Are short sales really the next big thing?

By Rick Sharga

For RealtyTrac

If you believe the hype, it appears that the next phase of the housing market recovery is going to rely heavily on short sales to help remove distressed properties from the home sales pipeline.

George Skene/Orlando Sentinel/MCT Mysty Stange of Keller Williams realty puts up a short sale sign on a house in Avalon Park in Orlando, Florida.

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A “short sale” is a sale where the bank accepts as full value a price that’s less than what’s owed on the property. The debt is forgiven (although not always without some tax consequences), a foreclosure is avoided, a buyer gets a good deal on a property, the bank saves thousands of dollars in legal fees and the real estate agent makes a commission. Elegant. Practical. Simple. But as we’ll see later, not really quite so simple.

Short sales were never intended to be a mass market solution. Rather, they were relatively rare occurrences that took place when an unfortunate homeowner had a financial catastrophe — a job loss, a divorce, a medical problem — at precisely the same time his or her home lost significant value. When that happened, a loss mitigation manager at a bank would research the market, review the homeowner’s financial documents, carefully consider whether the borrower and loan in question met the criteria to justify a short sale and act accordingly.

This approach worked well when there was one request a week or a few a month. But with over 1.1 million homes in various stages of pre-foreclosure in the RealtyTrac database, the workload for these loss mitigation managers has exploded from several a month to hundreds a week, with no drop-off in the amount of paperwork or research needed. So there are unavoidable delays in simply processing the volume of paperwork.

But it gets worse. Each lending institution has slightly different versions of short sale forms. Property valuations, even — perhaps especially — appraisals, are in a state of flux, so loss mitigation managers are at a loss to know whether a short sale offer is reasonable or just plain silly. And there are some accounting issues: in many cases, lenders may opt to decline a good short sale offer today so that they can defer the loss (even though it may be a much greater loss) to a subsequent quarter — or even later.

And there’s more. A second loan on a property makes it much more than twice as difficult to execute the sale. The second loan either needs to be negotiated away completely, or satisfied with some nominal payment. In other cases, the holder of the primary mortgage may find it better financially to foreclose, wipe out the second lien, and simply use that amount as a discount to sell the property at a profit. Similarly, if there’s mortgage insurance on the note, the investor may decide it’s better to foreclose, collect the insurance, and let the insurer worry about getting value for the house.

So why all the hype? Well, with the REO pipeline clogged and choking, and loan modification programs failing to make a dent in foreclosure numbers, short sales represent an opportunity to feed the demand for discounted properties while reducing the number of foreclosures. What can you do to help make this happen? What does the government have in mind? We’ll cover all that and more in next month’s column.