Everything You Ever Wanted to Know About Short Sales But Were Afraid To Ask
By Charles P. Castellon, Esq.
Throughout the foreclosure crisis, many distressed borrowers have pursued a short sale of the property as a solution to the problem. Though there has been much written about short sales, many homeowners evaluating their options lack a fundamental understanding of this process. In this article, we’ll de-mystify short sales and break it down to the basics of what, why, how and when a short sale should be done so you can better understand the process and decide whether it’s right for you.
What is a short sale?
Essentially, a short sale is the sale of real estate for market value when that value is not enough to pay the outstanding mortgage debt on the property. The main difference between a short sale and a conventional sale of a home is the seller/borrower walks away from the closing table with no money. Usually, the seller pays no money at closing either. A seller contribution most commonly occurs when there is a second mortgage or equity line on the home and that lender requires more money to approve the short sale and release their lien so the deal may close. Often, the second lender will offer the borrower the option of bringing a lump sum cash contribution to the closing or take back an unsecured promissory note (without a mortgage on any property) for a larger amount than the lump sum option. The amount of either contribution is usually far less than the outstanding balance owed to that second lender and when the borrower accepts a note instead of a lump sum, it is often with zero interest.
When there is more than one mortgage on a property, the lender with the first priority lien is in control. The first lender determines how much it needs to collect at closing to approve the deal. This lender also decides how much it is willing to allow to trickle down from the purchase price to pay off “junior liens” such as a second mortgage, which often takes the form of a credit line.
Why do a short sale?
One of the main reasons to consider a short sale is because it is largely an exercise in damage control. The circumstances leading to missing mortgage payment usually involve great financial distress. In some cases, there is no great distress and the borrower has the ability to continue paying, but instead makes a business decision to stop paying because the value of the property is far less than the debt owed with no hope of the value recovering for many years. This is commonly referred to as a strategic default. In either situation, a short sale represents an exit strategy to get out of a bad financial situation and move on.
One of the most significant ways a short sale contains the damage from a distressed property is through a far lighter credit impact to the borrower compared to a foreclosure. When a borrower closes a short sale, the credit harm will be much less than a foreclosure completed through the legal process in terms of credit score points lost, the duration of time the transaction remains on the credit report and how it is reported. A short sale is typically reported to the credit bureaus as “debt settled for less than full” or words along those lines. In my practice, I have seen many damage control success stories resulting from a short sale.
One memorable example is a family who sold a property with a mortgage balance of approximately $1 million for $500,000 in a short sale. Less than two years following that sale, these borrowers qualified for a mortgage to buy a new home. Had they not pursued the short sale and simply allowed the lender to foreclose, I’m certain they would not have been able to rebuild their financial lives anywhere near as quickly.
Despite beliefs to the contrary, it’s important to note that no bank wants to take title to a home. They are not in the business of owning properties. They are in the business of making money. The lending industry was hopelessly unprepared for the financial collapse they helped engineer and the resulting tsunami of foreclosures that followed. Banks want money and will always prefer to take short sale proceeds instead of becoming home owners. If a lender forecloses and takes title, it will then try to sell the property as an “REO” (real estate-owned). At that point, all the bank will receive is the market value minus many additional litigation and carrying costs along with delay that accompanies taking title through foreclosure. When the dust settles, the bank is very likely to net less money in the REO sale than they would have gotten through a short sale. They may be dense, but they understand this. The challenge is making the numbers work to get the short sale deal approved.
Another crucial damage-control justification for the short sale is the opportunity to negotiate a deficiency waiver. The “deficiency” is basically the difference between the market value of the property and the final debt owed to the lender. In a short sale or foreclosure case, unless the lender signs an agreement to waive its deficiency rights, it will have the ability to sue the borrower to collect this amount. I have seen many deficiencies in the hundreds of thousands of dollars as a result of the historic market collapse. In the majority of short sales our firm has handled, we have successfully obtained deficiency waivers for our clients.
This is an important condition of the short sale approval that every borrower should work hard to obtain. When the borrower is engaged with the lender in negotiating a short sale, the opportunity to work the deficiency waiver into the deal is available. For borrowers who simply surrender and allow the foreclosure to take place, there will be no such opportunity and the overall potential resulting harm is greater.
Another reason to consider a short sale is it provides the home owner the opportunity to continue living in the property while not paying the mortgage. For those who have suffered great financial distress throughout these terrible economic times, this means the chance to save up some reserves, pay down other debt or do other productive things while taking advantage of the breathing room that comes from living in a property without paying for it.
Simply attempting to short sell will not delay the foreclosure process indefinitely. Short sales usually do take a long time to close and most homeowners we have represented have continued living in their homes until the closing. It’s sad to note, however, that many borrowers have simply walked away from their properties very early in the process upon missing payments because they failed to understand their rights and options. Additionally, many real estate investors with rental properties have been able to collect rent while pursuing a short sale.
