fees out of the sale proceeds from your home. Professionals accustomed to dealing with short sale transactions will be able to give you guidance on how to pay them.
To put yourself in a more convincing position to complete a short sale, stop purchasing non-necessities. You don't want to look irresponsible to the lender when it reviews your short sale proposal.
When setting an asking price, make sure to factor the cost of selling the property into the total amount of money you need to get out of the situation. Of course, you want to sell the home for as close to the value of your mortgage as possible, but in a down market, there is bound to be a shortfall. In some states, even after a short sale, the bank will expect you to pay back all or part of that shortfall.
Gather all the documents you'll need to prove your financial hardship to the lender. These may include bank statements, medical bills, pay stubs, a termination notice from your former job or a divorce decree. It is up to you to come up with the short sale proposal. Be aware that the lender ultimately must approve a short sale after receiving all the details because the lender is the recipient of the proceeds. Your job is to find a buyer for your home.
Once you have a buyer and the necessary paperwork, you are ready to submit the buyer's offer and your proposal to the bank. Along with the documentation of your distressed financial status, your proposal should include a hardship letter explaining the circumstances that are preventing you from making your mortgage payments. You want to make it as convincing as possible and protect your interests while also appealing to the bank. Be careful about submitting your financial information to a lender because if it does not approve the short sale, it may use your financial information to try to get money out of you in foreclosure proceedings. If you still have cash assets, you may be expected to use them to continue making mortgage payments or to make up some of the shortfall between the sale price and the mortgage amount. An attorney experienced in completing short sales can help you navigate the details.
Because short sales can take longer than regular home sales due to the need for lender approval, they often fall through. The buyer may find another property while waiting for an answer from you. Be prepared for this possibility. If the short sale transaction goes through, consult with the IRS to see if you will have to pay taxes on the shortfall.
Also, be aware that a short sale can still affect your credit score in the sense that the months of mortgage payments you missed prior to the short sale can show up as delinquent payments on your credit report. It is up to the bank to decide what to report, so it's in your best interest to try to convince the bank not to report your defaulted payments. Your bank may be more likely to be generous in this regard if you brought up your hardship before you were significantly behind. For credit purposes, while this is somewhat damaging, it is certainly less damaging than a foreclosure.
Alternatives to a Short Sale
Before resigning yourself to a short sale, talk to your lender about the possibility of a revised payment plan or loan modification. One of these options might allow you to stay in your home and get back on your feet. Another possible option for staying in your home arises if you have private mortgage insurance (PMI). Many homeowners who purchased homes with less than 20% down were required to purchase PMI with their homes. If the PMI company thinks you have a chance at recovering from your current financial situation, it may advance funds to your lender to bring your payments up to date. Eventually, you'll have to repay the advance. (For more information on your housing payments, read Understanding Your Mortgage.)
Short Sale Strategies for Buyers and Investors
Short sales can also provide excellent opportunities for buyers to get into houses at a reduced price. Here are some tips to help you make smart decisions when considering a short sale property.
Prepare to Hurry Up and Wait
Realize in advance that short sales are complicated and time-consuming transactions. It can take weeks or months for the lender to approve a short sale, and many buyers who submit an offer end up canceling because the short sale process is taking too long. Buyers have to be ready to wait for the bank's short sale approval. Rules for short sale transactions vary from state to state, but the steps normally include:
Short sale package: The borrower has to prove financial hardship by submitting a financial package to his or her lender. The package includes financial statements, a letter describing the seller's hardship(s), and financial records, including tax returns, W-2s, payroll stubs and bank statements.
Short sale offer: Once a seller accepts an offer from a potential buyer, the listing agent sends the lender the listing agreement, an executed purchase offer, the buyer's pre-approval letter, a copy of the earnest money check and the seller's short sale package. If the package is missing anything -- either because a document wasn't submitted or due to a filing error on the bank's part (e.g., the bank lost it) -- the process will be delayed.
Bank processing: The bank's review of the offer can take several weeks to months. In the end, it will approve or deny it. It's important to note that just because the seller accepts an offer doesn't mean the bank will agree to the price. If the bank thinks it can make more money through foreclosure proceedings, it will reject the offer.
