Pricing the Short Sale Offer

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Pricing the Short Sale Offer

Denise Evans
JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes

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.

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Ron S.
Paradise, CA · Member since 2015 · 1k+ posts · 871 votes
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@ Denise - Excellent post. While it may work for the big 5 across the board, I wouldn't say it's the only methodolgoy used or that it works well universally for all banks.

Yes, we all do an NPV but the variables are different in each area (As you pointed out). We don't assume it will be worth the same at a minimum in a year. Many pockets of the country are still on a decline. That said, many are on an uptick in value and we factor that in our analysis.

Just as important (Military relocation notwithstanding) are the reasons for the short sale and the financial situation of the borrower. If they are sitting on significant liquid assets and/or have sufficient income but want out of a property because they don't like that they are underwater potentially or, don't like their current interest rate because market rates are better, well, we may decline a short sale.

A short sale is an alternative to foreclosure in the event of default. One of the options available that a lender may consider (I know, this is rhetorical).

By the way, we use a 12.5% discount factor in our modelling and we adjust quarterly.

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  • Paul Stephan
    Houston, TX · Member since 2015 · 21 posts · 0 votes
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    Solid post, thanks for sharing.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
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    Interesting theory, but I've never observed this as a pattern.  Some we've done at a good discount, some they wantFMV, or above, most at85-90%.

    @Ron S. You guys use any similar analysis?

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  • Denise Evans
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    JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes
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    @Wayne Brooks, it's not a theory, it's how the computer models are created. It is purely an NPV--net present value comparing two alternatives-- analysis.  An NPV that is positive, 0, or only slightly negative will be approved. An NPV of 0 means the offer exactly meets investor requirements. A positive number is better than investor requirements, and a negative number does not meet investor requirements. There is usually a range of negative NPV values that will still result in short sale approval.

    I typically price my offers 15% to 20% below market, and almost always get approved. I was simply explaining WHY that works.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
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    @Denise Evans I agree it makes perfect sense, and originally assumed that would be the proper analysis to use. I know that's the way I'd do it.  But, getting some of the counters we get from the banks, I begin to assume logic doesn't always prevail.  Not sure if their computed values simply come in so differently than mine, or there is just some disconnect in their internal system. A 1%/mo yield seems a little steep though.

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  • Denise Evans
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    JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes
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    The discount rate is market driven, @Wayne Brooks. I'm in Alabama, which used to have a 1-year post-foreclosure right of redemption, until the last legislative session. It depressed REO prices significantly, which probably fed into the high discount rate. In your market, the discount rate might be smaller, but the analysis is the same. Plus, you have to control the appraisal process. About two years ago I discovered banks starting to use an appraisal AND their own AI internal valuation, and the AI always trumped the appraisal. In that case, you have to appeal, protest, and produce your own comparable competing properties listed for sale, and comparable recent sales. If it goes that far, I usually get the valuation I want, and all else flows from that.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
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    Yes, as much as we all complained about FNMA's over priced short sale valuations, I generally had better success with dispute valuations with them, than with others.

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  • Ron S.
    Paradise, CA · Member since 2015 · 1k+ posts · 871 votes
    11y

    @ Denise - Excellent post. While it may work for the big 5 across the board, I wouldn't say it's the only methodolgoy used or that it works well universally for all banks.

    Yes, we all do an NPV but the variables are different in each area (As you pointed out). We don't assume it will be worth the same at a minimum in a year. Many pockets of the country are still on a decline. That said, many are on an uptick in value and we factor that in our analysis.

    Just as important (Military relocation notwithstanding) are the reasons for the short sale and the financial situation of the borrower. If they are sitting on significant liquid assets and/or have sufficient income but want out of a property because they don't like that they are underwater potentially or, don't like their current interest rate because market rates are better, well, we may decline a short sale.

    A short sale is an alternative to foreclosure in the event of default. One of the options available that a lender may consider (I know, this is rhetorical).

    By the way, we use a 12.5% discount factor in our modelling and we adjust quarterly.

    1Reply
  • Denise Evans
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    JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes
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    @Ron S., thanks for the input. I agree with you. And, thank you for the info about the 12.5% discount rate. Also, as you pointed out, things are different with regional banks and local banks. A local bank is MUCH less likely to forgive the deficiency, and much more willing to foreclose and take their chances on an REO sale. A regional bank is somewhat less likely to forgive the deficiency, but usually will do almost anything to avoid taking the property into inventory.

