Hello Jessica and thanks for your question.
Unless you are the only one making an offer on an REO or short-sale home, the lender is likely to choose the "strongest" offer, rather than the highest offer. Unlike a homeowner/seller who is likely to concentrate more on the "bottom line" (their money after expenses) in evaluating an offer, a bank will be looking at who will exhibits the greatest ability to close escrow and can do so in the least amount of time. So in terms of strength, from strongest to weakest for example, if the bank were to look at several offers, they would choose:
1. Highest Price
2. Highest Down Payment or All Cash
2A. Buyers want money back or concessions?
3. Fastest Close Date or Best Chance to Close Escrow
4. Type of Loan, Amount of Loan
5. FICO scores
Although your offer was rated high in the price category, with only 3.5 percent down payment, it made the likelihood of closing poor especially with an FHA Loan where the seller servicer conditions can be more strenuous than for other conventional loans. If another buyer proposed to purchase the home with all cash, even if the price were lower, the other conditions--highest down, fastest close, no loan--made that offer a much stronger, more desirable offer.
Although I understand your disappointment, there are definitely other homes out there for you to review. In the future, however, if you wish to purchase an REO home, remember to make your offer the "strongest" in the bunch.
Good luck and happy house hunting!
Grace Morioka, SRES, e-Pro
Area Pro Realty
San Jose, CA