The Difference Between Foreclosures and Short Sales for Buyers

Let me break down the difference between foreclosures and short sales and how they both differ from traditional home sales. I make one caveat that when I use the terms like “usually”, “typically” or “rarely”, it means while there can be exceptions, exceptions, in my experience, are unlikely.

Foreclosures:  Really these are misnamed. Foreclosure is actually the process by which the lender takes over ownership of the property per the terms spelled out in the Deed of Trust (the mortgage) when a borrower is delinquent on their mortgage.  Part of the foreclosure process is what you may have heard of and that is the property gets auctioned off at the courthouse steps.  This really does take place.  However, when the borrower owes more than the home is worth, what typically happens is the lender places an opening bid at the auction for the amount owed and no one else makes an offer (because it isn’t worth that much).  The bank essentially buys back the house and it becomes Real Estate Owned, or REO.  This is the proper name for what people are usually talking about when they speak of buying a foreclosure. 

So, once the lender owns it, they put it up for sale with a real estate agent and that’s what you see in the MLS/on my website.  Important facts about buying an REO property are: #1 they are sold AS-IS and the bank will normally not pay for any repairs.#2 you must use the bank’s contract, not the standard one we use.  This contract is weighted entirely in the banks favor; there few obligations and few repercussions for them yet there are a lot of demands and repercussions for you the buyer.  On the positive side, these homes can be purchased 10-40% below market value.  As long as the value is there, you love the house, and you have me helping you adhere to all the contract requirements, you should be ok.  REO sales will generally participate in paying some or all of your closing costs.  They typically do not accept offers that are net (including asked for closing costs) 5% below their current asking price.  A bank may start an REO listing at one price, say $200,000 and lower it 30 days later to $194,000 and 30 days after that to $188,000 and so on until it sells. It will usually not, however, accept an offer of $187,000 while it is listed at $200,000. 

Short Sales:  These are sales that are attempted by the seller before foreclosure has taken place.  In these situations the seller is forced to sell due to some hardship/inability to pay but owes more than the home is worth and cannot make up the difference in cash.  These sales require the third party approval of the seller’s lien holder to release the lien for less than the full amount owed so that it can be sold to the new buyer.  Short sales are AS-IS sales, too, but that is where the similarities to REO cease.  Because the bank already owns an REO, they determine what they will sell the home for and put it for sale with a list price.  With a short sale, the bank does nothing until they are presented an offer.  The list price is usually not an “approved” list price and is merely the best guess of the seller and the agent of what it will go for. If you offered full price on an REO you could be reasonably confident in getting your offer accepted within a few days, with a short sale, you will be waiting up to 4 months before finding out if your offer is acceptable or not.  The joke in the industry is there is nothing short about a short sale.  The seller’s lender will order an independent appraisal of the property and compare your offer to their estimate of “fair market value”.  Lenders will rarely accept offers that are more than 12% less than “fair market value”.  There are additional requirements to getting a short sale offer approved other than the terms of your offer.  The seller actually has to be approved for a short sale, just like you have to be approved for a mortgage only in reverse.  The seller’s bank must convince themselves that the seller really cannot pay or come up with the difference and they do that by making an extensive inquiry into the seller’s finances.  Finally, the terms of the short sale approval, if obtained, have to be satisfactory to the seller.  I’ve seen short sales get “approved” that required $30,000 cash contributions from the seller or where the shorted lender would not waive their right to a deficiency judgment.  A seller may elect to let the home go to foreclosure rather than accept such harsh terms.  All this is to say, there are a lot of ways short sales can fail and you had better count on a long wait before you close.  Unfortunately, there is less incentive to put up with all negatives than there is with REO.  Short sales (that get approved) are usually sold at between an 8-17% discount.

A note on AS-IS sales. You can get into a catch 22 with both REO and short sale if the house is in need of work.  Besides your inspection, the house you buy must pass two other inspections: the appraisal and the termite/moisture inspection.  The appraiser is going to evaluate the homes worthiness as collateral for your loan.  Therefore, it must not only be valued properly but it must meet some minimum standards.  A conventional loan appraisal will have less stringent criteria than a government backed FHA or VA loan.  Still, the home you buy cannot have a hole in the roof (or siding more commonly), or any other major problems that compromise the safe, sound, and secure nature of the dwelling.  Also, your lender will not loan money on the house if it has active termites or unrepaired termite damage.  If the house you want to buy has any of these issues (and you may not find out until you’re already under contract) you are in a difficult situation.  You can’t buy the house unless the items are fixed and the bank or seller’s lender won’t pay for anything to be fixed.  With REO, the bank will not permit you the buyer to make repairs prior to closing if you wanted to (something I strongly discourage anyway).  On short sales, there is more latitude since the seller still owns it not the bank and may authorize work to be done.  The trick is finding someone to pay for it.  For required repairs that exceed $1,000, it is often hard to find that money.  Under $1,000, there’s usually a way to get it done.  What this amounts to is that there are going to be some homes which, due to their condition, you cannot purchase even if you wanted to because they need too much work.  The best way to determine if this is the case or not is for me to first call the listing agent.  They have probably already made an evaluation and in some cases determination whether the property will pass the required inspections.  Other times, we just have to go look for ourselves. 

Now you are an EXPERT at knowing the difference between REO and Short Sales!  If you want extra credit, you can watch this video I made about a year ago that details many of the same points.   http://youtu.be/MkE56sZr7Ts

Brad Anderson
RE/MAX Peninsula
Office phone: 757-816-2968
Email: brad@peninsulahousesforsale.com
Website: http://brad.peninsulahousesforsale.com

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