Distressed sale word balloon with house - the difference between short sales and foreclosures?What is the difference between short sales and foreclosures? Do you know what an auction is, or what REO means? These are some basic terms related to distressed properties or financially distressed home owners, and we’ll go over what each of them means and why they matter.

Here is the quick summary on the difference between short sales and foreclosures:

  • When home owners miss a payment or two, their lender will record a “notice of default” on the property. This is pre-foreclosure.
  • A short sale happens most often after payments have been missed, but not always. If the home is worth less than the mortgage, then for the sale to be completed the lender must agree to a short payoff. The seller cannot take a penny from the proceeds of the sale.
  • If property owners don’t make up the missed payments, interest, and fees for being delinquent, the lender will then record a “notice of trustee’s sale”.
  • The trustees sale is the next step after a foreclosure notice. It’s an auction. Usually it will happen on the steps of the county courthouse. Buyers can purchase it then only if they pay ALL CASH. There are no guarantees that hidden liens from the government may still be owed. The future home owner may be stuck with them! (All other debts are erased.) You cannot get title insurance on the day you buy a property at auction. If the property is occupied, you may need to evict the tenants or former owners.
  • If the home is not sold at auction, next the bank takes back the property and then markets it for sale with a real estate licensee, it’s sold as an REO. REO stands for “real estate owned” by the lender. REO sales do not always have presale inspections and may or may not be cleaned up to be more presentable.

Bargain hunting: short sales and foreclosures or auctions, and REO purchases

Silicon Valley home buyers who are looking for a good deal can’t help but notice that prices on short sales and bank owned homes are a bargain compared to regular sales in the San Jose area. But what exactly ARE they? What’s the difference between a short sale and a foreclosure? What are the risks involved in buying one of these in Santa Clara County? Today we’ll have a look at the various types of distressed properties and the risks associated with purchasing each.

The difference between short sales and foreclosures?

The difference between short sales and foreclosures is sometimes partly a matter of where they are on the time line.  We’ll discuss the first stages in this process next.

What are short sales?

Short sales are when home owners need to sell their home but there’s not enough equity in the property to pay off the loans and closing costs.  So the only way they can sell is if the bank agrees to accept a “short payoff“.  The bank or banks get paid in short, hence short sale. If they sell the home, they won’t be allowed to get any cash out of the sale.

Short sales vs foreclosures – timing is everything! Often short sales are pre-foreclosures, meaning that the owners have missed some payments and the bank is working toward foreclosure proceedings on the condo, house or townhouse. But not always! Sometimes short sales are not pre-foreclosures.  In those cases the owners have made all their payments but can foresee not being able to do so in the future (example: someone knows that he or she will be losing his/her job very soon, or that large medical bills are coming etc.).

Many pre-foreclosures are not on the market, by the way.  Today some consumers and real estate agents track notices of default (“NOD”) to see what may be coming on the market. These home owners may have no intention of selling but may decide to wait it out for the foreclosure and stall on moving as long as possible.  Some may be scrambling to pull together money to get out of default.   In some cases, too, they are working on a loan modification. Do not assume that because they are behind on their mortgage that they will want to sell – some do, some don’t. Some would like to do a short sale, but simply do not qualify for a short sale – so it’s not a realistic option. In some cases, a foreclosure is preferable to them for tax or other reasons than a short sale.

Short sales may involve just one bank or multiple banks if the owner has a 1st and 2nd. (Or more loans.)

The easiest short sales:  not pre-foreclosure, one bank.

Hardest short sales: pre-foreclosure, notice of default has already been filed, close to deadline for auction (notice of sale has been filed), multiple loans and banks.  (The more loans and banks, the harder.)

Who’s the seller in a short sale transaction?

The short sale seller is the home owner (not the bank) but the seller has a contingency for bank approval.  That can take 60 days and if the seller does not like the terms of the approval (sometimes the banks approve but require the seller to pay some money), the seller can say no and the deal is killed.  Prior to bank approval (and in some cases, after that point), a better offer can “bump” the first one out too.

Short sales that do sell seem to close about 2/3 of the time now.  A couple of years ago it was only about 1/3 of the time, so it IS improving.  There is often (but not always) about a 20% discount off market value.  Some banks, though, will not allow for ANY discount and that can make selling these tough.

There are usually no pre-sale inspections with short sales.  Sellers cannot take away a penny when they sell, so often will not leave any personal property since they can sell that and get some cash for it. (Personal property = anything not affixed to the house, so things such as a refrigerator).
Time: it might take 30-60 days to get approval, then it’s like a regular escrow, so 30 – 45 days.  Allow about 3 months (though some take much longer.)

What are some of the risks in buying a short sale?

  1. There are no pre-sale inspections in most cases, so you’ll have to spend money before you even know if you want the property
  2. You may pay for the property  inspections, only to have the bank take the home back prior to close of escrow or get bumped out of escrow by a better offer. The accepted offer does not always stop short sale proceedings or mean that you are the only possible buyer.
  3. Sometimes sellers or tenants in a short sale may make inspections difficult, may not move out on time, or may take items that you expected to stay with the property.

What is a Foreclosure?

Foreclosures – there are really two subcategories here:  (i) when the actual auction happens on the courthouse steps and (ii) after the holder of the first loan takes the home back and sells it as a “bank owned property” or REO (“real estate owned” by the bank).

