How Do You Buy A Short Sale

Want to know about a great new investment opportunity? Real estate investments... or more accurately, real estate investment property you can acquire in a short sale purchase.

The combination of short sale purchase discounts, a strong rental market in many areas, and historically low mortgage interest rates mean that investments in short sale properties can, in some cases, provide generous annual returns on investment.

Predictably, though, determining which areas and which properties will produce high returns requires investors to think more carefully than in the past. In particular, investors looking at short sale properties need to calculate accurate cap rates, work from realistic appreciation forecasts, and carefully measure the risks and rewards of using financial leverage to gear up property returns.

Measuring Short Sale Capitalization Rates

One of the first things you need to understand if you start looking at short sale investment properties is this: in some areas, small short sale properties, including single family detached residences, are providing solid capitalization rates of four and even five percent.

If a $100,000 single family detached home or condo will (after subtracting expenses from rental income) generate $4500 a year in income, for example, that's a four-and-a-half percent capitalization rate. And at that cap rate, you may be able to generate amazing annual returns once you factor in the appreciation and leverage.

Developing Short Sale Appreciation Estimates

Obviously, no one, given the recent past wants to get too optimistic about property appreciation. But short sale properties may almost be destined to appreciate for a simple reason: The large short sale discount that buyers are receiving in many markets.

One hears different numbers from local brokers, appraisers and nationally known industry experts, but not uncommonly one gets good evidence of a twenty percent discount.

In other words, while the home on one side of the street might sell for $125,000 in a traditional sale, the same home just across the street may sell for $100,000 if that transaction is a short sale.

A large short sale discount probably means investors can more confidently forecast appreciation in the value—if only because the next sale of the property won't be a short sale. If one buys at a twenty percent short sale discount but then sells at no discount, that's sort of like two percent appreciation over ten years.

Factoring In Financial Leverage

The strong cap rates and the prospect of modest appreciation look even better if you calculate the effect of financial leverage using, for example, a four percent mortgage interest rate.

Say you do have a house you can buy for $100,000 and that the house generates 4.5% in operating income and will also appreciate by 2% a year. The property rate of return in this case is 6.5%--which is respectable in this economy.

However, if you assume you use an $80,000 mortgage costing 4%, you get an annual leveraged profit (due to both operating income and appreciation) equal to $3300 in the first year. I calculate this number by multiplying $100,000 by 6.5% to get $6,500 in first year profit, multiplying 4% by $80,000 to get the first year's mortgage interest expense, and then subtracting the $3,200 of mortgage interest from the $6,500 of operating income.

If you earn $3,300 on a $20,000 investment (the actual cash down payment you put into the deal), you're receiving a 16% annual return that first year. Wow.

Note: To calculate the average annual rate of return using an example like that described here over a number of years, you need a spreadsheet like Microsoft Excel. If you do use a spreadsheet to calculate the average rate of return over ten years, the return probably runs closer to 14%.


------

Seattle CPA Stephen L. Nelson adapted this short article from his how do you buy a short sale website. That website provides additional instructions and information on calculating short sale rental property investment returns.