Copyright © 2008 Lex Levinrad
When a bank loans money by giving a mortgage to a homeowner, the bank expects to be paid back in full when the homeowner sells or refinances the property. A typical bank mortgage is a loan at a loan to value (LTV) ratio of 80%. The standard conventional loan requires a 20% down payment and an 80% mortgage.
As long as the property does not decline in value, the bank has the house as collateral and can be assured of getting their money back by selling the house via foreclosure auction in the event that the homeowner does not pay.
However, occasionally prices decline so rapidly that the equity in the home is diminished to the point that there is no equity left in the property. In extreme cases, the homeowner is said to be “upside down” meaning that they owe the bank more money than what the house is worth.
Upside down situations usually result from either a sharp decline in prices, high LTV loans or a combination of both. Currently the foreclosure crisis that we are in is a direct result of poor lending standards and sharply deteriorating property values.
When a homeowner is “upside down” and cannot afford to stay in their home then the best option is for them to try and sell the home. However, if prices have dropped dramatically and they cannot sell the house for anything close to the loan value then when they do find a buyer, the purchase price will be lower than the amount that is owed to the bank. In this situation they will have to receive prior approval from the bank to accept an amount less than the full amount owed on the mortgage. This is called a “short sale”.
In this situation, the bank will have to decide if they want to accept the “short sale” offer which is an amount less than the full value of the mortgage balance. The bank has to carefully weight many factors including the condition of the house, the time it will take to foreclose on the property and the legal costs and holding costs of lost mortgage payments. Typically banks will easily accept a 5% to 10% discount off the face value of a mortgage when faced with a homeowner in foreclosure. However, the irony is that the bank will not be willing to negotiate with a homeowner that is current on their payments.
In order to proceed with a short sale, the bank has to feel that the homeowner is going to allow the bank to foreclose on the property. Usually a homeowner needs to be at least 90 days late in order for the mortgage bank to file a foreclosure notice called a “lis pendens”. Once the property is “in foreclosure” the bank will be more willing to entertain offers that are less than the full value of the mortgage balance.
The bank has to carefully analyze what they believe the house is worth, and what they think it would sell for at a foreclosure auction or as a bank owned property. Then they need to consider the time it would take to get the house back and how many months of lost interest payments that would amount to. They also have to consider the legal costs of the foreclosure as well as the currents condition of the property and if any repairs are needed.
Sometimes the bank will consider selling a property for as little as 50% of the face value of the mortgage. Usually this occurs when there is substantial damage and rehab required to bring the property to a marketable condition. A more typical short sale is probably at around 70% of the previous balance although each property is different and there is no set guideline. I have seen banks decline high offers and I have seen banks accept very low offers. Each case depends on the property in question, the sales comps, the condition of the property and many other factors. The ability to have a working relationship with the loss mitigation representative is also a key factor in the negotiations.
Negotiating a short sale is a time consuming and cumbersome procedure. It can typically take a few months of back and forth negotiations between the buyer, the owner and the banks loss mitigation department.
An astute buyer will have supporting documentation such as the following:
- Extensive documentation and pictures of all damages to the property (the more the better). If there is mold or severe damages to the property then the bank will be much less willing to take the property back than if the property is in perfect condition.
- Proof of low sales comps supporting a lower value for the property along with solid BPO’s (broker price opinions) as to the value of the house
- Proof of how long it will take to remove the occupant of the house and foreclose on the property.
- Proof that the seller is prepared to file bankruptcy (which will delay significantly the foreclosure process). Many sellers facing foreclosure are behind on all of their bills and so bankruptcy is an option for them to consider.
- A solid case for why the buyer is not prepared to offer more. For example previous REO sales at the same price, or previous low purchases by the same buyer. A solid cash buyer that buys many properties will be taken much more seriously by the bank than a buyer putting together their first short sale package.
After all of this information is gathered, it needs to be put together in a “short sale package” and then submitted to the bank. The loss mitigation department then reviews this package and takes it to their superiors for review. The process is extremely time consuming and cumbersome and there is no guarantee that loss mitigation will even be interested in negotiating at all. You can get anywhere from a great response to no response at all. It really depends on how desperate the bank is to make a deal and how professional the buyer appears to be.
Any buyer will have to be a cash buyer so a proof of funds is an absolute necessity in order for the bank to take the buyer seriously. You need to show that you have the ability to close quickly for cash and you need to be willing to waive inspections and have no contingencies to your contract. You also need to be able to show the bank that the previous owner is not deriving any benefit.
In an ideal situation you should seek a “non deficiency judgment” meaning that the bank will not go after the previous owner for the difference between the amount owed on the mortgage and the purchase price. The previous owner will be required to report the difference as income since the bank will definitely issue a 1099 since they will be deducting the loss for income tax purposes and their loss will be your gain which by definition means income. Filing bankruptcy will not absolve the previous owner from any taxes that are due in the following year as a result of this 1099 so the purchaser should make sure that the seller is aware of this fact.
Putting together a short sale package can be a cumbersome and time consuming task. There is no guarantee that the bank will accept, review or even communicate with you once you have submitted a short sale offer. It can be quite disheartening to spend so much time on a short sale only to get a tepid response from the bank. For this reason, in the current foreclosure crisis the easiest way to buy discounted properties is to buy them directly from the bank once they are bank owned REO properties.