This analysis works for full-deficiency states like Alabama. In other words, states in which the bank’s foreclosure bid price is credited against the mortgage loan balance, and the borrower will still owe the difference.
Let’s start with average lenders. The lender will bid its “asset value” at the foreclosure auction. That is not the Fair Market Value (FMV) of the property. The asset value is the cash the lender expects to have left in its hands after it forecloses, pays all the expenses of foreclosing and managing the property (lawyers, advertising, recording, property management fees to check on the property once a month, needed repairs before they can sell it, taxes, insurance, HOA dues, plus sales expenses of closing costs and real estate commissions).
They must also assign a time value of money to this, and discount the net proceeds to present. For example, suppose the property is worth $120,000. The lender thinks they will net $100,000 when they finally sell the property in 18 months. They also know that $100,000 in 18 months is worth less than $100,000 today. So, the expectation of receiving $100,000 in 18 months might be worth only $83,000 today. Also, paying $3,000 for repairs today but not getting repaid until 18 months later, might make today’s expense the equivalent of $3,540. All that number-massaging has to be gone through.
You also have to consider, especially in Alabama, that the FMV of a foreclosure property is less than the FMV of a regular property. A house worth $120,000 in a sale between a regular buyer and seller, might be worth only $100,000 if it’s a foreclosure. There are several reasons for that:
- In Alabama, the 12-month right of redemption depresses prices because title is at risk for 12 months. It also limits the pool of potential buyers. Most homeowners will not buy a foreclosure property during the redemption period because they do not want to take the risk of buying, nesting in, and then having to move if there is a redemption. As a result, when you are determining the fair market value, you can’t look at the entire market place to see what people pay for a similar property. The bank has to look at the marketplace of foreclosure properties sold to a limited group of buyers.
- Because the owners are gone, buyers are able to obtain only a limited amount of information about the property. They can’t ask questions like “Where is the septic tank?” or “Does that stain on the ceiling represent a current roof leak or an old one that has been fixed?” This chills the selling price.
- Because of both of the above reasons, investors are the most likely buyers for foreclosure properties. Investors usually pay less than a residential owner-occupant would pay. Investors are buying properties to flip, or to rent, or both. They can’t make money if they pay top dollar.
The foreclosing lender does not get a special appraisal to account for the matters above. Instead, their computers take it into account when figuring out an “asset value” after the appraiser provides the FMV. The computer might shave an extra 5% off the asset value, to account for this.
After the property is foreclosed, the ORE department will order another appraisal, for its own purposes.
Some lenders bid the full loan payoff at closing. Those lenders have already decided they will not pursue the borrower for a deficiency. Typically, those are loans owned by Freddie Mac or Fannie Mae, as examples. Rather than calculate an asset value, they just save time and money and bid the full loan payoff. Then the ORE department orders its own appraisal and markets the property.
Why is this important, besides just understanding the process?
First, if you go to a foreclosure auction on a Fannie Mae property, you will probably not buy it. That’s because Fannie will bid its full loan payoff. If you know ahead of time, you are not puzzled and perplexed.
Second, if you are trying to get a short sale approved, the net proceeds at closing must be reasonably close to the bank’s calculated asset value. In other words, if the real FMV is $120,000, but the bank thinks the present value of its asset is $80,000, then you just need a short sale offer that well net them around $77,000 or more. They are not going to quibble with you over $3,000 less than their asset value, because the whole asset value algorithm has a lot of guess work in it. Don’t take my word for it that the number is always $3,000. My point is, you don’t have to net them as much as their predetermined asset value.
Now that you understand the process, you should understand that with short sales, you have the opportunity to buy a $120,000 property for $77,000.
Is that a good thing to understand?
Is that a good reason to fill out the paperwork and wait for the approvals?
Of course it is! Also good for the borrower, because usually the borrower will receive full deficiency forgiveness as part of the negotiated short sale. Good for everybody except the bank, but they’ve already decided what they will accept, so they are not unhappy with the sale.