Table of Contents
Multiple Offers and Escalator Clauses in Short Sales
Understanding the Short Sale Market
In the last few years, short sales have become a growth industry. At the end of 2008 and especially in early Spring 2009, the federal government moved to make the market for toxic real estate assets more liquid through policy changes, asset purchase programs and capital infusion. Toxic assets are assets that are worth less than what has been invested in them. If a market contains too many toxic assets, the assets become hard to sell, even at a loss. Such assets are then said to be "illiquid." Time on market is a measure of liquidity in the residential real estate market.
Short sales are a mechanism for marketing toxic assets in an illiquid market. Normally, and this was certainly the case when the residential housing market first turned sour, there is little incentive for lenders to participate in short sales. Unless a short sale will result in significantly less loss to the lender than foreclosing on the property, the lender has no incentive to discount their loan. Short sales, therefore, are traditionally about convincing the lender that taking the short sale deal will actually make them money. See the Do the Numbers section of this subject.
In economic terms, the government's intervention in the distressed property market created a market entry opportunity. In a sense, this new distressed property entry opportunity is an echo of the residential real estate market entry opportunity created by the easy credit that caused the real estate market bubble in the first place. Indeed, many of the same mortgage brokers, property flippers and real estate speculators who drove the real estate bubble are back as foreclosure consultants and equity purchasers. Basically, the government is using its money and influence to encourage sales at well below what would otherwise be the market price in order to increase liquidity and, therefore, clear the market of distressed properties.
Encouraging sales at below market price does two things. First, it increases market activity, particularly market activity in distressed property. Today distressed properties in the guise of short sales and REOs make up about 20% of real estate listings in the average market but account for more than half of all sales. Secondly, encouraging below market sales creates a new market bubble. The distressed property bubble is intended to stop the deflation created by the end of the original bubble. In many markets it is generating the same kind of frenzied activity as was seen market-wide at the height of the original bubble.
return to top
Dealing with Short Sales in the New Short Sale Market
How long the distressed property market will last is hard to say. It is clearly a market aberration and, therefore, one would not expect it to last very long. While it does last, real estate agents who deal with distressed property will have to adjust. Paradoxically, that means adjusting to a hot market in the worse real estate market in memory. Hot markets are driven by investors hoping to buy low and sell high. Ordinary homebuyers may also be attracted to the market. That means, as it did at the height of the bubble, more people chasing the same properties. That in turn, as during the original bubble, means dealing with escalator clauses, multiple offers, frenzied buyers and sharp business practices.
Multiple offers, including agency and license law implications of being involved in multiple offers, are covered in the Multiple Offers section of Writing the Deal. The mechanics of dealing with multiple offers in the short sale context are, however, very different. To understand why that is the case, one must focus on the dual contract nature of a short sale. Although rarely appreciated by agents, a short sale actually involves two agreements that is, two contracts. The first is a standard purchase and sale agreement between seller and buyer. The second is a loan satisfaction agreement between the seller and the seller's lender(s).
What the industry calls a "short sale addendum" is really just a real property contract contingency. It is no different in that respect than a 72-hour contingency or other contingency that must be satisfied before a party is obligated to perform the contract. The industry has dealt with buyer-side contingencies for years. What is different about a short sale is that the contingency conditions the seller's obligation to sell, not the buyer's obligation to purchase. In a short sale, the seller's obligation to transfer title is contingent on the seller obtaining their creditor's consent to lower the payoff on the seller's mortgage or note so the seller can deliver clear title. To do that, the seller must reach an agreement with their lender(s) about satisfaction of the debt the seller owes the lender.
It is common in the industry to think of the interaction between seller and lender as one of the lender "approving" of the sale, but that is not what is going on. The lender is not a party to the sale and their approval of the sale itself will have no affect whatever on the seller's obligation to the lender under the mortgage or note. What the lender is approving is not the sale, but a modification to their mortgage or note. The fact that lenders will almost always demand changes in the underlying sale agreement as a condition to agreeing to modify their mortgage or note does not make the lender a party to the sale itself.