Finding Short-Sale Properties
Most short sale properties are listed by real estate agents and on real estate websites. Some listings may not come out and say "short sale," so you might have to look for clues within the listing, such as "subject to bank approval" or "give the bank time to respond."
An experienced real estate agent can make a big difference in terms of both finding and closing short sale properties. Agents who specialize in short sales may hold a Short Sales and Foreclosure Resource (SFR) certification, a designation offered by the National Association of Realtors. Holders of this certification have received specialized training in short sales and foreclosures, qualifying sellers for short sales, negotiating with lenders and protecting buyers. It's important to note that the certification doesn't guarantee an agent will have the type of experience you are looking for, nor does a lack of certification preclude it. Either way, you'll want to vet any potential real estate agents to ensure their short sale expertise.
Know the Numbers
In real estate investing, it is said that the money is made "in the buy," meaning that a good purchase price is often the key to a successful deal. If you can get a property for a good price, you increase the odds of coming out ahead when it comes time to sell. If the purchase price is on the high end, on the other hand, you'll likely watch your profit margin erode.
You should be able to buy the property, put it in great condition and sell at a price where you can still make a profit. Investors need to be able to turn around and sell the house quickly -- typically at below market -- and a good purchase price makes this possible.
The purchase price is only one important number, however. You'll have to make some other calculations as well, including:
Costs of repairs and renovations: These costs will vary depending on the property's condition and your plans for it. It pays to put in the time and effort to develop a realistic budget since this is one of the figures you'll need to determine if the investment can make money. Costs to consider include material, labor, permits, inspection fees, trash removal, storage costs and dumpster rentals. A good inspection (before making the purchase) can alert you to any large expenses, such as a cracked foundation, faulty wiring or extensive termite damage.
After Repair Value (ARV): ARV is an estimate of the property's fair market value after any repairs and renovations are made. (See Cheap Home Renovations That Pay Off.) Investors look at this number to determine whether a property has profit potential. The best way to evaluate a property's ARV is to look at comparables ("comps"), i.e., homes that have recently sold in the area (typically up to a mile away from the subject property) that have similar features in terms of square footage, number of bedrooms/bathrooms, etc.
Carrying costs: Carrying costs are your expenses for holding onto the property. The longer you own the property, the more you will spend in carrying costs, which include:
- Mortgage payment (including interest)
- Property taxes
- Condo and association fees
- Utilities (electric, gas, water, sewer, trash)
In order for an investment to be profitable, the sum of your costs (the purchase price, repair and renovation costs and carrying costs) must be lower than the ARV. If your costs are close to or higher than the ARV, it will be difficult or impossible to make a profit. You can determine the potential profit by subtracting the purchase price, repair and renovation (R&R) costs and carrying costs from the ARV:
Profit = ARV ˗ Purchase Price ˗ R&R Costs ˗ Carrying Costs
Real estate investors might expect to earn at least a 20% profit on a property, and some use guidelines to evaluate properties in different housing markets. Under these guidelines, total investment (purchase price, repairs and renovations and carrying costs) should not exceed:
- 80% of ARV in a market where home values are rising
- 70%-75% of ARV in a flat market
- 60%-65% of ARV in a market where home values are decreasing
If the ARV of a property is $200,000, for example, your total investment should be limited to about $160,000 in a rising market, $140,000 in a flat market and $120,000 in a market with falling values. The various investment levels are used to reduce risk in changing market conditions. You can risk more in a rising market since you are more likely to get your ARV or better when you sell. In a falling market, you are less likely to get your ARV, so your investment should be smaller.
A short sale property can provide an excellent opportunity to purchase a house for less money. In many cases, short sale homes are in reasonable condition, and while the purchase price might be higher than a foreclosure, the costs of making the home marketable (repairs and renovations) can be much lower. But, because of the lengthy process, buyers must be willing to wait. An experienced real estate agent can help you determine a fair offer and negotiate with the bank.
While many investors purchase short sale properties and quickly resell them for a profit, others choose to maintain ownership and use the property for income by collecting rent. In either case, each property must be carefully evaluated prior to purchase to determine if it has profit potential.
Note: Because tax laws are complicated and can change from time to time, it is always recommended that you consult with a CPA who knows about real estate investing and related tax laws to give you comprehensive and up-to-date information. It can mean the difference between making a profit and taking a loss on an investment.