What Is a Short Sale in Real Estate?

Contrary to what the gurus might say, real estate prices don’t always go up. And given the high loan-to-value ratios (LTVs) that some homeowners borrow, many become upside-down on their mortgage when home prices dip. 

Rather than foreclose, some mortgage lenders let borrowers pay off a lower balance than they owe. Taking a “short sale” on the loan payoff costs the lender less than foreclosing. 

But short sales aren’t all rainbows and unicorns for either buyers or sellers. Before buying a property through a short sale — or attempting one as a seller — make sure you understand the short sale process all with all its pros and cons. 

What Is a Short Sale?

A short sale involves the mortgage lender accepting a lower payoff balance than the homeowner owes. This happens when the homeowner owes more than the property value, known variously as an underwater home, having negative equity, or being upside-down on your mortgage. Lenders usually only accept a short sale when the alternative involves a costly foreclosure. 

For example, say the homeowner loses their job and falls behind on payments. They’re underwater on their mortgage, and can’t afford to come out of pocket for the difference if they sell for the current market value. The lender may accept a short sale (also known as a pre-foreclosure sale) rather than hiring an attorney to file for foreclosure. 

For the lender, short sales represents the lesser of two costs. It can also mean recovering most of their loan quickly, rather than spending months or even years going through the foreclosure process. 

Even after the foreclosure auction, lenders typically take ownership of the property back because few people actually bid. After taking legal ownership, they must then go through the eviction process to remove the prior homeowner, then clean out the property and prepare to list it for sale as a repossessed REO property.

Short Sale 101

The short sale process works like this for both buyers and sellers. 

Short Sale Process for Sellers

The first step for sellers involves contacting the lender to apply for assistance. Homeowners must typically submit a hardship letter, explaining the circumstances such as a divorce, death of a spouse, or losing the ability to work due to a health crisis or disability. 

Lenders also require documentation proving the hardship. These include documents such as bank statements, tax returns, bills, a personal financial statement, and other evidence.

Note that the lender may propose alternate ideas, such as a loan modification. They could move some of the payment arrears to the end of the loan, letting the homeowner resume making regular payments without first catching up on back payments. 

If the lender approves a short sale after reviewing the application, the homeowner then lists the property for sale with a real estate agent. Sellers should choose an agent that has experience with short sales. They come with extra red tape and requirements that many inexperienced or part-time Realtors don’t understand. The listing must also disclose that the property is being sold as a short sale.

As offers come in, both the lender and the seller must sign off on them. Lenders may reject offers they feel are too low, and it can make for an awkward and more convoluted negotiation with three parties involved.

Short Sale Process for Buyers

Buyers should understand before making an offer that short sales come with more headaches than traditional sales. 

First, they’re negotiating with two parties: the seller and the lender. That adds delays to the negotiation, and lenders often take a long time responding to offers. It also requires additional paperwork, such as a signed authorization from the seller allowing the lender to speak with you about the mortgage balance. 

The offer package may also require an appraisal, before you even know if your offer will be approved. Feel free to negotiate with the seller to require them to pay for it however. 

If the lender approves your offer, they may require a fast closing. After weeks of waiting for a response from the lender, suddenly the buyer may have to close in as little as 20 days if the lender approves the short sale. 

That means they need flexible financing from their own lender. 

Bear in mind that the seller won’t and can’t make repairs, regardless of what the home inspection turns up. You buy the property as-is when you buy a short-sale. 

From there, the process follows the normal steps to closing, such as a title search.

Pros & Cons of Short Sales

Real estate short sales represent a compromise for all parties involved. Keep the following in mind as you explore real estate short sale listings as either a buyer or seller.

Short Sale Pros & Cons for Sellers

The seller avoids foreclosure, and the embarrassment of having their home publicly auctioned off and advertised as a foreclosure sale. They sell their property through a real estate agent, without having to come out of pocket for the difference between the property value and their mortgage balance. 

That said, most states allow lenders to pursue sellers for a deficiency judgment even after a short sale. Sellers should discuss this with their lender when negotiating the short sale.  

Either way, short sales do leave a black mark on sellers’ credit history for years to come. Mortgages resolved by short sale get reported as “settled” on your credit report. It doesn’t cause the same damage to your score as a foreclosure, but it still hurts your score. 

If the lender does forgive the shortfall with no recourse, homeowners can expect to pay taxes on the forgiven debt. The IRS expects you to report it and pay taxes on it. 

