Short Sales in Residential Real Estate

by Joe Carey
REAE 5311 Blog Post

Introduction

There has been a lot of news surrounding housing markets and rising defaults in recent months. Generally in the mainstream media it seems to be assumed that defaults that are not cured lead to foreclosure. There are other options, however, one of which is known as a ‘Short Sale.’ A short sale occurs when a house has depreciated in value below the amount of the outstanding debt against it, and the lender agrees to accept less than the amount owed in the sale rather than foreclose. This article will present a general description of a short sale and why various parties may find it a favorable or unfavorable choice.

Mortgagor Perspective

When a homeowner faces a financial hardship affecting their ability to make their home-related debt service payments, they have a number options available to them. They can request a loan modification or other type of workout plan from the lender, allowing them to stay in the house by changing the terms of the loan temporarily or permanently. Failing that, they must choose from foreclosure, a deed-in-lieu of foreclosure, or a short sale. Each of these options result in the homeowner losing the home, but generally the short sale will look “least bad” on their credit.

In addition, Congress passed The Mortgage Forgiveness Debt Relief Act of 2007 (HR 3648) on December 14, 2007, which allows mortgagors to skip counting forgiven amounts of home loans as part of their gross income on their tax returns[1], in an apparent attempt to encourage them to work with the lenders to reduce losses.

Thus, for the homeowner, the benefits to a short sale are that it minimizes credit damage and relieves the debt without increasing their tax liability. The drawbacks are that it hurts their credit and they lose the home in a slow and painfully drawn-out process.

Mortgagee Perspective

Lenders obviously prefer that their customers stay current on their payments, but they also know all too well that doesn’t always happen. If you consider that a sale after foreclosure results in an average loss of 40% to the lenders [2] because of all the costs associated with foreclosing, owning the foreclosed property for some period of time, and finally selling it, you would think that lenders would jump at the opportunity to let the borrower sell the property and forgive the difference between the selling price and amount owed as long as it’s less than the expected foreclosure loss.

Why does it seem like lenders drag their feet when considering a short sale agreement then? Well, it may just be that the lenders are the least informed parties when this situation arises. Borrowers don’t often advise the lenders when they may default in the following month; in fact, it seems that generally the lender doesn’t get asked to agree to a short sale until there is a buyer involved and at that point they are expected to know the home’s value and the true financial condition of the homeowner, etc. The lender may have to take a loss anyway, but they won’t want to sell for less than a current fair market value. They would also want to be sure that the homeowner isn’t just trying to pass the loss on to them when they could actually afford the payments.

Market Perspective

According to the National Association of Realtors, 18% of home sales are short sales [2], but because of the extra time and red tape required to get them approved, these properties don’t move as quickly. An economics professor at the University of San Diego has observed that short sales have concentrated buying pressure into foreclosures and motivated-sales as buyers are trying to avoid the inconvenience of short sale properties [3].

Alternatives

The deed-in-lieu of foreclosure saves the lender some of the legal costs of foreclosure in that the mortgagor simply signs over the deed in exchange for extinguishing the debt, which is presumably at least marginally better for the homeowner’s credit than a foreclosure.

Of course, a homeowner always has the option to just walk away and let the bank foreclose at its leisure. This may not be the best option, but it is certainly easier for the homeowner.

Conclusion

A short sale seems like a good option to pursue for a homeowner who cannot keep up with their mortgage payments and cannot get the banks to agree to a loan modification. However, it takes time and effort, and patience from all involved parties. A good rule of thumb is to communicate with the lender early and often; let them know your situation and ask them to agree to a short sale.

Sources:

1. GovTrack.us. H.R. 3648--110^th Congress (2007): Mortgage Forgiveness Debt Relief Act of 2007, GovTrack.us (database of federal legislation) <http://www.govtrack.us/congress/bill.xpd?bill=h110-3648&tab=summary> (accessed Oct 24, 2008)
   
2. Simon, Ruth and Hagerty, James R.; Why Lenders Are Leery Of Short Sales; Wall Street Journal - Eastern Edition; 4/17/2008, Vol 251 Issue 90, pD1-D4, 2p
   
3. http://www.signonsandiego.com/uniontrib/20080928/news_1h28ratcliff.html