Sacramento Real Estate Blog

This question seems to come up a lot with home buyers, so I would like to deal with it in detail. I will be covering this topic in a two part series. Today we’ll discuss how REOs and short sales come to the real estate market. Since most homes on the market currently that are bargains are REOs and short sales, (sorry, non distressed sellers, but it’s true!) it is important that home buyers, especially first-time home buyers understand the difference between these two options.

What is an REO?

REO stands for Real Estate Owned. It usually means real estate owned by a bank or a lender. It is also referred to as a bank foreclosure, a bank-owned home, a bank repo (a word I detest, by the way), a repossessed house or simply a foreclosure. REOs find their way on to the open market when a home buyer who has bought the home with a mortgage does not make payments. The lender has given him the loan secured by the value of the home. In other words, the home buyer has said to the lender, “Give me the money to buy this home worth so much and I will pay you back with interest every month for the next 30 years while I live there. If I don’t pay you, you can take the house back,” and then has defaulted on his payments.

In this case, the lender has to “take the house back” through a legal process called foreclosure. First, the homeowner is given a notice of default. This is also recorded in the county clerk’s recorder’s office and is public record. The homeowner is given enough notice to be able to “cure” the loan by paying the back interest and principal. If he does not cure the loan the house is then open for auction. If no one buys it at the auction, the home then becomes real estate owned by the bank. Most banks are not interested in owning real estate.

Then What?

Two things happen. When a bank owns real estate, it stays on its books as a bad loan. A bank can only have a certain percentage of bad loans, so they are motivated to get rid of the house as soon as they can. Also, they understand that now their cash flow which should have been coming from the mortgage payments is stagnated, so they have less money to lend. Remember that a bank can only make money by lending money. So they hire a real estate agent.

The process by which they hire a real estate agent to sell the home can get a little complicated, but in the most direct way they ask for a broker price opinion (also called BPO or a rough appraisal) of the property and then list the home. That is how an REO ends up on the open market. Usually, until the house sells, it is up to the listing agent to maintain utilities, keep the home clean and get rid of debris inside the house. The agent can then bill the bank for it at close of escrow.

What is a short sale?

A short sale attracts many home buyers simply because of the term. They are erroneously led to the assumption that because a house is selling “short” it must be at a discount. Nothing could be further from the truth. While it is possible that the house is selling at a much lower price than its competition, a short sale could also be grossly overpriced. A “short sale” simply means that the sellers of the property are asking the lender to accept the current market value of the home as a sale price, which is less than the value on the note (loan) which secured the home. Thus, they are asking the lender to forgive the principal on the loan instead of foreclosing on the house. The assumption is that forclosures cost the lender money and hurt the seller’s credit score far worse than a short sale does. This is arguable and best discussed with an attorney. In my experience, clients have had the same damage to their credit.

How does a Short Sale get on the Market?

In most cases, the homeowners realize they are in financial trouble and cannot make their payments. In a better real estate market, this is not a problem. If they have paid down most of the principal on their total mortgage, they can sell the home. In other words, if the market value of the house is higher now than when they bought it, they can usually sell it without a short sale. The problem now of course is that the real estate market is trending down. So most homeowners who bought their homes in the upturn cannot sell them without a substantial loss.

At this point, the homeowners call a Realtor® and ask that the Realtor® speak with the bank and try and negotiate a short sale. The Realtor® becomes the listing agent and the seller’s real estate representative and works with the lender to approve the short sale of the property.

Most lenders currently are considering short sales seriously. We are definitely seeing the tide turn. But home buyers should be aware that just because a house is placed on the market as a short sale at a certain price that the lender will approve of the sale at that price. That, in my opinion, is the essential difference between REOs and short sales. With an REO, you know the sale price. With a short sale, the lenders don’t give out the information before the home is placed on the market and buyers are left playing the guessing game.

So now you know how REOs and short sales make it to the market. In the next part, I will discuss what some of the pitfalls are with both these options and also what, if any, are the benefits of buying either a short sale or an REO. Yes, that would be besides just the discounted price.