In this buyer’s market, many homebuyers ask themselves: Will purchasing a short sale or foreclosure end in disaster, or yield a great return? And which type is best to pursue – a short sale or foreclosure?

There is no right or wrong answer as it all depends on the buyer and what the buyer’s priorities are. Regardless, homebuyers should know the benefits and drawbacks of buying either type of “distressed” property: foreclosures, REO and short sales.

REO vs. Foreclosure?

“REO” is short for Real Estate Owned. These are properties which have been foreclosed upon and are now possessed by the bank or mortgage company. It is not real estate up for foreclosure auction.

If you buy a property during a foreclosure sale at auction, you must pay at least the loan balance plus any interest and other fees accumulated during the foreclosure process. You must also be willing to pay with cash in hand. And on top of all that, you’ll accept the property totally as is. That may involve all prevailing liens and even current tenants that need to be evicted.  

Are you sold on the idea of buying a foreclosure? Not so fast. Proceed with caution because there’s potentially a cost to that low price: a damaged house.

As a buyer, you could encounter scarred walls, carpets or appliances that were damaged or removed by the former owner. Sometimes, time and neglect are the culprits. Turned-off utilities coupled with the house sitting empty for months can do a good share of harm.

But in some foreclosures, the condition of the home may be the least of your worries. If you buy a foreclosure at auction sans research, you won’t get to take a peek to see if the plumbing works, if the walls are cracked — or if there’s an outstanding lien against the property. You’ll be responsible for these cosmetic and legal issues, so many investors research the property’s history before the auction. Usually, savvy investors take on these types of sales.

A bank-owned property, by contrast, is a much cleaner and attractive deal. The REO property was unable to find a buyer during foreclosure auction. Now the bank owns it. The bank will see to the removal of tax liens, evict occupants if needed and generally plan for the issuance of a title insurance policy to the buyer at closing.

Note that REOs may be exempt from standard disclosure requirements. For instance, in Texas, banks are not required to give a Seller Disclosure Statement to tell you about any defects of which they are aware.

Benefits of a Short Sale

Looking for a foreclosure-home price but in better condition? Sift through short sales in your local market. A short sale is still owned by the homeowner, who owes more on the mortgage than the home is worth.

A short sale can be a better deal than buying a foreclosure because the home is generally in better condition because it’s been occupied. The utilities have been maintained and usually the lawn is maintained as well.

However, the name “short sale” can be deceiving and often take a notoriously long time to close. Enter the federal Home Affordable Foreclosure Alternatives program, or HAFA, which helps the buyer and seller by speeding up the short sale process. It’s not perfect by any means but it has created a timeline that can hold the mortgage lenders accountable and it can speed up the closing process.

Some sellers assume they can start the short sale process on a whim. It is not a ‘get out of jail free’ card, and a homeowner has to qualify for a short sale. After the seller is approved, the first question a buyer should ask is whether there are two mortgages on the house.

If there is a second lien holder on the short sale, the transaction can get ugly for a seller as every entity that has a financial stake in the house has to agree to the short sale. If the sale price of the home won’t pay off the second mortgage, that second lien holder may not get paid and can block the sale.

In the meantime, the buyer is stuck waiting for the answer. Know when it is time to move on to another property.

Are these distressed properties a good deal?

Nothing in real estate is a sure thing, but you can bet on getting a good deal if you know what you’re looking for in a home. If your family needs a house within one or two months, a foreclosure or REO may be a good option, unless the seller is qualified in the HAFA program. If you have more time to work with, short sales could be within your realm of possibility.

Know your tolerance for defects and whether you have the time and money to fix up a house before buying a distressed home. If the choice is right, you could help a homeowner stave off a foreclosure if you buy a short sale, or you could help alleviate the nation’s glut of bank-owned properties.

You can snag a great deal with either a short sale or a well-maintained foreclosed home, but one requirement remains: You must work with a good real estate agent.

When considering the value of any home, you need to look closely at comparable sales in the neighborhood and be sure to take into account the time and cost of any repairs or remodeling needed to prepare the house for resale