We just wrote an article about how to negotiate the price of a house, primarily talking about a “regular” real estate purchase from a private-party seller. Buying a home that is listed as a short sale is a whole different game, and you need to understand how the listing price may be set, how the bank will approve the listing price and strategies for making an acceptable offer.
A short definition is probably needed here for those of you not familiar with short sales. As home prices have declined, there are many sellers who are underwater on their mortgages, owing the bank more than the home is worth. If a seller has financial difficulties and needs to sell the home, they likely do not have the funds necessary to pay off the remaining portion of their mortgage. A short sale is when the seller asks their bank to help them out by accepting a payoff that is less than what the bank is owed. This gets the seller out of the home and avoids costly foreclosure proceedings for the bank. The bank review process can be lengthy and stressful, so it pays to understand how to optimize your price for a bank approval.
How are short sale listing prices set?
In the vast majority of cases, the listing price is determined by the seller and their real estate agent with no bank involvement. Remember that the seller still owns the house and gets to make decisions about its sale, but those decisions are subject to further approval by the bank. We see a few different strategies being used by short sale sellers:
- Price the house at or above market value – These sellers may be trying to milk the process to live in the home as long as possible. Continuing effort to list the property may delay foreclosure proceedings, but only for so long.
- Price the home based on best estimate of the price that the bank will approve – Banks have a process for determining what sale price they will or will not approve on a short sale. The most experienced short sale agents will understand this process and price the property realistically within a range that is likely to be accepted. (More on this process in a moment.)
- Price the home very low to get a quick offer – The hardest part of the short sale process is getting an offer in hand so that the bank can start the review process. In their haste to get an offer to the bank, sellers often set prices far lower than will be realistically approved by the bank to get an offer in hand. If a home is worth $300k and the seller lists for $200k, you can be certain that they will get a quick offer, but you can also be certain that the price will not be approved by the bank.
- Pre-approved bank prices – Every once in awhile, a home will have a listing price that has been pre-approved by the bank. That is a great situation, because they have done a preliminary review and said what they are willing to accept. An offer at the approved price should be accepted quickly, though a bit of negotiation may still be possible.
How do bank determine the price when they approve a short sale?
For a bank to accept a payoff of less than they are owed, they want to understand two things. They want to make sure that they are not being taken advantage of, and they also want to know what they could sell the property for if they foreclose and have to sell the home themselves. If they can achieve a better result through foreclosure, they will not approve a low short sale price.
The exact process of short sale approval is a bit of a mystery, and each bank behaves differently. However, there are a few key pieces of due diligence that banks will utilize to approve a short sale. First, they likely have internal statistical models that give them a rough estimate of the current market value of the home. Second, they will use appraisals or Broker Price Opinions (BPOs) to get a real person to visit the home and estimate its value based on local market trends. Lastly, they will look at internal factors like the cost to foreclose, current inventory of distressed homes and how quickly (or slowly) they want to incur the losses on their balance sheet each quarter.
By far the most important factor for determining the current market value of a home is the BPO. I have done hundreds of BPOs for countless different banks, and the process and criteria that they use is remarkably consistent. While the bank will not share the BPO results with you as the buyer, you can use the same “recipe” for BPO values to give yourself a guesstimate on what the bank thinks about the market value of the home. Here is the set of factors you should analyze yourself when estimating a BPO price:
- Find 6 comparable homes: 3 recently sold listings & 3 active listings
- Within a 1-mile radius of the property for urban & suburban areas
- Comparable sold homes with sale dates in the last 3-6 months.
- Age of comparables within +- 10 years of the age of the home.
- Above Grade Living Area (AGLA) within +-20% of the home. Above grade living is far more important than below-grade rooms. Finished basements count, but very little.
- Similar style & room count – An ideal comparable is the same style, with the same number of beds and bathrooms. Comparables with one more or less bedroom can also be used if adjustments are made.
- Comparables with similar condition, construction quality and views.
- Most BPOs are “fair market” price evaluations, meaning that other short sales and bank-owned homes are ignored if there is a sufficient number of regular sales to choose from. Banks know that short sales and REO properties are discounted, but they want a price opinion that assumes a non-distressed listing.
- Once you have this list of six properties, BPOs will adjust values for differences in each property. You may add value for an additional bedroom, or subtract value for poorer views. The goal is to come up with data that is most consistent with the configuration of the property that you are evaluating.
- Final values are usually determined by looking at the adjusted sale values. If you show three sold homes that are similar to the property with an adjusted sale price of $300k-$325k, then the final value for the home in question will lie within that range.
