Common Questions Answered: Buying Short Sales & Foreclosures

Distressed property is all the rage these days. And it's a good thing: If it weren't for investors and bargain hunters snapping up low-priced inventory, we'd be in a whole different place (a much worse one).

When we speak of distressed property, we're primarily talking about short sales and foreclosures. In almost every initial conversation I have with any potential buyer, they inevitably ask me what the difference is between short sales and foreclosures. So I'll start there and pose a few of the most common questions I get, along with my answers. If you have a question I don't answer here, post it below and I'll get right on it.

Q: So what is the difference between a short sale and a foreclosure?
A: A foreclosure, also known as a bank-owned property or REO (real estate owned, which is how it shows up on the bank's books), is property the bank has repossessed from the owner due to nonpayment of the mortgage. The bank owns the property outright and hopes to sell it for as much as possible to recoup some of their losses on the deal.

A short sale is a situation in which, most likely, the owner has fallen behind on mortgage payments, the bank is moving to foreclose, and the amount owed on the mortgage is greater than the property's value (some call this condition "underwater"). The owner is trying to sell the property for whatever it's worth, hoping their lender would rather take a discounted or "short" payoff right now instead of seeing the rest of the lengthy foreclosure process through. So in this situation, the seller still owns the property, but their lender calls the shots.

Q: How long do these transactions take to close?
A: An offer on a foreclosure will usually get a response within five business days. After that, you can close within a normal time frame (30-45 days).

An offer on a short sale must be signed by the seller, then submitted to the seller's lender for review along with a litany of other documents. Depending on which lender holds the mortgage, how many mortgages and other liens there are, and the skill and experience level of the person handling the short sale (typically the seller's agent or attorney), buyers can expect a response to their offer within three to six months. That time frame is rarely shorter and occasionally longer.

Q: What additional risk is involved in buying distressed property?
A: Both short sales and foreclosures are sold "AS-IS." That means the seller is not going to do anything to the property and the buyer accepts it with whatever physical or legal defects it may have. Buyers CAN and always SHOULD have a home inspection done, and they can still back out of the deal if the inspection turns up anything unacceptable. The buyer is also responsible for passing any municipal inspections, purchasing all transfer stamps (even those customarily purchased by the seller), and ordering a survey if their lender requires one.

In the case of a short sale, the seller will provide the customary disclosures regarding the property's condition and any known material defects, as required by state law. A bank selling REO has likely never even seen the property; therefore it is exempt from those disclosures and buyers are truly on their own.

One thing that is NOT different about buying distressed property is that the seller (if it's REO) or the seller's lender (if it's a short sale) WILL provide the buyer with clean title and a title insurance policy, just like a traditional sale. That means they clear up any known liens on the property and pay or credit the buyer for any unpaid real estate taxes. You may open a can of worms fixing the place up, but at least you know it's yours!

Q: Should you include foreclosures and short sales in your home search?
A: It depends.

I almost always advise buyers to include foreclosures. They are frequently priced below-market and present great opportunities for instant equity. The only time we have to be careful with foreclosures is when a buyer only qualifies for FHA financing. When FHA appraises the property they expect everything to be intact and fully functional; they won't lend on it if anything is broken or missing (e.g. windows, a bath vanity or kitchen cabinets, a furnace). An ordinary seller might offer to get the property into "FHA condition," but if it's owned by a bank you can pretty much forget it. There are exceptions, but that's a whole other discussion.

I advise buyers to include short sales when their circumstances allow it. Due to the time frame they take to close, short sales are often a consideration for people who are not on a timeline: Those who don't have to sell and buy at the same time, investors purchasing multiple properties - in general, buyers who aren't in any sort of hurry. For buyers who need to close before their lease is up, live in a certain school district or area by a set date for school or work, or in general have to be moved by particular date, short sales are not recommended. Same goes for anyone who lacks patience!

Q: Which is a better deal, short sales or foreclosures?
A: Ah, the million dollar question. Where can you get the best deal? There are two schools of thought on this, but I believe foreclosures most frequently present the best opportunities. Why? Primarily because of the way the bank determines what price they'll take for a house when they already own it, which is different from how they evaluate it when the borrower still owns it.

With short sales, once an offer is received and submitted to the seller's lender, they hire an appraiser to give them the current, as-is market value of the property. They will usually accept a certain percentage of that value, commonly about 90%. If there are other liens on the property, such as a second mortgage or delinquent property taxes, those liens need to be satisfied too - after the lender who holds the first mortgage gets their 90%. So the best deal you're going to get is 90% of the property's current as-is value, as determined by an appraiser, but you might have to cough up a little more depending on secondary liens.

With foreclosures, the price is determined by an asset manager who bases his/her decision on a BPO - that's a broker opinion of value, a report completed by a real estate agent who is often going to be the one listing the property for sale. It's in the agent's best interests to get the bank to list the property for an attractive price. In fact, many banks request the BPO agent to recommend a "30-day sale price." So when these listings come on, they're often at hot prices.

A few years ago when short sales were just coming on the radar, banks used desktop valuations or BPOs for short sales instead of appraisals, and they didn't have the procedures and rules they have in place now. It's those appraisals, procedures and rules that have changed the game with short sales and made foreclosures more attractive in my experience.

I did a little research to back up my belief, for those who might disagree. I looked at the median sale prices of all foreclosed and short sale residential property that has sold in the past 12 months in Oak Lawn, Matteson, Tinley Park, and the Loop (as of October 2011). In every case, the median sale price of foreclosures was lower than the median sale price of short sales - by anywhere from 3% (in Matteson) to almost 30% (in Tinley Park). Further, in all three suburban areas, foreclosures sold for a larger discount off their asking prices than did short sales. That didn't hold up in the Loop where foreclosures sold for a median of almost 107% of their asking prices - but that was still 19% lower than the median short sale price.

So if you have any general or specific questions I didn't touch on here... Fire away!