Commercial property investments don’t always go according to plan. Perhaps the business didn’t go as well as one might have hoped, or there was a drop in market value of the property due to the economic climate at the time.
Whatever the reason, a property could at some point be at risk of a commercial foreclosure. One way out of this sticky situation is through a short sale. But what is a short sale in commercial real estate?
What Is a Short Sale in Commercial Real Estate?
A short sale in commercial real estate occurs when a borrower sells their property “at a price below the amount outstanding on an existing mortgage,” said Mike Broemmel for SFGate.
Typically, this situation occurs when a property owner is at risk of foreclosure, and the market value of the property is lower than what the borrower owes on the mortgage. In this case, the lender, usually a bank, can allow the borrower to sell the property for an amount less than the debt owed. If there are any other lenders or lien holders on the mortgage, they need to consent to the sale as well.
How to Perform a Short Sale of a Commercial Property in 5 Steps
There are a few different steps involved in first getting permission for a short sale, and then moving forward with the sale. For starters, knowing when to begin the short sale process is important.
According to Brandon Polakoff, Executive Director at Avison Young, the time to pursue a short sale is during pre-foreclosure. This period occurs, he said, when a borrower is “behind on payments, but the lender hasn’t filed the notice of default.”
From there, the property owner should take the following steps:
1. Get Permission From the Bank and Lien Holders
The first thing a borrower needs to do is get short sale approval. A bank won’t agree to a short sale unless the borrower shows they don’t have enough income or assets to pay the loan, according to Property Metrics.
To get approval for the sale, it’s a good idea to contact a broker, attorney or real estate agent to prepare the terms of the sale for you and prove you don’t have sufficient income to cover the loan repayment.
2. Wait For Lender Review
After the borrower seeks permission for a short sale from the bank, the bank and any other lien holders must then review the short sale proposal and get back to the borrower with a final decision. Banks generally don’t like short sales, but often they have little to no other options for getting their money back.
Property Metrics warns that sometimes lenders might ignore the request, they might reject the request outright, or they might return with a counteroffer. In these instances, borrowers might be able to negotiate with the lender or change the short sale terms so that the bank agrees. It’s always good to consult with a brokerage, real estate agent or lawyer to help with negotiations.
3. Place Your Property on the Real Estate Market
If the borrower and lender(s) come to an agreement, borrowers are then free to move forward with the sale of the property. Place the property on the market and work with a commercial realtor to cover your bases.
4. Enter a Commercial Real Estate Sales Contract with Your Buyer
Once you’ve attracted potential buyers, work with your broker to select the best offer. The buyers’ offer has to be more than the baseline amount you established with your mortgage lender.
At this point, you want to choose and include a closing date in your sales contract. Your closing date is the date when the deal is done and ownership is transferred to the buyer.
5. Transfer Ownership to the Buyer
At the closing, you’ll sign the deed that conveys ownership to the buyer in front of an attorney and/or notary. Your mortgage lender or a title company will likely prepare the deed for the buyer.
The buyer now owns the property. Proceeds from the sale go to your mortgage lender, and you are finally off the hook for this commercial property.
Advantages of CRE Short Sales
While it is never your goal to have to short sell your commercial investment property, short sales can at least get you out of hot water. Here are a few ways they can help you.
For both borrowers and lenders, a short sale is advantageous because it avoids foreclosures. Generally, commercial foreclosures are expensive due to all of the legal fees. They are also difficult to sell as REO properties, as the longer they sit, the more distressed they may become. Polakoff said, “a short sale might represent a loss, but it might cost 12 to 20% less than foreclosure,” for both the borrowers and the lenders.
Less Damage to Credit
While both a short sale and a foreclosure will negatively affect a person’s credit, a foreclosure will have more negative, long-term consequences that could affect a person’s ability to buy property in the future. Generally, according to Polakoff, short sales are less damaging to a person’s credit than a foreclosure or bankruptcy.
Borrower Is Incentivized to Protect the Property
Lenders also prefer short sales because sometimes, in the case of a foreclosure, borrowers will either abandon the property or intentionally damage it in a show of anger against the bank. Borrowers also stop paying property tax in a foreclosure, leaving the bank liable for that cost as well. With a short sale, however, none of these risks happen, as the borrower is trying their best to actually sell the property for the highest possible value. However, there are definitely investors who know how and when to invest in REO properties.
Disadvantages of CRE Short Sales
Credit Is Still Negatively Impacted
Although a short sale is often preferable to a foreclosure, there’s no avoiding the negative impact on a borrower’s credit scores. It’s important to remember that resorting to a short sale negatively affects future financing and property purchases.
It Can Be Hard to Get Many Liens on Board
Short sales require all lien holders to consent, and if a borrower has multiple liens on the property, sometimes, it’s not worth it to pursue the short sale. The more liens that exist, the less likely it is that a short sale will be approved, and the longer the process will take. If a borrower has defaulted on a loan, then they might not always have the time it takes for a short sale to occur. A bank might even foreclose on the property while the short sale negotiations are ongoing.
The IRS Can Tax Income on Forgiven Debt
If there’s any forgiven debt in the short sale, then the IRS can tax that as income.
3 Expert Tips and Best Practices When Considering Commercial Short Sales
If a short sale ends up being the best option for you to avoid foreclosure on your property, there are a few pieces of advice to keep in mind during the process.
1. Be Aware of Your Timeline
It’s always best to start the short sale process before foreclosure is on the table. If your lenders have already started your foreclosure process, then there often isn’t enough time to begin the short sale. Lenders usually want to liquidate properties quickly in the event of payment defaults, so always try to think ahead and be aware of your timeline. That way you can get short sale approval before the bank forecloses on your property.
According to Polakoff, a short sale usually takes about 90 days, but that timeframe can vary depending on the market and the conditions of the sale.
2. Consult a Broker or Advisor
Before beginning the short sale process, make sure to consult a broker or financial advisor who has expertise in short sales. These professionals should be able to adequately determine your current property value with a commercial appraisal. It’s the broker’s job, then, to submit your proposal to the bank so the short sale can be approved.
3. Ask Lenders to Waive Deficiencies
Although this situation is rare, after a short sale, lenders have the right to sue borrowers for any remaining debt owed on the mortgage, or “deficiencies.” However, if you make sure all lenders agree to the sale and waive deficiencies, this lawsuit won’t happen.
A Short Sale Can Be the Best Option to Avoid Foreclosure On a Commercial Real Estate Property
If plans don’t go as well as one would have hoped, a short sale is often the best last resort. Although the short sale will affect your credit, it’s a good way to prevent a bank from foreclosing on your property, thereby avoiding more long-term negative effects.