It is important to understand the two agreements nature of short sales before trying to understand the impact of multiple offers in short sale situations. The first impact of having two agreements is that because the lender will consent to only one deal, the short sale addendum itself effectively works as a backup offer contingency would in an ordinary real estate transaction. The short sale addendum by itself protects the seller from becoming obligated to transfer title in more than one deal. That means the seller can accept as many offers as they like as long as each uses a short sale addendum that makes the seller's obligation to sell contingent on the seller and lender reaching an agreement on the mortgage or note.
In short sales, there is no need to have offers in backup position as is done in ordinary sales. Every offer is in backup position, regardless of the order accepted, because the seller's obligation to convey title is contingent in every offer. The impact of this simple truth is spelled out in paragraph #5 of the short sale addendum most used in Oregon where the buyer is warned that the listing will remain "active" and the seller will continue to consider and submit to the lender(s) competing offers. This warning in the short sale addendum is a multiple offer warning.
return to top
Handling Multiple Offers in Short Sales
In an ordinary multiple offer situation, the seller alone has control of the situation and can make up their own mind about the wisdom of pursuing better offers. In a short sale situation, however, the seller is also negotiating with the lender over modification of the mortgage or note. The seller, depending on the exact situation, may or may not be liable for any deficiency should the lender end up foreclosing. See the Foreclosure section of this topic for an explanation of deficiency judgments under Oregon foreclosure statutes. The seller may or may not suffer tax consequences based on the amount of debt forgiven. The size of the deficiency can also affect the seller's credit rating. All of this suggests the lender's and seller's interests in obtaining the best possible offer coincide and sellers should accept and forward for consideration better offers if they are made. Paragraph #5 of the short sale addendum reflects this conventional view of short sales.
The problem is that in real life the interests of the lender, the seller and multiple buyers can, and do, conflict in ways that make deciding what to do about subsequent offers in a short sale situation very difficult. This difficulty can make it very hard for an agent to serve their client's interests and avoid risk. Take, for example, something as simple as an escalator clause in a short sale.
return to top
Escalator Clauses in Short Sales
Buyers will sometimes include in their offer a clause in which they agree to pay a sum (typically a thousand dollars or so) "over any other buyer's offer." Escalator clauses appeared at the height of the real estate bubble and are now reappearing in the short sale market. Escalator clauses were then, and are again now, a buyer gimmick designed to trick the seller into leaving money on the table. What the buyer with the clause hopes is that they will get the property without having to bid against other informed buyers.
Escalator clauses work only if the competing buyers do not know of the clause. Keeping the existence of an escalator clause a secret from other buyers means risking leaving money on the table because there is no way to know if one of the other buyers might have paid even more for the property than was paid under the escalator. In a short sale situation, leaving money on the table means the seller risking a larger deficiency, tax burden, or credit hit than would otherwise be the case.
As was the case during the earlier bubble, an escalator clause signals a buyer who is trying to purchase at less than their best offer price. Sometimes, escalator clause buyers will actually tell the seller what the buyer's best offer price really is by placing a limit price on the escalator. A rational seller will always seek each buyer's best offer. It follows that an offer with an escalator clause should always be rejected and the buyer asked to make their last best offer.
If there are multiple offers pending at the time the offer with the escalator is made, each offer can be rejected and each buyer informed there are multiple offers and they should make their last best offer by such and such a date. The best offer is then accepted and forwarded to the lender. If the escalator comes after another offer has already been accepted and forwarded to the lender, simply reject it and ask for the buyer's last best offer. If the buyer is just fishing for a fool, they will go away. If not, they will make their best offer. Either way, the situation is resolved without bringing in the complication of an offer with an escalator clause into an already complicated situation.
return to top
Understanding Multiple Offers in Short Sales
The idea of getting to the last best offer applies equally to all offers in short sale situations, not just those with escalator clauses. The big question in short sales is how much "better" does an offer need to be before it should be accepted by the seller and forwarded to the lender. Notice first, there are two steps: (1) accepted by the seller and (2) forwarded to the lender. If an offer is not accepted by the seller, there is nothing to forward to the lender. This is where the two-contract nature of short sales becomes important.
