A borrower facing foreclosure is in a bad spot. Loss of their property, litigation costs, damage to their reputation because of the lawsuit, and damage to their ability to borrow money in the future. A lender facing foreclosure is in a bad spot too. The risk that a foreclosure sale won’t bring enough proceeds to make it whole, litigation costs, the possibility the borrower has abandoned or is actively damaging the property, and the potential liabilities the lender may incur if it has to take title to the property.
But there are alternatives that can eliminate most of these concerns. A short sale is one of these. This article discusses the characteristics of a short sale, its advantages and disadvantages, and then describes in detail the steps both borrower and lender must take to consummate a successful short sale.
Let’s start with the characteristics of a short sale and why borrowers and lenders may prefer one over a foreclosure.
What is a Short Sale? When is a Borrower Eligible to Ask for a Short Sale?
A short sale occurs when:
- A lender allows a borrower to sell the property securing lender’s loan
- For an amount less than the total debt owed, plus closing costs, commissions and all other liens against the property
- With the proceeds of the sale going to the lender
- In exchange for the full or partial satisfaction of the borrower’s debt, and
- All other lien holders agree to items (1) through (4) as to the debt borrowers owe them.
In order for a bank to agree to a short sale the borrower must establish (i) that it faces a hardship that prevents them from meeting their loan obligations, and (ii) it doesn’t have enough income and assets to pay off the loan. Such assets can include not only equity in the property, but also borrower’s available cash, other real estate, available credit, investments, and virtually any other thing of value the borrower can use to pay the loan. And though borrowers are often already in default of the loan when they ask for a short sale, they aren’t required to be. If a borrower shows that it can’t make its payments today, tomorrow or months later, a bank will consider a sale.
While a bank won’t be excited to agree to a short sale (which by definition means the bank will receive something less than what it’s owed), lenders will consider one where they think it will be more beneficial than having to foreclose on the property.
Before we get to the advantages and disadvantages, let’s note four very important characteristics of short sales.
First, as noted in item (5) above, all lien holders have to consent to the sale. This means not only does a borrower have to get the primary mortgage holder’s approval, but also, to the extent they exist, the consent of any junior lien holders. That means second mortgagees. That also means taxing jurisdictions, contractors and homes associations holding liens. Everyone.
Secondly, their approval is not required. No matter how convincing the borrower’s evidence that it can’t pay the loan, the bank and any other lien holder can deny borrower’s request and prevent the short sale.
Thirdly, a short sale is a voluntary agreement. There is no court to decide if the deal is fair. There are only the parties.
And lastly, if the short sale proceeds weren’t enough to pay off the debt owed every a lien holder, then any holder shortchanged may be able to go after the borrower for the amount still owed, i.e., they may be able to sue the borrower to recover the “deficiency.”
Okay, then if the lien holders are going to get less than what they are owed, why would any of them agree to a short sale? Simple. What’s their alternative? Unless they can negotiate a workout with the borrower (for example, a loan modification), the lender will have to foreclose on the property. So, the lender will take a look at a whether a short sale or foreclosure is more beneficial.
Advantages of a Short Sale
A borrower would prefer to avoid foreclosure because:
- Foreclosures are expensive to defend. Lawyer’s fees. Court costs.
- A short sale might have about the same impact on their credit rating as a foreclosure, but typically they’ll be able to find financing for a new property much quicker than if a foreclosure was on their record. A later lender may be more likely to work with a borrower who took the proactive steps of a short sale than one who did nothing as the property fell into foreclosure.
- A short sale is a private negotiation and transaction between the parties. A foreclosure is a public event, and public means not only that the borrower may suffer embarrassment, but also that it will have to endure an onslaught of credit repair and foreclosure “fixing” offers from companies that monitor public records. Both these headaches, and the stress they can cause, are eliminated with a short sale.
Lenders would prefer a short sale over a foreclosure because:
- Foreclosures are expensive to file and win. Lawyer’s fees. Court costs. Sound familiar? Plus, while a short sale and foreclosure can both take a long time to complete, in the case of a short sale the bank is largely in control of how long the process takes.
- A short sale reduces the likelihood the borrower will damage the property. It’s trying to make the property as attractive as possible for a sale. In contrast, a borrower in foreclosure may either simply abandon the property or actively vandalize it to vent anger against the bank.
