Should You Gamble on a Distressed Sale?

If you are in the market to buy a home, expect to see distressed sales: foreclosures, short sales and Real Estate Owned sales (REOs). Many buyers associate distressed sales with “deals,” causing their eyes to light up. More risk-averse buyers hear “distressed” and steer clear.

All distressed sales aren’t created equal, and each type should be approached differently. Before you set out in search of your next home, know the differences between them and what exactly they mean.

Short sales

Short sales are listings where the current market value of the home is lower than what the homeowner owes to the bank. The homeowner is the seller, and they have a good deal of control over the home sale.

It’s important to know that the seller’s short sale position could be no fault of their own. A job transfer, divorce or growing family could mean a move is necessary, but unfortunately their home’s value took a hit since they purchased the property.

The risk

Although they have control over the sale, the seller needs the bank’s permission to take less than what is owed. This is where short sales get complicated.

Banks can be slow in responding. So a buyer may make an offer, and the seller accepts and even signs a contract, but it could take months for the bank to respond. And it could do so with conditions like asking the seller to bring money to the table, or countering on price.

It’s this uncertainty of timing that scares some buyers off, because most want to be in their new home by a certain time. Additionally, some buyers get emotionally attached to a home, only to be let down if the bank rejects their offer, or the seller and the bank can’t come to terms.

The upside

If time is on your side and you can refrain from getting too attached to a home, you could get a good deal — sometimes up to 10 percent below market value. The longer the process goes on, the better the price, because the market, in some cases, is improving as the bank works through its processes.

Also, short sale sellers tend to price their listings below market value because they know that many buyers won’t want to wait around or deal with the uncertainty of the bank’s decision. So, the price suffers, and the patient buyer wins.

Foreclosure sales

Buying a home through a foreclosure sale should be reserved for only the savviest of real estate investors. Here’s how it works: If a homeowner doesn’t make their mortgage payments over time, the bank initiates foreclosure proceedings. After providing enough notice to the homeowner, the bank will sell the home to the highest bidder on the courthouse steps, auction style. If the loan amount is much lower than the market value of the home, you can expect to see bidders there. If the mortgage amount is more than the market value and nobody purchases the home, the bank is forced to take the home back and become the new owner.

The risk

There is no going back to the bank for credits or asking for a refund if there are problems. And bidders must show up with cashier’s checks in hand, because foreclosure sales are cash-only sales.

Also, since these homes are not listed for sale on the open market, chances are most bidders won’t ever have the opportunity to step inside to inspect the property. Foreclosures are sold absolutely “as is.”

Finally, there could be additional liens on the title, tenants in place, or any number of red flags, all of which make the purchase riskier because they become the problem of the new owner.

The upside

Generally, foreclosure sales will trade for at least 25 percent below the market value, and sometimes more, simply because most home buyers can’t show up with cash, won’t buy a home as is, and don’t have the experience or knowledge to take on such risk. Typical foreclosure buyers will take on the risk and do what is necessary to make the home marketable for sale or rent.

Real estate owned (REO) sales

If nobody shows up to purchase a home at the foreclosure sale, the bank takes it back, and the property becomes “Real Estate Owned” or REO.

Banks don’t want to be in the business of owning real estate. So, once they take the property back, they want to get it listed and sold as quickly as possible. You will likely see bank-owned homes for sale through online listings and your agent, just like other listings or sellers, except that they will be marked as REO and the seller isn’t a person.

The risk

Like foreclosure sales, there are few to no disclosures, and the home is sold as is. With an REO, you can actually go inside the home, look around and see it for yourself. They may even have open houses. You can have the property inspected and learn as much as you can. But since there isn’t a homeowner there to disclose what they know, it is still a bit of a risk.

The upside

REOs are generally listed at 15 to 20 percent below market value. (Of course, this varies by region and bank.) And REOs often need improvements, both cosmetic and structural, so an REO sale likely has the added value of a fixer upper. An REO could be listed at even 30 percent below the true potential value of the home, cleaned up and habitable.

It is important to understand that few banks are negotiable on price today. They know that the real estate market has improved, and will hold out for top dollar. Also, it is all a numbers game to the bank, so don’t expect letters to the “seller” to get you anywhere.

If you are entering the market for the first time, plan on seeing distressed sales in your search. Have a talk early on with your agent about the type of risk associated, and whether or not you would be a good candidate for one.

Don’t assume that all distressed sales are nightmares — or that they have “deal” written all over them. Each opportunity should be highly scrutinized, and you should always have a qualified real estate agent on your side.

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Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Zillow.

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