Short sales, we have already said, are about sellers reaching agreements with lenders about mortgages or notes. To get that agreement (the seller/lender agreement), the seller needs to show the lender a particular offer the seller has accepted and negotiate with the lender based on that accepted offer. There is nothing that says a seller must accept and forward every offer they receive. The seller does not lose control of their property just because they are seeking an accommodation on their mortgage or note. What happens instead when a seller seeks an accommodation agreement from a lender is that the seller takes on the duties of honesty, good faith and fair dealing with respect to the accommodation agreement. The intentional lack of honesty is called fraud.
Fraud is about deceit. It is about the intentional concealment of material fact. The material fact we are talking about in a short sale is the fact of another offer. That fact is material to the lender because the seller is asking the lender to reduce the payoff on the mortgage or note based on the price of an accepted offer. If I negotiate for the lender to take a $50,000 loss by hiding the existence of an offer that would substantially reduce their loss, I am not being honest, dealing fairly or performing the mortgage reduction agreement in good faith once I get it. Stated plainly, once a seller asks the lender to take a loss based on a specific offer, they cannot simply ignore subsequent better offers.
That the seller cannot ignore subsequent better offers does not mean they have to continue to market the property or take all subsequent offers. They may very well want to do those things, but we are talking about whether they have to do them. The seller's obligation is honesty, good faith and fair dealing. Good faith, and fair dealing are, setting aside for the moment intent, basically the same thing as honesty. The simplest way to be honest is to make full timely disclosures of material facts.
In real estate, disclosures are often thought of as forms to be signed. Disclosure is actually just the act of imparting what is secret or not fully understood. The legal definition, when it comes to contracts and agreements, is: "obligation of parties to reveal fact which is material if its revelation is necessary because of the position of the parties to each other." As soon as the seller starts negotiating with the lender to reduce the payoff on their note, a subsequent better offer becomes material because of the position of the parties to each other. Other than as the triggering event for the lender/seller negotiations on the mortgage or note, the underlying sale agreement has nothing to do with it.
return to top
Developing Practices for Dealing with Multiple Offers
Now that we understand that subsequent offers in short sale situations are material facts in the negotiation between seller and lender, we can develop practices and strategies to meet the resulting obligation of honesty, good faith and fair dealing. Timely disclosure, we know is the key to meeting these obligations. That being the case, the time to resolve the subsequent offer dilemma is when negotiation is opened with the lender on the first accepted short sale offer. What are needed are sound business practices that anticipate and handle subsequent offers in short sales before the offers are made. In short, practices that get the seller and agents in front of the situation by anticipating the situation.
There are only a handful of possible ways in which subsequent offers can be handled in short sales. One is to not market and not accept subsequent offers. Another is to accept subsequent offers in a "backup" position and send them to the lender sequentially as the lender rejects them. Another way is to request offers for a specific period of time, then close the offer period, stop marketing and send the best offer to the lender. Another is to accept all offers on a short sale contingency and send them all to the lender. Yet another is to send only offers better than previous offers by a set amount and then only until a certain cutoff date. Which among these alternatives is best depends on the circumstances.
There may be situations where the size of the deficiency doesn't concern the seller or where there simply isn't time to mess with subsequent offers. In such cases, the agent would submit the first offer with a cover letter or email (or phone conversation with a follow-up letter or email) that says due to the circumstances the seller will not market or seek subsequent offers. If the lender says nothing, they have agreed to that approach. If they do say something, the seller can negotiate with the lender to resolve the issue. That may involve postponing a foreclosure, taking only backup offers or whatever is necessary. Meanwhile, the accepted offer is in the works and the seller's and agent's duty of honesty, good faith and fair dealing has been met by communicating their intent to the lender.
