Understanding Short Sales
Once a homeowner is “upside-down” in their home mortgage, there is an opportunity to use this to your advantage while helping them out of a tough situation. A successful short sale requires that all parties involved see that it is in their best interests, in other words everybody wins.
Temporary market fluctuations, life situations, and just bad stuff can force homeowners to sell their properties through a short sale to avoid repossession. Most investors, and even homeowners, walk away from these situations, but this is where all your work in locating these properties and your knowledge of the process can bring you big rewards that are well worth your efforts.
Here’s a simple rule that you as an investor should abide by: if the owner has little, no or negative equity in the property, we look at short sale opportunities. As a rule of thumb, if they have more than 15% equity, we are buying the equity.
What Does “Upside-Down” Mean?
Many homeowners refinance to remove equity from their homes to make improvements or to finance other purchases, only to find that their total loan balances far exceed the current appraised value of their homes. When you can’t sell it for enough to cover the amount owed on the home, you are “upside-down”.
Understanding a Short Sale
When a lender releases a homeowner from their mortgage at anything less than the full amount owed, they are accepting an amount “short” of the agreed-on pay out figure.
The costs to legally repossess a home can be quite high, with estimates starting at $30,000 in costs on average for the lender.
It’s not hard to see that the lender might be willing to accept something short of the entire mortgage balance in order to get out of the situation. In a short sale, the bank is basically taking or accepting a smaller percentage on each dollar owed.
If the lender proceeds to a mortgagee repossession, it is a legal action, and the time necessary to carry it to completion can be months to more than a year.
When the mortgagee sale is over, if the amount received doesn’t cover the mortgage, fees, and costs, the lender can pursue the borrower for the difference.
The problem with deficiency judgments is that they are a legal claim on the money, with no indication that they’ll actually ever receive it. Further collection actions must be taken, and those can cost the lender even more money.
Another drawback is that the lender usually has reserve requirements for non-performing loans.
Banks have financial regulations they must abide by, one being that they must maintain liquid funds to cover the shortfall. These funds cannot be reinvested or used to generate income.
As you can imagine, this isn’t a fun position for the lender. As a result, you can see why a lender might agree to a sale to a qualified buyer for an amount short of the mortgage owed by the homeowner.
In a short sale, there is a third-party buyer who is willing to purchase the property at an amount that will not satisfy the balance of the loan.
The lender may be willing to allow this because the cost and time involved to repossess the home would cost them more than the shortfall, and they aren’t certain to receive more at a mortgagee sale or auction. They will also avoid the requirements for holding reserves during the foreclosure process.
You cannot do a short sale without the full consent and co-operation of both the bank and the owner. The owner needs to sign a contract for sale to you and the lender needs to agree to discharge the mortgage for that contract price.
You may find that by the time you get to speak to the owner, they have already been in contact with the bank and have informed the bank in on the status of their financial position.
If you find that the owner you are dealing with has a good understanding of their situation and an appreciation of what you are proposing for them and they feel comfortable talking to the bank, then you may get the best results by asking them to speak to the bank in the first instance without revealing anything further to the bank from your side.
The home owner would simply ring the person at the bank who has been corresponding with them and say something along the lines of:
“I have found a buyer who has agreed to purchase the property at $x. Would you allow me to sign the contract for a sale at this figure?”
You may need to coach the owner on how to discuss this with the bank and what they should say (and not say).
They should be stressing that they have spoken to agents and that this offer represents the best they think they can get in this market given the state of the property and they are keen to accept it with the lender’s blessing as they want to try and mitigate the loss (to themselves and the lender).
They must not mention that there is money on the side or that there is some sort of history with you (this is an arm’s length transaction with a separate, disinterested third party buyer at market price (ie you) for all intents and purposes.
The upside to this is that if the bank agrees, you have bypassed many of the issues that commonly have to be resolved when we approach the bank as a third party and ask to buy the property from them at a substantial discount.
The bank sometimes suspect collusion or something untoward or a conflict of interest insofar as you have a power of attorney and are trying to rip them off and steal the property cheaply.
The downside is that because you will not have contacted the bank with a Power of Attorney to confirm the mortgage details with the lender, you are relying upon what the homeowner has advised when you work out your figures as to what you can offer the bank.
Therefore, you should just set your own price for the property – what you can pay, plus duty and renovation costs etc and still make the deal work (as opposed to working backwards from what you think the mortgage is – eg 10% less than what the owner tells you is owed).
If you choose this approach, it would be best to get an up to date mortgage statement from the homeowner showing the outstanding balance. If they do not have one, then ask them to obtain a copy from the bank before you proceed.
You should also ask to see any letters the bank has sent them demanding payment, as they will show the amount that is in arrears. You will then need to micro-manage the owner in relation to their call to the lender telling the lender about your offer to purchase. It is easier to do it this way in the scheme of things if you have a homeowner who can handle the call.
Short Sale Case Study
This case study is a divorce situation in Melbourne. Husband leaves home and stops paying mortgage on a house he is not living in. Bank is repossessing.
Argument to bank is that they are better off selling to Wendy (a REAL ESTATE RESCUE student) and getting a bird in the hand than waiting to repossess, market and sell the property themselves.
Wendy gets market appraisals from three agents who value the property in its current state at between $230K and $250K. This is too high for Wendy’s liking so she engages a private valuation which comes in at $190K. She then signs an unconditional contract for sale with the owner at $190K.
She takes photos of the property to paint it in a bad light – with rubbish piled up everywhere and damage internally and externally as well as all the debts against the property (eg photocopies of council notices for rate arrears).
She has the owner fill out a statement of financial position which shows that she is on Centrelink benefits and is impecunious (no money and no hope of having money in the foreseeable future so the bank will never get blood out of a stone).
She writes a cover letter to the bank attaching all of her supporting evidence to prove her point and to convince the bank that they would be better off taking a bird in the hand and selling the property to her for $150K than repossessing and marketing it.
Wendy spins the numbers to the bank as follows:
Initial Mortgage: $148,000
Mortgage + Arrears: $187,000
Less Legals: $10,000
Less Repairs: $30,000
Commission (2.2%): $4,180
Auction Costs: $5,000
Holding Costs (6 mths): $12,000
Council Arrears: $2,030
Future Council Rates: $2,000
Total to come off top: $65,210
What the bank will clear if they go through the normal process of repossessing and selling:
$190K minus $65,210 equals = $124,790
Short Sale offer: $150K
The bank goes for a bird in the hand now rather than wait the standard 6 months (which is what it takes to sell a property in that area at that time. Wendy shows them RP Data reports where properties are taking 6 months to sell and which reveals that there are 70 similar properties on the market in that area at the time.
The result – the seller was saved from bankruptcy and is free from her crippling debt. In exchange, the investor made a fair and reasonable profit. It was win/win for both parties.
Get the picture?