Sellers also leave their home with no proceeds to put toward a new home. They must start from scratch with savings, and rent for a while as they rebuild both their credit and their savings. 

Short Sale Pros & Cons for Buyers

Buyers might — might — score a small discount on short sale properties. But don’t expect mortgage lenders to leave much meat on the proverbial bone. They’re taking a haircut on their loan balance, after all. 

As touched on above, buyers suffer through far more red tape than the typical transaction. That includes an ungainly three-way negotiation process, rife with delays. To avoid wasted time, consider making your best offer first, and walking away if the lender declines.

And after a lengthy and delayed offer approval process, the lender may turn around and demand a quick closing. That puts buyers in a position to potentially need flexible and fast financing. 

Short sale buyers also enter the contract knowing that the property sells as-is. That could create room for forced appreciation — but for other buyers and properties, it just adds risk.

Real Estate Short Sale Listings

While real estate short sale listings look similar to normal real estate listings, they must disclose that the transaction is a short sale. That may scare off some homebuyers, although many real estate investors make a business model of buying short sales.

With the help of a real estate agent, you can search the MLS for short sale listings. You can also establish relationships with the few short sale specialist Realtors in your local market, and ask them to call you when they come across a potential short sale. 

Before wasting time visiting the property, get a sense for its condition. Scour the photos carefully, and read every word of the listing description. Then call up the listing agent to ask probing questions about the property’s condition. 

If you market to pre-foreclosures already, consider incorporating short sales into your approach. As you reach out to homeowners in foreclosure, you can propose negotiating a short sale with the lender as one more option. Have an experienced short sale Realtor ready to connect with the homeowner. 

Tips for Short Sale Buyers

Thinking about targeting short sales as an investor or homebuyer? Keep these short sale buying tips in mind. 

Cash Remains King

Lenders like cash offers just as much as sellers. They want a sure settlement, want to avoid wasting time on back-and-forth negotiations with a buyer who can’t close. 

If you can make a cash offer, do so.

Don’t Lowball

Sending a shotgun blast of lowball offers to identify desperate sellers can sometimes work. But not with lenders considering a short sale.

Lenders aren’t desperate sellers, but usually bloated bureaucracies with preset policies. Most won’t sell beyond a certain discount below market value. 

Make your highest and best offer, then sit back to see if the lender bites.

Know Your Numbers for Vales & Costs

Like any other fixer-upper, you need to know the market value of the property as-is, the after-repair value (ARV), and repairs costs and other expenses. These numbers allow you to calculate your maximum allowable offer. 

Make sure you build in a buffer for all renovation costs, and use the most conservative ARV estimate. Get these numbers wrong, and you can find yourself upside-down just like the seller.

Partner with a Pro

Unless you’ve done dozens of short sales before, enlist the help of a real estate professional. 

Short sales aren’t like other property purchases, even for investors. You’ll have to cut through a tangle of red tape, so get an expert on short sales to help steer you through it. 

Confirm Other Liens

While lenders are unlikely to greenlight listing a home as a short sale if it has other liens attached, don’t make assumptions. Confirm with the listing agent whether there are other liens clouding the title.

It doesn’t matter how good of a deal the primary lender offers you if you’d also have to pay off a second mortgage or tax lien. 

Connect with the Decision Maker at the Bank

While easier said than done, it helps to negotiate directly with the loss mitigation officer who is actually reviewing your offer for the lender. 

Ask the seller to sign an authorization form for them to speak with you, and ask for their contact information. They may or may not actually speak with you, but the more direct your line of communication, the more likely you are to close a deal. 

Watch Out for Deed Restrictions

Some lenders prohibit short sale buyers from flipping or wholesaling the property. They put a deed restriction on the property, preventing the buyer from reselling it within a certain period of time. 

If you flip houses or wholesale real estate, confirm whether the lender puts deed restrictions on their short sales. You could always keep the property as a rental — if a buy-and-hold fits with your investing strategy and the property’s cash flow numbers support it. 

Final Thoughts

Some real estate investors have made a lucrative niche for themselves buying short sale properties. But they must know how to navigate the morass of rules and lender restrictions to make it profitable.

For underwater homeowners, short sales can offer an escape route to avoid foreclosure. Short sales definitely come with their share of downsides for sellers however, so make sure you understand what you’re signing up for. 

What is a short sale? It’s a three-way compromise between the lender, seller, and buyer. Every party sacrifices something. Enter a short sale transaction with both eyes open, or risk being blindsided by the cons and risks inherent in them.