- Contract contingencies may allow the buyer or the seller to cancel a contract
- Contingencies for selling an existing home can create a domino effect
- Buyers can shorten contingency time periods to make offers more attractive
- There are several options for reducing contingency concerns
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Selling your home has plenty of stress, but contingent purchase offers can bring additional stress. Buyers worry about not being able to back out if something goes wrong. Sellers worry about buyers backing out of purchases. According to a recent survey by Zillow, 52% of sellers worry about the sale of their home falling apart. Managing contingencies is a big part of having a smooth transaction.
In this article, we look at the various types of contingencies, and how sellers and buyers can navigate around them.
What are contingent home offers?
A contingent home offer is simply an offer to either buy or sell a home with an additional condition. These conditions, if not met allow the buyer or the seller to cancel their contract.
The majority of home purchase contracts have some condition for the sale to be completed. Contingent offers are so common, that boilerplate Realtor® contracts have several contingency clauses built in to them. For example, in California, the standard Realtors® contract includes contingencies for home inspection, appraisal, financing and the sale of the buyer’s existing home.
What problems do contingent offers create for sellers and buyers?
Contingencies allow buyers, and sometimes sellers, to cancel a contract without penalty.
When a seller accepts a contract with buyer contingencies, the seller is usually required to stop marketing their home for sale. They are unable to accept any other offers, other than for backup purposes. In the event the buyer backs out of the contract, the seller has lost valuable marketing time or even better offers.
The more contingencies an offer allows, the more opportunities one party or another can cancel the agreement.
Common purchase contingencies
As previously mentioned, a home inspection contingency is one of four standard contingencies in your Realtor® provided contracts. Most buyers spend less than 30 minutes in your home. While they’re all starry eyed over the kitchen, they’ may be blind to problems beneath the surface. They miss things like foundation cracks, electrical problems and termites.
As part of the buyers due diligence, their agent will typically order a home inspection. Professional home inspections allow buyers to be aware of potential problems in the home. These home inspections are extremely important. In fact, most agents won’t let their buyers purchase a home without obtaining a professional home inspection. They also protect agents from lawsuits from their clients.
The typical home inspection involves the inspector testing the home’s various systems. These include the HVAC, hot and cold water, electrical as well as reviewing basic structural components.
The inspector then provides a report back with their observations and recommendations. Sometimes the problems found are minimal, such as a missing electrical cover plate. Other times they’re significant such as a aging HVAC system.
Once the home inspection is completed, the buyer has the opportunity to continue with the purchase, request specific repairs or to cancel the purchase contract.
Most home buyers require financing unless they are cash offers. Typically, cash offers come from investors or move up buyers with substantial savings.
Purchase contracts that require financing will usually have a financing contingency. This allows the buyer to back out of the purchase if the buyer is unable to obtain financing. Additionally, they may stipulate the maximum interest rate the buyer is willing to pay for the loan.
If you are considering accepting a financed offer, look for the buyer’s “pre-approval” letter with their offer. A pre-approval letter is written by their lender stating the buyer has been approved up to a specific purchase price. You should also ask if the buyer has gone through “desktop under writing”. Desktop under writing means the lender has reviewed the buyers’ documents even more thoroughly. The more thorough your buyer’s pre approval, the less likely financing will be a problem.
Any purchase that is being financed, is likely to also have an appraisal contingency.
The buyer’s lender will order a professional home appraisal to be completed prior to funding the loan. If the property doesn’t appraise for the value required by the lender (typically the purchase price), the lender may not fund the transaction. The alternative is for the seller to agree to a lower sales price or for the buyer to provide additional funds above the appraised value. If they home is priced correctly for the market, and the buyer hasn’t overbid the purchase price significantly, the appraisal shouldn’t be a problem.
Don’t be fooled. Just because someone offers you substantially over market price for your home, doesn’t mean it will appraise for that value.
A few years back we were selling a home and received a purchase offer for 10% above asking price. We knew the home wouldn’t appraise for the buyer’s offer price. Additionally, the buyer didn’t have the funds to cover any difference between the appraised value and their offer price. The agent was simply playing games. They knew that if we accepted their client’s offer, that it would be several weeks into the sales process before there was a problem. Then we would have to renegotiate the sales price due to a low appraisal. The alternative would be to start the marketing process all over. If the buyer had the funds in their bank accounts and been willing to pay the difference that would be different. We might have negotiated that the buyers pay the difference between the appraised value and their purchase offer.
Sale of existing home
While move up buyers offer the advantage of higher down payments and more cash, they often need to sell their existing home prior to completing the purchase of their next home. If your home is in a move up neighborhood, expect this contingency. These buyers will want to be able to sell their existing home and use their equity to purchase your home.
Beware of the Domino Effect
Jeff Lichtenstein of Echo Fine Properties in Florida cautions about what he refers to as the “Domino Effect”. A domino effect occurs when the sale of your buyer’s home, is contingent upon other conditions for the sale of their home.
For instance, what if the offer from your buyer (Ms. Andrews) is contingent upon the sale of Ms Andrew’s? Then what contingencies do the buyers of Ms. Andrews home have in their contract? What if Ms. Andrew’s buyers, the Stewart’s purchase is contingent upon the sale of their home? It only takes the Stewart’s sale to fall apart, for your sale to be potentially impacted.
The domino effect can be carried on through two or three transactions. If you don’t know what contingencies the sale of your buyer’s home has, you are working blind. If you are considering an offer contingent on the sale of another home, have your agent obtain a copy of that contract and any addendums. That way you won’t be guessing as to what might possibly go wrong with your buyer’s sale.