It is not terribly difficult to figure out what the bank may think is a fair market value for the home. The tricky part is guessing how much of a discount from that value they will approve. Successful short sales almost always sell for less than the fair market value. The process is difficult and time-consuming, and there are additional risks that a buyer takes on to buy a short sale. Given the opportunity, many buyers opt to ignore short sales in favor of easier transactions, so a more compelling price is needed. Banks know this, and will approve discounted prices. How much of a discount is a mystery, and varies by the day and by the bank. There is a complex mix of decision makers that need to weigh in, including the investor on the loan and potentially a mortgage insurance company as well. Some banks may give a 5% discount, others may give 10%, and still others may not approve any discount. While it is impossible to say exactly what they will approve, it is safe to assume that they will not approve gigantic discounts. Banks are not going to approve short sales offers that are 25%, 30%, 40% lower than the fair market value of the home. In most cases, it will make better financial sense for them to foreclose on the home, rather than approve such an offer.
Strategies for a successful short sale offer
Successfully navigating the purchase of a short sale requires patience, persistence and willingness to deal with price uncertainty during months of waiting. Here are a few key things to keep in mind when making your offer:
- Sellers generally don’t care about the price –Whether you offer $400,000 or $1, the seller makes $0 on the successful completion of a short sale. Their only motivation is to get the process over with and avoid foreclosure.
- The seller’s real estate agent is highly motivated to close – Short sales can be a lot of work for agents. They only get paid if it closes, and a good percentage fail and go to foreclosure, so the agent gets nothing. Agents may be overly motivated to accept any offer that comes in the door to keep the process moving.
- Low offers may be accepted, but not approved by the bank – Motivated sellers and their agents may accept offers that are unrealistically low out of desperation to keep the process moving with the bank. If you make such an offer, you may not hurt anyone’s feelings with the offer, but you need to be fully aware that the bank is very likely going to come back to you with an approved price that is much higher than your initial offer. If you understand you may wait 3-4 months for this unpleasant price surprise, they you have the right mindset. Remember that just because your short sale offer was accepted is no guarantee that it will be approved by the bank.
- Time on market at each price point matters – If you see a short sale property listed for $400k that is not selling, then suddenly drops the price to $300k, it may look very appealing to make an offer. However, if you make an offer within a week of the price drop, you are almost certain to get a bank approval at a much higher price. As listing prices move downwards, the bank needs evidence that a property did not sell at a certain price point. Here are two examples:
- Property listed at $400k for 90 days with no offers received.
- Example 1: Price is dropped by $25k every 30 days until an offer is received. Finally an offer is received at a listing price of $300k. The bank sees the property history where it did not sell at $400k, $375k, $350k and $325k. Short sale approval around $300k is fairly likely in this scenario.
- Example 2: Price is dropped from $400k to $300k and an offer is received instantly. The bank sees no history of attempts to sell at intermediate price points. They do know that it didn’t sell at $400k, but they have no idea if the market would have paid $350k or even $375k. In this scenario, it is likely that a bank will counter with a very high approval price relative to the offer.
- Property listed at $400k for 90 days with no offers received.
- The economics of short sales and foreclosures are difficult to estimate – You will never have a full financial understanding of the bank’s motivations. They may be receiving mortgage insurance payments behind the scenes or have larger macro issues that prevent them from approving a short sale price that seems logical to you. Our experience with short sales is that sometimes big banks make logical decisions, and other times their short sale approvals make no sense at all.
- Estimate what you think the bank will approve – Do your homework and determine a fair market value for the home. If you make an offer close to that range, your chances for bank approval go way up, and you can avoid the unpleasant price surprises months later. By all means, you should attempt submit a lower offer to try to get the best deal, but that needs to be balanced with what the bank perceives the property is worth.
- Realize that short sales are negotiated between sellers and their bank – Buyers mistakenly believe that they are negotiating with the bank on a short sale. In reality, short sale approval is a process that occurs only between the seller and their lender. Both of them need to agree on the final short sale terms. You may reach an approval price that you are OK with, only to have the seller back out of the deal because the bank wants to continue collecting the deficiency from the seller after the sale.
- Assume that the house is “as-is” – Short sale sellers may have little or no financial capability or willingness to make repairs. Their banks will approve short sales only on an “as-is” basis. You should assume that you will be purchasing the home in “as-is” condition. That doesn’t mean that you can’t attempt to negotiate on needed repairs, but if you assume that the property is “as-is”, anything that you get through these negotiations will be a bonus.
Successfully purchasing a home that is a short sale can be a stressful and time-consuming process. By understanding how prices are set and approved, your chances for success will go up. It can also be helpful to engage a real estate agent who is well-versed in the process to help you through it.