As you are no doubt aware, today's real estate landscape is filled with a large number of properties sitting on the market waiting to be sold. The result of this glut of unsold homes has led to an increase of inventory and a decrease in real estate market prices.
If you have purchased a property within the past decade, you may be one of the army of homeowners that got caught in the real estate perfect storm: liberal lending practices coupled with inflated real estate prices, and the resulting crash that has led to a record number of Short Sales and REO's.
The Storm is Rising: the Federal Reserve continuously dropped the discount rate in hopes of spurning a sluggish economy following the dot com collapse and the 9/11 tragedy. For consumers, this significantly reduced the cost of borrowing money and as a result, the demand for goods sky-rocketed. Meanwhile, as real estate values climbed, service lenders and large institutional mortgage investors like Fannie Mae began to relax their lending policies.
While it is easy to look back and assign blame on either the lending industry or the borrower for today's financial mess, the short term results of the policies seemed beneficial for everyone: the economy bounced back, lenders were making loans, mortgage investors were making money, agents were selling houses, property sellers made huge gains, and home buyers were purchasing more house than they would otherwise be able to afford. There certainly wasn't any finger pointing at the time - perhaps we were too busy counting all of our money...
As the price of housing rose, the number of qualified buyers able to purchase these properties decreased. Lending guidelines soon shifted causing an increase in the pool of available buyers. Typical lending standards such as work history, proof of income, down payment, and good credit scores soon gave way to an environment where one could obtain a loan with very little documentation, not much by way of a down payment, and much less than terrific credit scores.
While the borrower's qualifications for purchase may have been questionable, so were the types of loans these lenders were selling: interest only and the adjustable rate mortgage being the main culprits. The adjustable rate mortgage (ARM) was designed to start at a low fixed rate in the beginning of the loan - allowing one to qualify - and then adjust upward. The plan for the borrower was to refinance out of the ARM into a standard 30 year fixed rate loan before the ARM adjusted.
This works well in theory as long as the real estate market continues to climb in value. But when market prices began to stabilize...trouble.
Given the relatively short period of time in which the ARM would adjust, the principle on this type of loan did not decrease much, if at all in the case of an interest-only loan. Once real estate prices began to sag, refinancing the property was no longer an option because the necessary level of equity needed to refinance was now unattainable.
And here we are...
That was a quick recount of how we find ourselves in today's current distressed real estate environment. Before moving forward, let's get a definition of the two terms mentioned above because we will see them quite often for the next few years: a short sale occurs when the homeowner owes more on the mortgage obligation than the property will sell for and the lender agrees to allow the property to sell short of the seller's entire obligation in lieu of foreclosure. An REO, or "real estate owned," is an accounting term used by the lending industry when a property is foreclosed and repossessed by the bank. Once the home owner stops paying the mortgage, what was once an asset for the lender, is now a liability.
For quick reference, you can always distinguish the two terms this way: the seller still owns the property on a short sale (although the lender has final approval on sale), while the lender owns the property outright when it becomes an REO.
In our next article we'll look at some ways in which a seller caught in a short sale or on the verge of foreclosure may be able to find themselves an acceptable resolution to their real estate issue.

Author's Bio: 

Kevin Sullivan is an active real estate investor and owner of Maplegate Realty.
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