While potentially tricky, short sales are some of best ways to find new deals to fix & flip. Let’s talk about how.
Competitive real estate markets require investors to get creative with their inventory. When dealing with a non-stop stream of bidding wars, you realize you’ve got to expand your pool of potential properties to find a better deal. One of these expansions might include looking at short sales. But what is a short sale, and is it actually a profitable way to invest in real estate?
A short sale is a real estate transaction where the original homeowner gets their lender to agree to a property sale for less than what’s originally owed. Short sales mitigate the chance of foreclosure and can be an excellent way for real estate investors to get good deals on well-maintained homes.
But, as with all things that come with real estate, short sales have some caveats. So let’s talk more about what a short sale is, why it’s better than a foreclosure, and the things you need to keep in mind before making an offer on that potential investment property. Let’s dive in.
What is a Short Sale?
A “short sale” is the term used for when a property owner sells their house before they are foreclosed on. Typically it’s because the home is now worth less than what the homeowner paid, but it can also be due to things like job loss or other financial issues. Successfully creating a short sale involves an agreement between the homeowner, the lender, and the new buyer.
How a Short Sale Works
The process for a short sale doesn’t vary much based on location or market conditions; it generally goes like this:
The homeowner realizes they can no longer make ends meet and stay up to date with their mortgage. It might also happen that the market has tanked, and the homeowner realizes they’re paying on a mortgage that’s more than the property is now worth. Rather than getting foreclosed on, they and their real estate agent list the house for sale on the MLS as a short sale.
A potential buyer sees the house for sale and makes an offer. The offer is less than what the homeowner owes the bank but is competitive enough that the lender might agree to the offer anyhow.
The homeowner approaches the lender with a request to sell the house for less than what they owe and show proof of a new buyer ready and willing to transfer ownership ASAP. The lender then crunches the numbers and either agrees and accepts less than the original loan amount or denies the request and moves ahead with the original homeowner.
If the bank agrees, the short sale releases the original homeowner from any further obligation on the mortgage so long as they receive a Payoff Letter. If no Payoff Letter is offered, the original homeowner is still on the hook for the balance owed.
What’s the Difference Between a Short Sale and a Foreclosure?
If you’re not savvy to real estate lingo, then you’ve probably mixed up “short sale” and “foreclosure” at some point, and it’s understandable why. Both short sales and foreclosures happen during a similar milestone in homeownership: the inability to keep up with your mortgage payments. They both also cause your credit score to take a hit. But short sales are still better than foreclosures when you’re the homeowner.
First, short sales put a smaller ding on your credit score. Yes, your score will still go down, but the penalty will be less severe than a foreclosure. It’s like the difference between getting a payment plan with a credit card company to pay off your debt versus declaring bankruptcy. Bankruptcy is like setting a bomb off on your credit report, while a payment plan is more like an “Oops! My bad. Won’t happen again, I promise.” The same goes for short sales and foreclosures. Having a short sale on your credit history might make lenders wary of working with you, but you’ll most likely still find one who will give you a mortgage within a few years (possibly at a higher interest rate than if you didn’t have that ding on your report). Foreclosures, however, get very tricky to navigate when you’re trying to buy a home, lease a car, or even cosign for your kid’s student loans. They’ll fall off your report eventually, but those eight or so years will be hard times for loan approvals.
Next, short sales are much faster than a foreclosure. Foreclosures are both an event and a process (just to confuse you a little further) and can get drawn out for years in court. Consequently, a short sale will most likely end up being cheaper for everyone, including the lender, since they’re removing all the legal fees and carrying costs that go along with assuming ownership of the property.
Why Would a Bank Accept a Short Sale?
It seems counterintuitive that a bank would accept less than what’s owed, right? Shouldn’t they just say “no” and force the homeowner to keep paying? The answer is: it depends. Those lenders are smart and know a lot when it comes to probability, statistics, and what’s the better bet for their money.
Times When a Lender Would Accept a Short Sale
- It’s cheaper than going through a foreclosure.
- There’s a new buyer available that’s pre-qualified or is bringing cash.
- The carrying costs for taking over the property are too high.
- The market is tanking, and the value of the home is dropping.