- If a short sale is used the lender never takes title to the property. Borrower’s ownership passes directly to the buyer. However, in a foreclosure sale, if the lender is the highest bidder it takes title to the property. Being in the chain of title can subject it to claims for such things as environmental contamination (even if the bank didn’t cause it) and construction defects if the bank performed any work on the property. And, of course, taking title also means the lender has to add the property to its REO inventory. Never an ideal outcome for banks.
- Lastly, under a foreclosure the borrower has stopped making all payments, including those for insurance. In order to avoid uninsured damage to its collateral, the bank will have to cover this cost until the foreclosure is completed.
Additionally, the borrower has likely stopped making tax and homes association payments. If these have to be paid from the foreclosure proceeds, it will reduce the net payment to the lender. And while some states allow a lender to sue for a deficiency following foreclosure, not all do. Those costs are just lost.
Plus, if the lender is making these payments, it has to front the cash outlay. In contrast, in a short sale the borrower is generally still making all these payments, and eliminating these foreclosure risks.
Disadvantages of a Short Sale
Borrowers don’t like short sales because:
They’re (i) time consuming, (ii) costly, (iii) will have a negative impact on their credit score and ability to get future financing, (iv) may allow the lien holders to sue for deficiencies, and (v) any forgiven debt by the lenders may possibly be taxed as income. However, a borrower will face these same downsides in a foreclosure. So, borrowers typically will prefer a short sale for the main reason that a foreclosure prevents them from future financing for a longer time than a short sale. Nonetheless…
A borrower can successfully navigate all the hurdles of the short sale process, finding a buyer, getting approval from all lien holders, and then still have a buyer back out at the last second. Or the bank never consents in the first place. Or worse, never responds and drags out the process for months. Or even worse, the bank forecloses on the property before the short sale happens. Time waits for no man, and lenders don’t wait to foreclose just because a short sale negotiation is happening.
All this uncertainty is problematic for a borrower. Its first calculation of the time and cost savings of a short sale may have clearly shown it was more advantageous than a foreclosure, but if it has to repeat the process over and over, a short sale lose its luster.
The other reason borrowers may not use a short sale isn’t because of a cost to them, but just because it may not be practical. Short sales require the consent of all lien holders. Where there are many, short sale approval may be next to impossible (and at the very least, becomes very time consuming and expensive negotiating with multiple creditors).
Lenders don’t like short sales because:
Like with the borrower, short sales have downsides to lenders (they’re time consuming and costly; they get paid less than they’re owed, and may not be paid at all; if multiple buyers back out, the lender may have to repeat the process). But, as with the borrower, these downsides exist with a foreclosure too. So a bank does the math. Is the short sale less expensive than the foreclosure process and potential chain of title liabilities that accompany foreclosures.
The Short Sale Process: Summary
We’ll take a look at each step, but the short version of the process is:
- Engage Professionals & Pre-Negotiation Meeting: Borrower engages a real estate agent and consults with them, its attorney, and tax advisor to determine (i) likelihood of short sale success, and (ii) its related costs. If the bank agrees , these parties meet with the bank’s loss mitigation department to get an idea of the bank’s requirements and see if a workout is possible.
- Property Listed, Marketed & Sales Contract Submittal. The agent lists and markets the property. A buyer is found, a sales contract (which is subject to the lender’s approval) is executed and submitted to the lender. Note that this item may also occur at the same time or after Step 3 depending on the bank’s preference.
- Short Sale Package & Submittal to Bank. Borrower submits its “short sale package” to the lender, including, among other things, proof that the borrower is incapable of meeting its loan obligations.
- Lender’s Review. Lender reviews the information borrower provided, performs its own due diligence, and negotiates with the borrower’s representatives on the terms of a proposed approval letter.
- Lender’s Response. The lender either doesn’t respond, rejects the offer outright, rejects the offer but details what terms it will accept, or approves the offer and issues a short sale approval letter outlining the terms of the deal. If necessary, borrower can continue to negotiate with the lender regarding desired changes to the letter’s terms. Borrower then presents lender’s response to the buyer, who either rejects it outright and cancels (and borrower gets to start the process over again), agrees to a change in the purchase contract to meet lender’s demand, or accepts the letter as written.
- Short Sale Closing. At closing, title and possession is transferred to buyer, and sale proceeds are disbursed to the lender.
- Post-Closing Actions. Borrower defends against any deficiency actions brought by those creditors who refused to release borrower from a liability.
