The alternative to a short sale is not the value of the house or the debt. It is a year or more of foreclosure, and the price follows from that.
The lowest short sale a note investor should approve is the gross price whose net proceeds, after commission, closing costs and the payments to the junior lien and the borrower, are worth as much today as the foreclosure route, adjusted for the chance that the sale falls through. On an illustrative non-performing first lien against a $150,000 house, foreclosure is worth $80,229 at an 18 per cent return, so any offer above $100,456, 67.0 per cent of value, beats it, even with a 30 per cent chance the buyer walks. A $118,000 offer that looks low is worth approving.
Worked in full in The Mortgage Note Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A short sale lets the borrower sell the house for less than the debt, with the note holder accepting the net proceeds in full settlement. The borrower brings the buyer and the price; the investor only says yes or no. The instinct is to compare the offer with the value of the house or with the debt. Neither is the alternative. The alternative is foreclosure, with its legal costs, carrying costs, an REO sale at a discount and, above all, a year or more of waiting.
| Input | Value |
|---|---|
| Unpaid principal / total debt with arrears and advances | $148,000 / $162,500 |
| Value of the house, as is | $150,000 |
| Short sale offer, closing in month 3 | $118,000 |
| Commission / seller closing costs | 6% / 1.5% |
| Release payment to the second lien / relocation to the borrower | $3,000 / $2,500 |
| Taxes, insurance and servicing a month | $450 |
| Foreclosure sale month / legal fees | 12 / $5,500 |
| Months to possession / repairs / months to sell | 2 / $8,000 / 3 |
| REO discount to value / selling costs / extra REO carry a month | 8% / 7% / $300 |
| Required return | 18% |
| Probability the short sale closes | 70% |
Net proceeds = $118,000 − $7,080 commission − $1,770 closing costs − $3,000 − $2,500 = $103,650
PV = $103,650 × 0.9563 (three months at 1.5 per cent) − $1,310 of carry = $97,812
REO sale in month 17 at $150,000 × 92% = $138,000, net of 7 per cent costs $128,340, worth $99,641 today
Less present values of carry $6,708, extra REO carry $1,200, legal $5,009 (half at filing, half at the sale) and repairs $6,495
Foreclosure PV = $80,229
If the buyer walks, the investor has lost three months and forecloses from month 3: that route is worth $75,413, $4,815 less than foreclosing today.
Value of approving = 70% × short sale PV + 30% × $75,413
Minimum price: solve 70% × PVshort sale(price) + 30% × $75,413 = $80,229, giving $100,456
In Excel, put the price in one cell, build both routes month by month, and use Goal Seek on the difference between the expected value of approving and =NPV(18%/12,FC_Flows).
At $118,000 the short sale is worth $97,812 if it closes, $17,583 more than foreclosure: 60.2 cents on the total debt against 49.4. Weighted for the 30 per cent chance it fails, approving is worth $91,092, still well ahead. The offer clears the minimum by $17,544.
Two things drive the gap. The short sale pays in month 3, foreclosure in month 17, and at 1.5 per cent a month fourteen months of waiting costs about a fifth of the proceeds. And the short sale avoids the REO discount, the repairs and a second set of carrying costs, because the borrower keeps the house in saleable order until closing. The $5,500 paid to the junior lien and the borrower is the price of that cooperation, and it is cheap.
| Foreclosure sale month | REO sale month | Foreclosure PV | Minimum, certain close | Minimum, 70% close |
|---|---|---|---|---|
| 6, fast non-judicial | 11 | 90,782 | 110,053 | 112,609 |
| 12, base case | 17 | 80,229 | 98,123 | 100,456 |
| 24, slow judicial | 29 | 61,751 | 77,234 | 79,176 |
| REO discount | Foreclosure PV | Minimum price |
|---|---|---|
| 0% | 88,893 | 110,434 |
| 8% | 80,229 | 100,456 |
| 15% | 72,647 | 91,725 |
The timeline matters most: in a slow judicial state the investor should approve anything above $79,176, barely half the value of the house, which is why the bid on a judicial note, covered in what a judicial foreclosure takes off the price, is so much lower. Certainty matters less than it looks: the minimum moves from $98,123 with a sure close to $99,083 at 85 per cent, $100,456 at 70 per cent and $103,566 at 50 per cent, because a failed short sale only delays the foreclosure by three months.
Build both routes month by month, discount them at the return the note was bought to earn, and solve for the price at which approving is worth as much as foreclosing. Here that is $100,456 against a $118,000 offer. The same discipline prices cash for keys once the house is yours, and the foreclosure floor behind it is laid out month by month in the free workbooks for The Mortgage Note Investor.
Often yes, because the alternative is foreclosure, not a sale at full value. In the illustrative case a $118,000 offer is 78.7 per cent of a $150,000 value, yet it is worth $97,812 today against $80,229 for foreclosure, which pays only in month 17 after legal fees, repairs, carrying costs and an 8 per cent REO discount.
The first lien holder, out of the proceeds, because the junior lien must release for the buyer to get clean title and it has nothing to gain from foreclosure. Junior lien holders often ask for a few thousand dollars; here $3,000 to the second lien and $2,500 of relocation to the borrower come out of the $118,000, leaving $103,650 net after commission and closing costs.
It delays foreclosure by the months spent waiting. In the illustrative case a failed sale after three months cuts the foreclosure route from $80,229 to $75,413. That raises the minimum acceptable price only modestly, from $98,123 with a certain close to $100,456 at a 70 per cent chance and $103,566 at 50 per cent.
This article is one calculation from The Mortgage Note Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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