Communicating intent to the lender is the key to meeting the duties of honesty, good faith and fair dealing. For instance, another way to handle the multiple offer potential would be to advertise (MLS comments are advertisements) that the seller will entertain all offers for a specified time (three weeks, a month, six weeks, whatever) and then accept and forward the best offer to the lender. Buyers would then make offers with an expiration date longer than the specified period. A buyer could, of course, revoke their offer at any time prior to the seller's acceptance at the end of the period, but so what? To make this work, all that is necessary is to work out the details with the seller and inform the lender of how the seller intends to proceed. Silence is again agreement for honesty, good faith and fair dealing purposes. If the lender objects, the seller and the lender can work out the lender's problems.
If the situation is such that the seller intends to continue marketing and accepting better offers to forward to the lender, then the thing to do right at the beginning is to establish some criteria with the lender regarding subsequent offers. That can be done with a cover letter that accompanies submission of the first accepted offer. In the letter, the seller can tell the lender they will continue to market for a specific period of time and accept and forward better offers. This lets the seller decide how long he wants to continue looking for a better offer and to define "better."
How long the seller wants to seek better offers depends on the situation. Certainly, the foreclosure date is going to be a factor. There may be other considerations for the seller based on lender plans. Since all that is happening here is that the seller is covering his honesty, good faith and fair dealing obligation, setting a marketing time or criteria for determining a better offer is just informational. The same is true of defining what will be considered a better offer. The idea, again, is to communicate to the lender the seller's idea of what is reasonable in the circumstances. If nothing is said by the lender, the assumption is that whatever the seller decided is considered reasonable. If something is said by the lender, the matter is negotiated and resolved.
There is a final scenario that should be mentioned while we are talking about communication and resolving matters by negotiation. There is a movement in some areas of the country to have sellers accept subsequent offers in short sales in what is termed "backup position." This means the seller will accept, but not forward to the lender, any subsequent offers in short sales by having buyers agree to a backup position before the seller will accept an offer. This approach confuses the sale agreement with the lender/seller agreement and raises a couple of serious issues.
The first issue arising when sellers take backup offers in short sale situations is whether the backup offer is better in the sense of reducing the lender's potential loss. If it is for a higher offer, accepting it as backup and not forwarding it raises the same honesty, good faith and fair dealing problem as simply rejecting the offer. As far as the lender is concerned, an offer not forwarded is an offer that is hidden. As we have already discussed, hiding better offers while negotiating with a lender to reduce the payoff on a loan raises very serious liability problems. Calling the hidden offer a backup offer doesn't change anything with respect to the relationship between the lender and the seller.
To use the backup offer approach safely when a subsequent offer has the potential to reduce the lender's loss, the seller would need the lender's approval to treat subsequent offers as backups. That can be done by communicating in a cover letter to the lender, with the first accepted offer just like with other processes, the intent to take backup offers. Don't be too surprised if the lender disagrees on this one. We are talking here about subsequent offers that are better in the sense of reducing the lender's potential loss. In reality, a seller would be free, without any further communications with the lender, to accept in backup position an offer for less money than the one already forwarded to the lender.
The key to a successful short sale lies in understanding that in negotiations with a lender over how much money the lender is willing to forgive, the seller cannot hide from the lender other offers that have the potential of reducing the lender's loss. The way to deal with that obligation is to tell the lender what you are going to do with subsequent offers when you submit the first one. If the lender doesn't object to the plan, the seller has met his obligation of honesty, good faith and fair dealing. If the lender does object, the seller negotiates a process the lender will agree to. That way, you never get into a situation where the seller is hiding material information from the lender.
return to top