The Difference Between a Short Sale and a Foreclosure
Short sales and foreclosure are common terms in real estate with which most professionals and homeowners are familiar. What’s less clear is how they apply to investors and which is the smarter choice for investment. The truth is, they both carry their own unique sets of benefits and drawbacks, and if you’re an investor who’s on the prowl for properties below market value, it helps to be aware of both and how they relate to your own goals.
Just about the only thing short sales and foreclosures have in common is that they’re both financial options available to homeowners who are distressed borrowers. These homeowners are usually behind on their mortgage payments, have a home that is underwater, or in many cases both. Should that situation arise, the owner is forced to part with the property, but that’s pretty much where the similarities between foreclosures and short sales end.
The homeowner usually initiates a short sale, but it does have to be approved by the lender. When the owner falls behind on mortgage payments or when the value of a home drops by 20% or more, a short sale becomes a viable option before foreclosure is initiated. It’s not strictly the owner’s call, though; the lender that actually holds the mortgage has to sign off on the decision to execute a short sale because they ultimately stand to lose as well (hence the term “short sale”).
This is important to remember because the lender also has the right to foreclose in most situations, and the decision boils down to which option is the better deal for them. Because of that, the lender will require documentation that explains why a short sale is the best option for them. If approved for short sale, the buyer will negotiate with the homeowner and then get approval from the lender as to whether or not the deal may proceed. Ultimately, it’s the lender’s call.
In a foreclosure, the former owner is already removed from the situation and the lender has already repossessed the property, so approval for selling the property isn’t necessary. The lender already has it and is concerned with moving it as quickly as possible. Like a short sale, a foreclosure happens when a borrower falls behind on payments, but by this point they’ve defaulted on the loan. The lender then seizes the home as collateral on the loan and forces the sale with the expectation that they’ll get a return on their initial investment of the mortgage.
Foreclosures are typically an expensive and time-consuming process for the lender, which is why they’re sometimes open to a short sale instead, but it all depends on the circumstances, the state of the market, and the lender’s assessment of the numbers involved in the property and the proposed course of action.
So as an investor, which types of sales should you focus on? Both short sales and foreclosures can yield, in theory, properties below market value for which renovation and resale can be a single-digit percentage of the home’s actual market price. What’s true in theory isn’t always true in practice, though, and it becomes even more complicated when you consider your own goals as an investor.
Short sales can be a good deal, but there’s a certain amount of risk involved for you as a buyer. For one, you’ll need to negotiate with the buyer before getting approval for the lender, which they may withhold. That’s a problem because it wastes a lot of time and effort for no return, especially considering that the approval process could take up to a year and involve a good deal of paperwork. If you were looking for a quick fix-and-flip, maybe a short sale property could afford you that after closing, but actually getting to that point will take quite some time.
The other disadvantage with a short sale is even though you have to get approval from the lender, they don’t actually own the home in a short sale (but they still need to approve it because they’re the ones who will collect the proceeds from the sale), so they’re unlikely to make any repairs. The homeowner is even less likely to do so because they wouldn’t be in the position of initiating a short sale if they weren’t hurting financially, and because of the way short sales are structured they have little interest in precisely how much the property is sold for since they’re ultimately not the ones who are going to collect from it.
What does work in your favor though is that you’ll likely have amicable dealings with the homeowner because they’re in a better position than they would be if they were foreclosed on: they have time to make arrangements and are able to avoid a huge hit to their credit (which enables them to buy a home surprisingly soon after selling). This is important because while they may not have an interest in the price of the home, they do have an incentive to see to it that the deal goes through, so you probably won’t run into occupants you have to evict after closing or a property that’s been trashed out of spite.
Having to remove occupants from foreclosed properties and dealing with trashed homes is a possibility when buying foreclosures, and that can be difficult emotionally on you as an investor and also put a big dent in your returns. With foreclosures you only have to deal with the bank, but at the same time you’re not as likely to have to buy the property sight-unseen. The lender isn’t going to make repairs usually (they’ll just adjust the price), but the home may be sold “sight-unseen” or “as-is,” and even if you’re able to view the home, most foreclosed homes are boarded up so you’ll only be able to inspect it visually from the exterior.
Timing is also a huge advantage here, as the lender already has the property and has no need to approve the sale. They’re eager to liquidate it and price it accordingly. They make no money from having the home sit on their books, so to speak, so a foreclosure sale takes a lot less time. Foreclosed homes are often even auctioned. Because of this, and the lender’s incentive to quickly sell the property, you may find that a foreclosure is priced further below market value than a short sale. Unlike a short sale, it doesn’t have to be proven that the sale is in a lender’s interest nor does the price need as much negotiation; they already have the property, and they want to get rid of it.
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– Get It Right Solutions