Times When a Lender Would Not Accept a Short Sale
- It’s not profitable enough.
- They’ll lose money closing on a new deal now and can make more if they wait.
- The market is heating up and will become competitive soon.
- The value of the home is rising.
Should I Invest in Short Sales?
Investing in short sales as a real estate investor seems like a great idea on the surface. You’re able to get a deal on a home that most likely has low competition since retail buyers typically don’t know what to do with a short sale and get intimidated quickly. There are a few reasons that short sales can be great investment properties, including:
- Short sales have lower costs than MLS-listed properties. Not only are short sales discounted to entice buyers for a quick offer, but their overall costs for rehab are low.
- Short sale properties are in better condition than foreclosures. Typically foreclosures come with “spite damage” caused by the evicted owner. With short sales, they’ve intentionally listed the property for sale and know it’s got to be in good condition to move. Otherwise, they’ll be stuck dealing with the lender and going into foreclosure.
- It’s a win-win for you and the homeowner. Sometimes real estate investing can feel like you’re taking advantage of someone’s distress and get a little icky. However, with short sales, you’re getting a great deal and helping a homeowner who’s down on their luck avoid the severe ramifications of foreclosure.
However, there are a few factors you should consider first before going all-in on short sale properties.
Length of Time to Close and Flip
While short sales are faster than foreclosures, that doesn’t mean they’re fast. To give you an idea of the timeline you’ll be up against, here are the average times it takes to successfully flip a house, depending on how you acquired it.
Fix & Flip – 24 weeks
Short Sale – 18.6 weeks to close + 24 weeks to rehab and flip
Foreclosure – 101.85 weeks to close + 24 weeks to rehab and flip
Homes bought off the MLS or off-market typically take 24 weeks or six months to sell successfully. Short sales and foreclosures have their own timelines for closing that add to the six-month holding period, so if you need to unload your properties quickly, short sales won’t work for your business model.
Just because retail buyers (buyers looking for a home of their own) get intimidated by the paperwork involved in a short sale doesn’t mean your competition level is zero. Experienced real estate investors seek short sales out when they’ve got other things going on that bring in revenue and have the luxury to wait for the deal. If you’re new to investing or aren’t yet turning a profit, your situation might be too risky to focus your attention on short sales. Look for off-market properties instead.
Gambling with the Lender
Putting an offer on a short sale never comes with a guarantee that you’ll be successful. Lenders have all the power in a short sale and can trigger any number of problems that mean you’re not getting the deal you imagined.
- They can deny the short sale. Then you’re back for Square One.
- They can come back with a counteroffer. This might blow your budget out of the water, so you’ll really need to know your numbers should a counteroffer be presented.
- They could approve the short sale but not absolve the buyer for the remaining balance. The lender will issue a Payoff Letter that must explicitly stipulate that they consider the short sale to be paid in full for the original monetary obligation. If the Payoff Letter doesn’t have this clause, it means the original buyer is still on the hook for whatever is left on the original mortgage. For some homeowners, that’s a dealbreaker (why sell the house when they still owe the original amount anyhow?)
Dealing with the Seller
Real estate is emotional; there’s no way around it. Even in the best of conditions, selling a house means losing tangible pieces of memories forever. Often these properties will be where families have grown, where holiday parties took place, and where significant milestones (“our first home!”) were made. That’s a lot of baggage to contend with as the buyer. Now toss in the feelings associated with losing that home because the owner has no choice but to sell due to their financial situation. Needless to say, it’s a lot to deal with. If you’re an empathetic person, it can be difficult to take those feelings on while balancing the need to run a successful business. The truth is, it doesn’t get easier since every situation is unique; you just get used to knowing what you’ll be up against. My advice is to find ways to cope through self-care and never let yourself feel guilty. You didn’t put them in this situation where their back is against a wall. If anything, you’re solving a massive problem for them that not only lets them walk away from their financial obligations but saves them from foreclosure and possible bankruptcy.
Working with short sales as a real estate investor has its positives and negatives. While you’ll be able to get a hefty discount on a well-maintained property, that doesn’t mean the process is easy. As long as you can navigate the extended timeline and stress of working with the whims of the lender, you’ll come through okay. Just go in with your eyes open and know what to expect before you send that offer over.