One more reason why a short sale may be the best strategy is the typical alternative to keep the property—a loan modification—usually is a bad deal that doesn’t work out for the borrower. The much hyped government-initiated HAMP modification program has been a dismal failure that has helped only a tiny fraction of distressed borrowers trying to save their homes. Though there has been a lot of talk, which is cheap, the government has yet to force the lenders to do anything meaningful they don’t feel like doing to help borrowers.
Most importantly, the most difficult thing to get out of a loan modification is a principal balance reduction. Lenders commonly use many slight of hand tricks to lower the monthly payments. An example of this is the deferred principal play, in which a chunk of the upside-down mortgage is taken out of the monthly principal and interest calculation (the amortization) and “put on the back” of the mortgage. This technique may allow the borrower to pay a lower monthly amount, but that piece of the debt must be paid upon sale or refinance of the property and the borrower is often unlikely to remain in the property beyond the point at which the market value surpasses the debt.
I recommend going to a website called youwalkaway.com and using their Walk Away Calculator to determine the estimated time it will take your property to recover its value and have equity. The numbers can be shocking and quite often greater than 20 or 30 years. The bottom line is the loan modification usually represents the only available “stay strategy,” but it is usually a disastrous financial undertaking. All things considered, the short sale, which is an “exit strategy” is more likely to be the best move to recover and rebuild.
How do I do a short sale?
First, you need a realtor to list the property. The borrower should carefully select a listing agent with experience working these kinds of deals. Short sales can be complicated and stressful, but a skilled and experienced agent will make the process easier. Ask how many short sales the agent has handled and closed and what kind of training he/she has received in this specialized area. Once the borrower signs a listing agreement with the realtor, the agent will market the property on the MLS (multiple listing service) to seek offers. The listing will need to give prominent notice to prospective buyers and their agents that it is a short sale. It is necessary to clearly label a short sale and notify everyone that third party lender approval will be necessary and the sale proceeds will not satisfy the lien(s) on the property.
Once a written offer is submitted to buy the property, the short sale really gets cooking. At this stage, either the listing agent or a third party negotiator will get to work to collect all the necessary paper work and submit it to the lender’s negotiator for approval. Our law firm has a title and short sale processing division that handles all the negotiations and closes the deal. Some realtors are glad to handle the negotiations themselves, but most prefer to hand that cumbersome and difficult work to another negotiator.
Sellers will need to open their financial books so the lender can evaluate whether to approve the deal based on financial hardship. If the seller is a strategic defaulter without much, if any, hardship to note, it is more likely the lender will require a cash contribution to approve the deal. What constitutes a “strategic” default versus a default by necessity is not always clear. There are gray areas and there is often room for compromise. The way I like to look at it is, if the borrower ends up getting out from under a far greater amount of debt and a bad investment, but still pays the lender something, we can call it a “win.”
When do I do a short sale?
The timing of a short sale is largely a matter of discretion for the seller. A homeowner may want to move quickly to sell the properties or try to extend the process, depending on needs and circumstances. For many who have suffered and are continuing to endure financial distress, it may be in the borrower’s best interest to try to remain in the property as long as possible before selling. In other cases, there may be a need for quick action and the desire to close this chapter and move on.
The foreclosure crisis has evolved in different ways since it began around 2007 and will continue to change in response to political and economic circumstances. What we are seeing now is most lenders taking at least six months, quite often longer, to file a foreclosure case and take the borrower to court following the first missed payment. Once filed, the lender may complete the foreclosure case as quickly as within six months in Florida if, and this is a big “if,” the borrower doesn’t respond and mount a defense. On the other hand, we have litigated some cases as long as 3-4 years in court and some of these remain open from the inception of the foreclosure crisis. As the recent fraud and “robo-signing” scandal that the media discovered has shown, foreclosure cases can be anything but “open and shut” and there are many legitimate defenses borrowers can raise to defend the case. The timelines are all over the place, depending on many factors.
Many borrowers who stop the mortgage payments and thus find themselves in “pre-foreclosure” (behind in payments, but not yet sued) begin trying to short-sell only after being served court papers. Some don’t want to face litigation at all and try to sell before being served. Unfortunately, many of these rushed borrowers move so quickly out of ignorance of the legal process and its timing, their rights and what can be done to fight a foreclosure.
Others choose to handle the matter more aggressively and only attempt to sell once the case reaches a more advanced stage in litigation. There are many ways to plan and time a short sale and it can be done either before a foreclosure case is filed against the borrower or while the case is pending. A short sale is likely to take six months or longer to close from the placement of the listing until the closing. Accordingly, the borrower who wants to short sell should make sure to plan to close prior to the court auction that concludes the legal process, at which point the lender or a third party bidder will take title and the chance to sell will be forever lost.
I hope this article answers most of the questions about short sales. A short sale is not the best solution for everyone, but I’m convinced it’s the best for most who find themselves in trouble with their mortgage. For more information and to discuss your options, please call our firm.
