Be Careful with Real Estate ContingenciesMarch 7, 2014
Most people fall into one of two categories when dealing with real estate contingencies. Some believe that every offer should include contingencies to give the buyer the right to back out of a contract under various circumstances. Others believe that all offers have to be non-contingent in order to be accepted. Both of these views are too broad in application and scope.
A well-constructed offer will only include those protections that are important to the particular buyer under the circumstances of that particular transaction. Keep in mind, there is no requirement for the buyer to stick with the broad language in the standard form contracts used in the area. For example, if a buyer is only concerned that they will be able to remove an unwanted pool for less than $15,000 and add 300 square feet of living space on the east side of the home, then they can make their offer contingent upon only those items. Thus, this more narrowly drafted contingency will provide the specific protection that the buyer seeks while eliminating the subjective elements of the standard language that may relegate the offer unacceptable to the seller.
Allocation of risk
As a general rule, it is most effective to allocate risk to the party in possession of the most information. Buyers typically know if they are likely to get approved for financing while sellers have to take a lot more on faith. A buyer that has a large down payment, long and stable income history, strong credit score and low debt to income ratio may feel confident that they are going to get approved for a loan after a candid discussion with their bank. However, a seller that receives multiple offers is likely to assume that any buyer that includes a financing contingency is worried about some flaw with their credit. The buyer has more access to information so they can better assess the risk. If, on the other hand, the buyer’s only concern is that the home will not appraise, then they should so limit their contingency.
Types of Contingencies
Property Inspection Contingency—this is generally considered to be the broadest of the contingencies included within the standard contract used by most realtors in and around Palo Alto because it includes a high level of subjectivity and ambiguity. Paragraph 14.A. of the PRDS Real Estate Purchase Contract provides that the buyer has the right to cancel a contract based on their evaluation of the “factors and circumstances related to the Property” and “all physical and non-physical aspects of the Property and any other matter, on- or off-site, that materially affects the value and/or desirability of the Property…” This is very broad. Hence, a buyer that includes such a contingency may be at a considerable disadvantage when facing another offer that does not include this broad language because the contingency gives the buyer almost unfettered discretion to back out if there is anything not to their liking.
On the other hand, a thorough review of disclosure information and inspection reports may uncover significant issues that deserve further investigation. It would be foolhardy to move forward with a non-contingent offer under these circumstances unless the buyer was planning to extensively remodel or rebuild.
Financing Contingency—the financing contingency is considerably more narrow in that it only applies if the buyer makes a timely application and a good faith effort to obtain financing. Occasionally, poorly advised buyers believe that they can submit an offer with a financing contingency and back out of the deal if they change their mind or if they determine that the home’s physical characteristics don’t suit their needs. Many don’t realize that their deposit is at risk under these facts just as if they had no contingency at all.
Appraisal Contingency—the appraisal contingency is also a very narrow contingency, but it may be important to a qualified buyer who is worried about over paying for a home or someone that is only putting down 20 percent.
Sale of the Buyer’s Home Contingency—from the seller’s perspective, it is very difficult to accept an offer that is contingent upon the sale of another home because the seller has very little insight into the value of the buyer’s home and the buyer’s willingness to accept a reasonable offer. Generally, a buyer that is convinced that a home will sell would be better served by putting in an offer without the contingency but with a longer close of escrow. This would shift the risk that the buyer’s home won’t sell to the buyer, the person that has access to the pertinent information and control over acceptance. Plus, the buyer is demonstrating confidence by putting their own money on the line.
Too often, contingencies are addressed generically and with too little application to the particular facts at hand. There is no universally right answer and a potential buyer should discuss all of the contingencies with their realtor or a residential real estate attorney.