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  • Scott Steffek
    Flipper/Rehabber · Crown Point, IN · Member since 2009 · 482 posts · 216 votes
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    So how do they price them when the hosue needs major rehab work? I have a property in Crown Point Indiana and it seems the bank won't even entertain offers! Not even "decent" offers. The ARV is around $165k. They're asking $115k. However, the house needs a minimum of $50k in rehab work. So where would I price the offer? What's even stranger, is that the house has been on the market for over a year. I was also told by the realtor that there's an attorney involved and a couple of other people, besides the bank. I just can't imagine them sitting on this house for such a long period of time. They had to come over and prop up the fence, because it's falling down!

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  • Denise Evans
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    JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes
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    Hi @Scott Steffek, sometimes you just don't know all the facts and hidden agendas. Rather than waste time and emotional energy on that type of deal, move on. It's kind of like that romantic relationship that seemed perfect but just fizzled out.  You'll make yourself crazy wondering why.  Usually, there is no lesson to be learned, it's just something irrational about that situation, or an outside factor (such as another love interest) that you know nothing about and can do nothing to fix.

    3Reply
  • Vicky S.
    Investor · Aurora, IL · Member since 2015 · 39 posts · 6 votes
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    @Denise Evans

    this was a great post. great information for a newbie like me. I am evaluating a short sale currently and found this info really useful. 

    now would you say your model works for all scenarios - whether its 100K or upwards of 500K? does the discounting change with the value of the property? 

    In my case this property has been there for last 1 yr but it has kept on moving in and out of MLS. So not sure what the rational behind this is.

    Additionally, in your example you mentioned that you have been successful in getting properties at 15-20 % discount - is there a thumb rule that 20% is more accurate for a property that has been in the market for 6+ months or anything other facts that would help determine what discounting to apply. (i also noticed that the loan owned by the bank is currently at 20% less than listing price so is it possible to get at a much higher discount considering that the bank is already incurring expenses on this property??)

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  • Denise Evans
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    JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes
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    @Vicky S., I usually worked on properties with loans in the range of $375K to $1.2MM.  Properties in the $375K to 600K range were considered McMansions in this market, and those up to $1.2MM were considered luxury properties. I tell you that so you can compare to your own market. Generally, the banks were more flexible with luxury properties because that market always recovers more slowly than starter homes or McMansions.

    Years ago, when I worked on larger commercial transactions, I saw the same relationship. The larger the loan, the larger the discount.  Probably because the fear of a mistake is also larger.

    In your situation, you said the first mortgage balance is 20% less than the list price. Why do you think this would be a short sale opportunity? Is the list price any place near the market value? Is there a second mortgage that is perhaps preventing a deal at a reasonable price?

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  • Vicky S.
    Investor · Aurora, IL · Member since 2015 · 39 posts · 6 votes
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    @Denise Evanssorry for the confusion. The property is already listed on mls as short sale. The 20% discount I saw on zillow stating that the property is being held for by mortgage company at the current listed price. It was listed at a much higher amt but has dropped its pricing  by at least 120k over the past 1 yr. my agent tells me that there seems to be something wrong as it has never gone into contract as a short sale in the last 1 yr. 

    As for the market - it is an in demand area. Properties of similar sizes are listed/ sold at much higher prices. Houses  real good price. So not sure what's preventing it from moving forward.  

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  • Denise Evans
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    JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes
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    Do not rely on Zillow. Research the property records to find mortgages. Unless a mortgage is more than ten years old, the principal balance will not have reduced by very much.

    If a property is correctly listed as a short sale, but the 1st mortgage balance is less than the list price, then a 2nd mortgage is causing the problem.

    Call the listing agent to see if they will give you more information that will yield some insights. If not, then talk to some other agents who work in that same price range and area of town. I guarantee you, most of them know the story behind that property.

    Then, get back in touch with me.

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  • Account Closed
    Professional · Jacksonville, FL · Member since 2015 · 397 posts · 34 votes
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    Originally posted by @Denise Evans:

    Interesting use of time value of money and capital budgeting concepts which is applicable to real estate investing.

    The only issue here is that there isn't a universal discount rate. Most banks make most or a good part of their money by making mortgage loans. The current average mortage rate on a 30 year loan with prime credit is in the 4% range. The bank may want to use a lower discount rate since it results in a higher net present value.

