A Short Sale and Selling Short

June 11, 2008

I had a question the other day about "short sales". It was from a friend who is a fairly sophisticated investor in the stock market. he didn't quite understand how a short sale worked in real estate. He did understand what "selling short" or short sales in the stock market work.

A short sale in the stock market is generally a sale of a stock you do not own. Investors who sell short believe that the price of the stock is going down. When you sell short your brokerage firm loans you the stock. If the price of the stock drops, you can buy it back at a lower price and make a profit. If the price rises, you still must buy it when your borrowed time is up. In that event, you take a loss.

A short sale in real estate is an agreement between a borrower and a lender. If the amount that a homeowner owes on the mortgage is greater than the present value of the property, the homeowner negotiates with the lender and the lender agrees to a reduction in the pay off amount. The transaction is called a short sale.
Real estate short sales seem to require lengthy escrows as there may be more than one lender or investor who must agree to the reduction of the loan amount. As this declining real estate market unwinds, lenders are setting up loss mitigation departments. Short sales can be a useful tool for both the borrower and the lender to cut their losses. However, unlike stock market short sales, short sales are not a strategy for profit making. They are a strategy for cutting losses.