Auction – there is no “role” for me or any Realtor at the trustee auction.  The home is made available for bidding, usually at the sum total of all liens against the house.  As an example, let’s say there’s a 1st loan for $500,000 and a second loan for $100,000 and back property taxes for $10,000 all due.  The bidding begins at $610,000.  If the home is worth $700,000, then this may be a good deal.  Most of the time, though, the home is worth much less than the sum total of the liens against it, maybe 70% or 80%.  Then there’s no bargain.

For those who purchase at auction, there must be financing lined up so that it’s cash the day of transfer.  There are NO warranties.  There is NO inspection contingency, loan contingency or any contingencies of any kind.

Buying at auction is risky because (1) you get no guarantees and (2) you cannot change your mind even though you will have bought it without even seeing the inside of the house.   There may be many hidden risks.  In one recent case, a Boulder Creek couple purchased what they thought was a home at auction, only to find out they’d paid for a second deed of trust.  The bank foreclosed on the home a month later – they lost everything!

Bank owned or REO homes – here the lender has taken back the property.  Once it goes on the market, the seller (bank) is VERY anxious to sell.

Time: these can usually close in 30-40 days.

No pre-sale inspections.  As with short sales, you will have to spend money to see whether or not you really want the house.

As Is – the bank will not usually do any repairs.  The bank will allow very few days for all inspections (often just 7).  The contract may be “normal” but the bank will have an REO Addendum that strips away many of the buyer’s rights and protections in the contract.  It varies from one bank to the next.  Some, for instance, will not agree to arbitration but will insist that if there’s a big problem with the bank, a lawsuit would have to take place and it would be in the home state of the bank, not here.  Others will agree to arbitration.

REOs that sell usually close escrow unless the buyer finds that the home is in terrible condition during the inspections.
The REO ‘discount” is often about 10% off market value for a similar home that would be a “regular sale”.

What are some of the risks in buying a bank owned home or REO?

Many consider REOs the least risky to purchase of distressed homes here in the South Bay.  They also involve some risk, though.
  1. No pre-sale inspections, no helpful disclosures upfront. You have to spend money to see if you want the home. Be prepared to risk $1,000 and learn you don’t want the house after all!
  2. Short timeframes for doing your inspections: a lot of lenders won’t allow more than 7 days to inspect.  You might really need more like 10 or 14 days.
  3. Passive contingency removals: the bank’s counter offer will usually include a clause that states that if you don’t object prior to the deadline for removing your property condition contingency, it will be deemed waived.  Normally we have “active” removals of contingencies and you have to sign a paper stating that you’re removing it.
  4. The bank’s asset manager may or may not be super cooperative in returning your deposit if you back out during the contingency period.  If they don’t, you may have to pay a lawyer to help you get it back.  (This just happened to me but we did get the cancellation signed and the check is now supposedly on its way.)
  5. Some banks won’t agree to arbitration and they insist that the jurisdiction for any complaint is not here in California but in their home state.
  6. In a few cases, previous home owners have been known to move back into the property.  Sometimes other squatters move in, too (I have previewed some REOs for my buyer clients and been very creeped out when finding squatter belongings in the house!)
  7. Sometimes the house will have been “stripped“, meaning that things have been removed which ought to have stayed with the house.   Worse, in rare cases the home has been maliciously damaged by the previous owners (things like flushing concrete down the toilet).

Why go to the trouble of buying short sales and foreclosures in the San Jose area?

In a word, Silicon Valley home buyers make offers and complete sales on all types of distressed properties because there is a good price attached to buying short sales and foreclosures.  The higher the risk, often the lower the price.  Many buyers will pay a premium for a “regular sale” because they don’t want to deal with the unknowns and the risks involved in short sales and foreclosures (or buying on the courthouse steps).

Some parts of Santa Clara County have a lot of distressed homes on the market – south San Jose, Blossom Valley, Alum Rock, downtown San Jose.  Other areas, particularly those with the best schools, have far fewer of them and those tend to sell very quickly: Los Gatos, Saratoga, Monte Sereno, Cupertino, Palo Alto, Almaden Valley – all of these have a more competitive situation for distressed sales.

The difference between short sales and foreclosures relates to ownership (short sales and pre-foreclosures are owned by the homeowner, REO is owned by the bank). The foreclosure auction is a way of purchasing a distressed property.
If you do decide to purchase a distressed property, please make sure to have a good attorney ready to assist you in reviewing the paperwork (particularly any bank addenda).  The legalese involved is beyond the scope of a real estate licensee and it is imperative that you understand what you’re agreeing to!
Here are some helpful articles on short sales and foreclosures:

Buying Distressed Homes: Foreclosures, Short Sales, REOs this is an About.com article written by a good Realtor I know up in Sacramento. Just one correction.  She writes “A short sale occurs when a home owner is in foreclosure but before the property goes to public auction.”  That is OFTEN true but not ALWAYS.  Some short sales are not yet in default.

There are a bunch of related links under this article that you might also find helpful.

How to buy foreclosures at an auction – bankrate.com article which discusses both the courthouse steps type auction and a new trend we’re starting to see here of selling regular homes at auction too.  (That’s a common way to purchase in Australia!)
The safest ways to buy foreclosures – MSN & bankrate article suggesting that buying an REO is a lot less risky than buying at auction or as a short sale.  One correction:  this article says “With good credit, many banks will loan the full price of the foreclosure or more.”  I have NEVER known this to be true!!  The banks want 20% down.  Maybe that’s true in places like Vegas where there are a ton of foreclosures, but not here in my experience.
Here are some of my own articles on these subjects:


  • Mary Pope-Handy

    Silicon Valley Realtor, selling homes in Los Gatos, Saratoga, San Jose, Silicon Valley, and nearby since 1993. Prolific blogger with a network of sites.

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