Pricing the Short Sale Offer

[Denise Evans]

I'm a former banking lawyer, and former lawyer for the FDIC closed-bank division. I can tell you, from the inside, how banks evaluate short sale offers. Since then, I've successfully negotiated many short sales to buy properties at huge discounts.

Understanding the process starts with simple math.

What is the present value of a foreclosure, which is the only real alternative to approving a short sale. The present value of a foreclosure is the amount they will take home at the closing table after an REO sale, minus foreclosure expenses, holding costs (taxes, insurance, HOA dues, property manager, maintenance, etc.), and then discounted to present value using a VERY hefty discount rate.

If a property is worth $125,000 today, then the bank will assume it will be worth the same amount in one year after a foreclosure. Let's suppose that all the expenses will cost the bank $25,000, so they will net $100,000 in one year, upon a sale.

The question then becomes, what amount of money today, invested at 12% interest (the discount rate) compounded monthly would yield $100,000 in 12 months? The answer is $88,744.92. The discount rate is how the bank takes into account market changes, stigma discounts for foreclosure properties, uncertainty regarding valuation and expenses,, and the loss of use of their money. For foreclosures of entire subdivisions, I've seen discount rates as steep as 22%, calculated over a 7-year sell out of the lots!

For our example property, the bank will approve any short sale offer that will net them $88,744.92 at closing.

In reality, because neither the $125,000 appraisal, nor the $25,000 in expenses are firm numbers, but simply estimates, the bank will accept slightly less than $88,744.92. Money at the closing table after a short sale is "for sure." Money after a foreclosure and REO sale is speculative.

So, in this example, the bank might approve a short sale offer that netted them $84,000 at closing. Which means, in most markets, you can buy a $125,000 property for around $91,300 if the real estate commission is 6%.  If you have a real estate license and are willing to waive a commission, and if the listing agent is willing to accept only a 3% commission, then you can buy that same property for around $88,400.

In my opinion, that makes short sales the best foreclosure investing strategy.