Two thoughts. Don’t forget, the above process has to occur for all lien holders. Don’t expect this process to be quick. The timeline will vary from bank to bank, and can take anywhere from a month to a year or more. On to the detailed process…
Step 1: Engage Professionals & Pre-Negotiation
Because short sales are complicated transactions, and may have significant tax consequences, a borrower should, where it is feasible seek the advice of its attorney, tax advisor and real estate agent. It may be obvious, but a borrower will want to find professionals who are experts in short sales, especially as to the real estate agent. Not all agents understand the minefield that is the short sale process, and an experienced one can easily mean the difference between a successful process and a long and expensive denial.
For example, an agent knows that a bank has one department that handles short sales (the loss mitigation department) and a separate one handling forecloses (aptly often called the foreclosure department). These department sometimes don’t communicate well with each other, and where they don’t, a foreclosure might happen just as a the mitigation department has issued its sale approval letter.
In any case, if the professional advisors agree a short sale is the best option, they can ask the lender to meet and outline its likely terms, process, and possible workouts. This meeting is more likely to occur with commercial properties than with residential.
If the lender agrees to meet, it generally will want to pre-qualify the borrower for a short sale, asking it to provide some initial evidence that: (i) the property is worth less than the outstanding debt and closing costs, (ii) the borrower has, or will inevitably be, in default of its loan obligations, and (iii) the reasons borrower will never be able to meet its obligations (i.e., its “hardship”). Some banks may also want to see that the borrower as already begun marketing the property for sale.
Step 2: Property Listed, Marketed & Sales Contract Submittal
Although short sale properties are generally sold “as-is,” with the borrower disclosing nothing, often agents are required by their local real estate commission to disclose short sale status both when listing the sale and when dealing with potential buyers. Commissions may require this to notify buyers that the borrower can’t perform its contractual obligations on its own, and the sale may take much longer than a normal sale because of the bank’s approval process.
Before the property can be listed, in order to determine the property’s true fair market value, the agent will likely perform a comparative market analysis (CPA; also referred to as a broker’s price opinion (BPO)). The CPA/BPO looks at sold, pending and closed sales for comparable properties. A bank will require that a short sale property is closed for ass close as possible to FMV for two reasons: (i) lender’s assume, rightly or wrongly, that if it has to foreclose, the auction will bring close to FMV anyway, and (ii) if the proposed sales price is significantly below FMV, the transaction may not be arm’s length, and may in fact be fraudulent.
If the agent doesn’t perform a CMA/BPO, and an appraisal hasn’t been made, the lender will obtain one as a part of its due diligence.
Once the property is being marketed, an experienced agent will record all of its marketing efforts. Even if a bank doesn’t expressly require this information (and some do), it shows the lender that (i) the borrower is making every effort to sell the property at a fair market price, and (ii) that if the bank rejects the short sale, it may have to make these same efforts, and likely couldn’t get a better price than the offer already before it.
Once a buyer makes an offer at an acceptable price, the borrower and buyer sign a sales contract. The contract will expressly condition the borrower’s duty to close on the its lender’s approval. The agent then submits this contract to the lender, along with: (i) the agent’s listing agreement (the bank may demand a lower commission), and (ii) proof that the buyer will be able to buy the property (e.g., a preapproval letter, available cash, etc.).
Once this information has been submitted, the borrower may (but is not required to) continue marketing the property and accepting back-up offers. This provides some protection against having to start the search process from scratch if the original buyer cancels the sales contract. Professionals are divided as to whether these back-up offers should be submitted to the lender as they occur. Some believe they show the borrower’s continuing efforts, and may even reveal a better qualified buyer or higher offer price. Others argue that giving a lender more than one offer just complicates an already complicated process, and shouldn’t be necessary if the first submittal was of a qualified buyer at a fair price. Of course, where a bank requires back-up offers to be submitted, the decision is taken out of the borrower’s hands.
Step 3: Short Sale Package & Submittal to Bank
As noted above, a borrower may give the lender an offer to buy before it submits its short sale package, or submit them both at the same time. It is entirely up to the bank. But even if the bank prefers to get them at the same time, a borrower should start putting together its short sale package as soon as it first decides to ask for a short sale.
The package contains all the proof borrower has that (1) it faces a hardship that prevents them from meeting their loan obligations, and (2) it doesn’t have enough income and assets to pay off the loan.
Banks generally require the following proof in the short sale package:
- Letter of Authorization. This letter gives the bank the right (and direction) to speak with the borrower’s agent or attorney. Letters typically include the property address, loan number, borrower’s name, and agent or attorney’s contact information.