    So 12% may be quite high although the investor may be inclined to use 12% or something higher. 

    Also, other than the opportunity cost or alternate investment route, another firm or bank though may use the 'cost of funds' approach to establish the discount rate and for banks, its cost of funds often may be way lower than 4% for that matter.

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  • Denise Evans
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    JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes
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    At least in Alabama, the discount rate for defaulted loans I much higher than the earning potential of the  money.  Other states might be different. Appraisers might know, because the banks often quote a discount rate for the analysis. For example, I once negotiated a deal on a subdivision in which the bank anticipated 7-year sell out of all lots if they foreclosed, and a discount rate of 22%. That was pretty horrific.

    0Reply
  • Account Closed
    Professional · Jacksonville, FL · Member since 2015 · 397 posts · 34 votes
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    Originally posted by @Denise Evans:

    At least in Alabama, the discount rate for defaulted loans I much higher than the earning potential of the  money.  Other states might be different. Appraisers might know, because the banks often quote a discount rate for the analysis. For example, I once negotiated a deal on a subdivision in which the bank anticipated 7-year sell out of all lots if they foreclosed, and a discount rate of 22%. That was pretty horrific.

    It being a distressed asset has quite a bit to do with it and it isn't just Alabama. Banks have been having a debate on what discount rate to use in valuing defaulted loans for quite a while. Basel have also gotten into this.

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  • Andrea Johnson
    Portland, OR · Member since 2015 · 29 posts · 9 votes
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    Great information, @Denise Evans! I have spoken with a couple of motivated FSBOs that are underwater and I have shied away from making any offers. Good to know some of these numbers.

    0Reply
  • Rachel Trimble
    San Antonio, TX · Member since 2015 · 47 posts · 18 votes
    10y
    Great info
    0Reply
  • Maurice George
    Member since 2019 · 113 posts · 25 votes
    6y
    Originally posted by @Denise Evans:

    @Ron S., thanks for the input. I agree with you. And, thank you for the info about the 12.5% discount rate. Also, as you pointed out, things are different with regional banks and local banks. A local bank is MUCH less likely to forgive the deficiency, and much more willing to foreclose and take their chances on an REO sale. A regional bank is somewhat less likely to forgive the deficiency, but usually will do almost anything to avoid taking the property into inventory.

     Hi Denise, short question to you. If a property has a mortgage principle of 115K, but bank has racked up maybe 7K in interests, and maybe another 5K in fees. if I submit a 115K offer, would bank approve a $115K offer quickly or they still want to go to formal short sale process? 

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    6y

    @Maurice George Those fees are small for most foreclosures. If you’re trying for a short sale there is no avoiding the full short sale process. You need an experienced short sale agent. 

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  • Maurice George
    Member since 2019 · 113 posts · 25 votes
    6y
    Originally posted by @Wayne Brooks:

    @Maurice George Those fees are small for most foreclosures. If you’re trying for a short sale there is no avoiding the full short sale process. You need an experienced short sale agent. 

     Wayne, thank you first. One more question, if owner pleading the bank and asking them for some reductions, would bank gonna reduce those fees? Such as reduce from (115K + 12K) 132K in total to 120K? I do not mind pay bank 120K if this is not go through short sale process and owner does not get a hit on credit. 

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    6y

    @Maurice George No, they won’t just reduce them. Anything less than the full balance owed would be a short sale....which will only happen if the house is worth less than the amount owed. 

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  • Maurice George
    Member since 2019 · 113 posts · 25 votes
    6y
    Originally posted by @Wayne Brooks:

    @Maurice George No, they won’t just reduce them. Anything less than the full balance owed would be a short sale....which will only happen if the house is worth less than the amount owed. 

    Wayne, the problem is, the property may worth 130K as is. If they go through the foreclosure process and then go to REO liquidation, they may get $130k or even less (after commission). Bank will not reduce any fees in exchange for remove this one off the book (especially what I am going to pay is higher than principle)?

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  • Denise Evans
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    JD, CCIM , Real Estate Broker · Tuscaloosa, AL · Member since 2014 · 1k+ posts · 1k+ votes
    6y

    @Maurice George, a small local bank might do that. Any larger regional or national bank, or any servicing company working for a bank, will not.  All decisions by those banks will have to be supported by new appraisals and by financial analysis.

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