REO v. Short Sale

Foreclosure investors have several strategies to choose from when buying properties. Due to the fact that the foreclosure process tends to be lengthy, investors can target properties in various stages of the legal proceedings - either in preforeclosure, at the foreclosure auction, or bank owned properties following the foreclosure proceedings (REO). Each strategy has its relative merits and drawbacks, but most investors find that preforeclosures and REOs offer the least amount of risk, and the greatest opportunity to score a bargain.

As detailed in my prior post, many investors find that purchasing properties at foreclosure auction is not preferred because: (a) foreclosure auctions do not allow the buyer to inspect the property before bidding, (b) the competitive atmosphere of the bidding process can cause prices to escalate quickly, (c) buyers at the foreclosure auction typically have to make a significant down payment in cash and close within thirty days thereafter, (d) there is no ability to negotiate the terms of sale as these terms are governed by statute, rather than agreement between the parties, (e) there is less certainty since the foreclosed owner retains redemption rights (depending on the state, this period can be a few days, or up to a full year), and (f) the bidding process can be corrupted by collusion among bidders (this is illegal but undoubtedly happens from time to time).

By contrast, preforeclosure and REO buyers do have the ability to inspect the property, negotiate in a less competitive environment, typically greater flexibility in negotiating downpayments, closing schedules and other terms, and have greater certainty of closing once an agreement is reached. So, how do short sales and REO transactions differ, and what are the relative advantages and disadvantages of each.

A preforeclosure is the purchase of a distressed house prior to the foreclosure auction. In these instances, you are generally dealing with property owners who (for whatever reasons) can no longer pay their mortgages. If the property owner has significant equity in his or her home, you may be able to buy the owner’s equity (and therefore the house) at a discount. In today’s market, these instances are rare. Instead, investors will more likely find preforeclosure owners who have no equity or negative equity in their homes because the mortgage is greater than the market value of the house. In these circumstances, a short sale is the only option. The procedure for submitting a short sale offer and the most effective negotiating tactics you should use are addressed in further detail in my publication How to Buy a Short Sale: An Investor’s Step by Step Guide, which also includes the form letters, contracts, and financial statements you will need to complete these transactions.

Logically, short sales should be the best way to purchase a distressed property at the lowest price. Short sales focus on the acquisition of properties early in the foreclosure process and logic dictates that banks should be willing to accept the lowest prices earlier in the process as they could save the costs of (a) lost interest income, (b) accrued property taxes, and (c) legal fees and costs associated with the foreclosure process.

Unfortunately, logic does not always prevail when dealing with the loss mitigation department. One foreclosure service company recently conducted an informal study of 500 short sale offers it had handled last year and found that only 43% of the offers resulted in a sale. In the other 57% of the cases, the bank rejected the short sale offer and chose instead to foreclose on the homes and sell them as REOs. The study determined that 93% of these REO sales ended up selling for less than the last short sale offer price.

The results of this study defy good business sense. After all, a good businessperson would seek to obtain the highest possible price when selling their asset and incur the lowest possible cost. Still, there are some plausible explanations for this apparenly illogical result. One possible explanation is that the study’s methodology was flawed (most scientific studies use a sample size of at least 1,000 random examples). In this case, there were only 500 samples which were all chosen from a single firm’s case load (which may have included a disproportionate number of examples involving certain banks, or geographic regions, for example). Another possible explanation is that the loss mitigation representatives responsible for the study sales were simply incompetent. Another is that these representatives were so overworked that they were incapable of making good business decisions in the cases cited. Yet another possibility is that the banks failed to recognize that housing prices would continue to fall when they rejected the short sale offers - or that prices would fall as quickly as they did. As a result, the homes were worth much less than expected at the time they were eventually sold compared to when the banks received the last short sale offer.

Whatever the cause, the findings of this study, appear to indicate that REOs are the better investment option compared to short sales. Not only were the REOs purchased at a lower cost than the last short sale offers, but they required less of the investors’ time and effort. The results of this single study should not be considered conclusive evidence for investors going forward, however. For one, the study does not tell us what price the successful short sale offers would have been had they gone to REO sales. Furthermore, the unprecedented surge in foreclosures seems to have taken the banks by surprise. It would be unwise to assume that these banks are not conducting their own studies and have not learned from their mistakes. One would expect that the banks to take steps to make their loss mitigation departments more effective going forward and anecdotal evidence indicates that this is, in fact, occurring. Consequently, although the study indicates that REOs may have proven the better investment strategy in the past, there is reason to believe that short sales may be more competitive going forward for those investors who are willing to work harder for higher returns.

Great post. I recently canceled a contract on a short sale purchase because after 4 months I still had very little response from the seller’s lender. They had the nerve to up their price after I went in with a full offer (L/A had written permission to list it at the price I offered), and when I went up slightly in my offering price they wasted another month doing absolutely nothing, so I backed out thanks to a clause in the contracts’ addendum. The whole process has frustrated me to the point that I’m trying to only look at REO properties now.