- Financial Statement & Proof of Income and Assets. Lenders want to know how much the borrowers spends, on what, how they pay for these expenses, and how they could pay for them if their income changed. They will look at savings, other real estate holdings, stock and bonds, retirement accounts (e.g., 401k, IRAs), available credit through other sources, and anything else a borrower could sell to pay off the bank. For example, if a borrower as a credit card or a line of credit with a limit of $10,000 and a current balance of $0, the bank may require the borrower to get a $10,000 cash advance on this limit.
- Other Financial Proof. To get an accurate picture of a borrower’s financial situation, they’ll also require: (a) the last two years of federal tax returns, (b) two years of W-2s or, of the borrower is self-employed, its 1099s and a profit and loss statement, (c) 30 days of payroll stubs, (d) explanations as to any bonuses or any unusual changes in salary, and (e) the last two months of bank statements.
- Preliminary Closing (or Settlement) Statement. The preliminary closing statement is prepared by the party handling the closing (typically a title insurance company), estimates all closing costs, and shows the sale proceeds going to each lien holder. Closing costs can include such things as agent commissions, title insurance costs, attorney’s fees, recording fees and repair expenses requested by the buyer. Generally the lender agrees to pay these costs, though they will of course reduce the net proceeds to the lender, which might then be pursued by a deficiency action.
In many cases, junior lien holders will get nothing. After all, a short sale is defined as a sale whose proceeds aren’t enough to pay the amount owed the lender, plus closing costs. If the first lien holder is getting less than what is owed, anyone below them on the food chain isn’t getting paid. This is why short sales may not be feasible where there are more than one lien holder. All lien holders must consent to the sale, and if they’re not getting paid, they have no incentive to consent.
However, where a primary lender believes the short sale will net significantly more than a foreclosure, it may be willing to share a small amount of its proceeds with a junior lender to get their consent.
For example, a lender holding a second mortgage is owed $10,000. It knows that if a foreclosure happens: (i) its lien will be extinguished, (ii) it may not get paid anything if the foreclosure sale proceeds won’t fully pay the lien holders in a higher priority than it, (iii) it will cost $10,000 in legal fees to win a deficiency judgment against the borrower (if such action is even permitted by state law), and (iv) even if it wins a deficiency action, because the borrower is clearly in a bad financial position, it’s likely the junior lien holder won’t be able to collect on the judgment. So, if the primary lien holder offers the junior $1,000 to agree to the short sale, $1,000 may look better than the likely $0 through foreclosure.
- Seller’s Hardship Letter. This explains (1) how the borrower got into its present situation, (2) how they’ve tried to fix it, and (3) why, despite their efforts, they won’t be able to meet their loan obligations. Not today, not tomorrow, not ever. Borrowers are often told to explain in great detail, and with emotion, the difficult times that have caused their dire straights. Some common hardships include:
- Reduced income through no fault of their own making (e.g., down-sizing)
- Tax problems
- Significantly increased expenses
- Unexpected property repairs
- An uninsured loss (e.g., damage caused by an uncovered natural disaster)
- Illness or medical emergency
- Military service
- Death in the family
A borrower should include in the package documentation to evidence the hardship claims, such as the divorce decree and property settlement, company termination letter, rejected claim from insurance company, etc.
- Comparative Market Analysis / Broker’s Opinion of Value (CMA/BPO). If this hadn’t already been provided earlier in the process, borrower will include it in the short sale package. If one was never created, the bank will order one. If the property is currently worth less than when borrower bought it because of a market downturn, the borrower should submit evidence of the downturn.
- Arm’s Length Affidavit. A lender wants to ensure the proposed short sale is an arm’s length transaction, and thus, one resulting in a price reflective of the property’s fair market value. A non-arm’s length transaction, meaning those between related parties, increases that chance the price has been manipulated or expenses inflated in an attempt to defraud the lender. The borrower states in this affidavit that it has no relationship, familial or in business, to the potential buyer, and that the proposed price is fair market value.
- List of Junior Lien Holders and the Amounts They’re Owed.
- A Preliminary Title Report. If not provided, the lender will get one to identify all recorded interests against the property.
- Necessary Repairs. If a property needs to be repaired to be marketable, the borrower should submit multiple estimates for this repair. Generally a bank will deny this request, require the property to be sold as it is, or simply deny the short sale request completely. Accordingly, if the request has any chance of being accepted the borrower has to show the repairs will significantly increase the sales price and proceeds to the lender.
Step 4: Lender’s Review
Following its receipt of the short sale package, and the other items discussed above, lenders generally take these steps:
Negotiator Assigned & Terms Negotiated.
