Short Sale

Sometimes homeowners find themselves underwater, increasingly unable to pay the mortgage, taxes and other costs for their property. When this situation happens at the same time that property values have fallen to the point where the house is worth less than the mortgage on it, a homeowner may decide to put the property on the market. This type of deal is called a short sale, or pre-foreclosure sale because the property is sold for less than the amount due on the mortgage.

Such real estate sales can benefit the lender, which can avoid the lengthy and costly foreclosure process, and the borrower, who can eliminate or reduce mortgage debt and keep a foreclosure off their credit report. Short sales can also provide excellent opportunities for buyers to get into houses at a reduced prices. Here are some tips to help you make smart decisions when considering a short sale property.

Prepare to Hurry Up and Wait

  • 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 preapproval letter and 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 Properties

Most short sale properties are listed by real estate agents, and you can search listings on local web sites and the MLS (multiple listing service). 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. For more information, see Find Short-Sale Listings.

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”): 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/baths, 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
    • Insurance
    • 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; and
  • 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.

The Bottom Line

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. For more information, see Purchasing A Short-Sale Property.

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.

Read more: Short Sale Strategies For Buyers And Investors | Investopedia