Recently, some gurus have decided to push ‘short sales’ as a way to part you from your money.

Should you pursue ‘short sales‘ as a real estate investment strategy? No, not as a strategy. Rather, you should understand them and try to do them if you come across an opportunity to do so. In other words, they are a rarely-used “tool” that should be in your real estate investment “tool box,” not a focal point for your investment program.

What is a ‘short sale?’

Properties are sometimes worth less than the mortgage that is secured by them. In the other words, their mortgage is bigger than what the property would sell for. Such properties are referred to as “under water.”

The general idea of bargain purchase real estate investing is to identify equity, then buy that equity for less than it’s worth.

Can you do that with under-water properties? By definition, no. The properties have no equity so you cannot buy the equity in them for less than that equity is worth.

Discount lien release

However, sometimes equity can be created in under-water properties by persuading one or more lenders who hold mortgages or liens against that property to release their lien from that property for less than the face value of the lien. My book How to Buy Real Estate for at Least 20% Below Market Value Volume 2 has a chapter on discount lien releases. That book has many, many actual case histories. Sales involving discount lien releases are ‘short sales.’

Let’s say the property is worth $100,000 and has $105,000 worth of mortgages and lien against it. How much equity is in the property? None. Minus $5,000, actually, if the loan is recourse, that is, the lender can go after the borrower personally (collect the remaining money from the other assets of the borrower like cars, second home, garnish wages) for the amount remaining after a foreclosure sale. That amount is called a “deficiency” and the lender sues for a deficiency judgment to get the right to collect it.

Let’s further suppose that the liens are an $85,000 mortgage and a $20,000 judgment held by a credit-card company. To pursue the discount lien release strategy, you would contact the two lienholders—the mortgage company and the judgment creditor and ask each if they would release their lien in return for a payment of less than full face value.

Something on the dollar is better than nothing on the dollar

Why might they agree to this? If they believe they will get more money from doing so than from refusing to do so. In other words, if they believe the foreclosure will net less money than the discount lien amount.

Why would the owner of the property agree to sell to you? Generally, you have to offer him some money that he would not otherwise get—like money for moving and putting a security deposit and first month’s rent down on a new place to live.

Back in the early 1970s, I learned about discount lien releases at a seminar. Shortly thereafter, I was handling the sale of an under-water property as an agent. I contacted the lender in question, a local savings and loan, and asked about a discount lien release. Their lawyer lived in the community and knew the property values. He said nicely, “I think we’ll get 100% of our money from the sale so it would not be in our interest to agree to that.” He was right. The property was barely under water and had already been sold by me. (Until I sold it, I had no incentive or standing as an agent to seek the lien release.)

My 20% Below Market Value book has actual case histories where the discount lien release was obtained.

How do you do it?

How do you pull this off? Again, see my book. Basically, you need to persuade the lender or creditor that they will probably get more from doing this with you than from the foreclosure.

Is that really true? I’ll put it this way, the more profit you are going to make on the deal, the more the lenders and creditors should tell you to bug off. Only when your profit is slim is it likely that the creditors would be better off agreeing to the discount lien release than just letting it go to foreclosure.

Also, loan bureaucrats often make decisions against the interest of their company. It’s not their own money they are deciding about. They may find it more fun personally to say no to you or to prevent you from making a profit even though their employer will net less if they refuse your request.

Cyclical

The incidence of under-water properties on which to try this is cyclical. That is, when real estate is booming, there are few such properties. This generally only happens when real estate is sagging. Furthermore, in order for you to profit, you have to sell the property in that same sagging market.

That’s another reason why this is a poor strategy. A sound strategy generally must work all the time or you are out of business for half the cycle.

Excessive risk

The combination of having to settle for a slim profit margin and having to sell quickly in a down market makes this relatively unattractive because the risk is high and the reward is not.

If, as you go about another real estate investment strategy, you encounter an under-water property you should contact the lenders and/or creditors who hold the liens and ask if they will release the liens for less than face value. If the numbers make sense, go ahead and do that. But as far as pursuing short sales as your whole strategy, forget about it. It is an approach that only exists when there are numerous under-water properties so it would have you sitting on the sidelines doing nothing most years.

Why are gures hyping this?

I guess that some gurus are suddenly pushing short sales because to an ignorant layman, the name “short sales” sounds intriguing. “Short sales” are also associated with seller distress and laymen believe that anything associated with seller distress means big profit opportunities. That is absolutely not the case. If a buyer overpays for a property by 20% then the property falls 10% in value, tha buyer is in distress big time. But you cannot buy a property that is 10% overpriced and make a profit thereby. I has to fall a lot more than that before you can get a bargain purchase price in relation to true market value.

In addition, some seller distress can offer adequate profit opportunities to an investor, but other seller distress—like toxic contamination—is stuff you want to stay away from as a general rule. Generally, there is no profit opportunity in an under-water property for a real estate investor. But in the rare case when adequate-size discount lien releases can be obtained, there can be some small profit.

Alexis McGee of Foreclosures.com has another article about short sales at http://www.foreclosures.com/www/forecast/ff_Feb07/default.asp?topic=marketing. Her article has a slightly different perspective, but arrives at a similar conclusion to mine.