The bank assigns a negotiator to review the package and negotiate the best sales price and terms for the bank. The negotiator may work with the agent or attorney to negotiate the terms of the deal. Some banks won’t take this step until they have issued their approval letter. Borrowers typically want to negotiate the following:
- Waive the Right to a Deficiency Judgment or Contribution. In most states a lender can sue its borrower for any deficiency after a short sale. They can collect this amount by doing such things as garnishing wages or levying bank accounts. Given that a borrower can’t pay its loan, it naturally doesn’t want to be liable for additional amounts. A bank may waive its right to deficiency if it determines the short sale, even if it loses the ability to pursue a shortfall, will still result in greater net proceeds than a foreclosure.
Banks may also respond to a request for such waiver by requiring a borrower to make a contribution to the transaction. These funds would come from the liquidation of assets revealed in borrower’s short sale package. Further, where a loan has been bundled with other loans and sold to a third party, the agreement detailing the administration of the packaged loans (a “Pooling and Servicing Agreement” or PSA) may actually require that borrowers make a contribution to short sales.
Alternatively, the bank can agree to recover its deficiency over time through a new unsecured loan with borrower.
- Reporting to Credit Bureau. In an effort to protect its credit rating. Borrower may ask the lender to not report the short sale and deficiency to credit bureaus. Such requests are typically denied, but where the short sale alternative is much rosier than a foreclosure, a lender may accept this request.
- Full or Partial Satisfaction. Borrowers will want to make sure the sales approval letter states whether its payment of short sale proceeds to lender will be in full or partial satisfaction of borrower’s outstanding debt.
- Sales Price. If the lender believes the offered price is not fair market value, or simply is unwilling to complete the short sale at that price, the lender will detail what price it will accept.
Mirroring the efforts of the first negotiator, a lender will assign a second to verify that the best terms have been achieved.
The lender will determine if the short sale is in conformity with all the PSA’s terms.
Step 5: Lender Response & Submittal to Buyer
Following its review of the short sale package, the bank will either (i) not respond at all, (ii) reject the offer outright, (iii) reject the offer, but explain what net proceeds and terms it will accept, or (iv) accept the offer.
If the lender approves the offer, it issues a short sale approval letter. This letter details the terms of the deal, including (i) the net proceeds the sale must bring to lender, (ii) closing date, (iii) maximum closing costs and commissions, (iv) and any other terms agreed to such as whether lender waived its right to a deficiency judgment, whether payment is in full or partial satisfaction of loan, and whether the short sale will be reported to credit agencies.
If any of these terms are completely untenable to borrower, it may try to further negotiate with the bank.
If the bank responded with a counter-offer, the borrower takes this back to the buyer to see if it will accept a higher sales price. Subject to its rights to terminate under the sale contract, the buyer may decide to cancel the contract.
At this point the borrower can move on to its back-up offers to see if any of them will accept the new price. And if not, the borrower can, subject to the lender’s approval, relist the property as an “approved short sale.” If the bank denies this request, borrower may have to start the process over again.
Step 6: Short Sale Closing
The closing occurs on or before the date required by the lender in its approval letter. Title and possession is transferred to buyer (unless the sales contract allowed for a later possession), and the closing agent disburses funds according to the closing statement.
Step 7: Post-Closing
Following closing, if a borrower failed to get all lien holders to waive their right to pursue deficiencies, the borrower may soon be facing deficiency lawsuits.
The good news for borrowers in this situation is that lenders can’t go after a borrower’s funds until it spends the money to file and win a deficiency action. Remember, a short sale is a non-judicial proceeding, so no court awarded deficiency judgment as part of the process (as opposed to a foreclosure, where the deficiency judgment can be awarded as a part of the foreclosure lawsuit). As described above, junior lien holders and unsecured creditors will often decide it isn’t worth their effort to go after a borrower who likely has no ability to pay.
While it should be clear that getting a short sale approved and closed is no easy task, it may nonetheless be the best solution for all parties. As mentioned before, as between short sale or foreclosure, if the sale can get done, it is often the lesser of two evils.
Of course, getting it done requires a thorough understanding of the process, what borrowers need to provide, and what lenders will want to see. Because each lender’s rules are different, and deficiency laws vary from state to state, the persons in the best position to give you answers to any specific short sale issues are your attorney, your tax advisor, and your real estate agent.
If you’ve ever navigated the short sale waters before, whether as a seller, buyer, lender or advising professional, we’d love to hear your stories in the comments below!