Less common contingencies
A 1031 Exchange is a tax strategy used by investors to swap one investment property for another without incurring capital gains taxes. In a 1031 exchange, your buyer will have an investment property they need to sell. Then they will use the proceeds from that sale to buy your home.
1031 exchanges have strict timelines that must be followed in order to avoid tax implications to the investor. These tax implications should not affect you as a seller, but may impact the timeline for the sale of your home. Your agent should discuss your buyer’s timeline for doing a 1031 exchange before you agree to their purchase offer.
Tenant move out
While most homes are vacant at closing time, some landlords may have difficult tenants to work with. When this happens, buyers and sellers may need to negotiate with who will be responsible for removing the tenant. As of the time of this article, there was a COVID-19 eviction moratorium in affect. This prevented landlords from removing tenants from rental properties if the tenant had been impacted by COVID-19. In this scenario, a seller may have had to accept a lower price for the buyer to take over their tenant.
Buyer physically seeing house
Due to COVID-19, many buyers are moving from the coastal cities to inland locations. As a result, it is not uncommon for potential buyers to write offers sight unseen. These buyers may be fully depending on their Realtors®pictures or a video walk through. Buyers who are purchasing an out of state home will typically stipulate that they are able to see the home prior to sale.
This can add substantial risk of cancellation to the sale of your home. Lichtenstein says he sees about a 50% cancellation rate from out of state buyers. He says, “Things just look different in person. And once the buyer makes a commitment to come down, they take a look at everything else on the market”.
Many areas of California have been impacted by wildfires causing their homeowners insurance to be cancelled. Other states are impacted by hurricanes. For instance, Tiffany Heathman a Realtor® in Houston says, “when a tropical storm is incoming, insurance companies sometimes refuse to start a new policy, and they can force a delay in the sale.”
In some of these areas, affordable homeowners insurance can be difficult to obtain. In parts of California that are deemed to be high wildfire risk, homeowners insurance can be as much as $4,000 a year. You might find your purchase contract has a contingency for the buyer to be able to find affordable homeowners insurance.
Tip: If you live in an area with high insurance costs, you might consider requiring potential buyers to obtain insurance quotes before they present their offer. This way you know that your buyers are aware of the additional insurance costs before you accept their contract.
In some cases, a seller may add contingencies to a sale contract. One common seller contingency is the ability for the seller to buy a replacement home. This is common when the seller want to move to another home, but needs the proceeds from the sale of their current home.
Contingency time frames
Most contingencies have a specific time frame in which they must be removed. For instance, in California, buyers have 17 days to complete their inspections. Financing contingencies typically are 21 days.
While these are standard, time frames can always be negotiated. For instance, in a sellers’ market, sellers may also negotiate for shorter inspection periods. Additionally, buyers wishing to have a more attractive offer may choose to remove their inspection contingency in 7 days.
What can a buyer do to alleviate contingency concerns?
There are two standard ways to alleviate concerns over contingencies.
The first and most common is to shorten the time frames. As previously mentioned, if your standard inspection time frame is 14 days, you can shorten it to 7 days. If you are purchasing with cash, you can shorter or even eliminate the appraisal contingency. You’ll need to work with your agent and any home inspections to make sure your inspections, lenders and other third parties can meet your shortened deadlines.
The second means to alleviate concerns over contingencies is money. You don’t necessarily need to pay more, just make your offer more appealing.
This can come in several forms. You can put down a larger amount of earnest money or earnest money deposit (EMD). An EMD doesn’t necessarily cost you any more, it just means your serious about purchasing the home. In most states, you can easily get your earnest money back should you cancel your contract. The exception is when there is serious breaches of contract.
You may also be able to put a larger down payment towards your purchase. This makes any problems with financing less likely. Are you in a seller’s market? Offer to pay the difference between the appraisal price and your purchase price. For example, you might say, “Buyer is willing to pay the difference between appraised value and purchase price, up to $10,000 above appraised value with maximum purchase price of $310,000”.
Remove contingencies with your counter offer
Not every contingency will be acceptable. Keep in mind that some agents ask for the world, hoping the seller will simply say yes.
For example, we routinely receive offers from buyers with a contingency for the sale of the their home. Sometimes, the buyer’s home isn’t even listed for sale yet. Most of the time, we would simply reject these offers. However, what if you own a home that is more difficult to sell? You might want to consider accepting their offer, but negotiate timelines of when their home must be listed and sold by.
Kick Out clauses
When your buyer’s purchase is conditional upon the sale of their home, you may negotiate a kick out clause. Kick out clauses allow the seller to continue to market their home for sale and potentially accept another offer. Kick out clauses require that the original buyer be notified in writing that you have a competing offer. Your kick out clause would then have a specific time frame in which your original buyer needed to remove all of their contingencies. If they do not remove their contingencies, the seller can cancel the contract and move on to the second buyer. Usually, these time frames are 48 to 72 hours for the original buyer to remove all of their contingencies or cancel the contract.
Passive versus active removal of contingencies
Most contracts require that contingencies be removed in writing. However, not every agent, buyer or lender is timely in removing contingencies. It’s not uncommon for a seller’s agents to have to contact buyer’s agents to get written contingency releases. Technically, buyers are failing to perform if they do not release contingencies by the contract date. However, threatening buyers with a Notice to Perform is usually frowned upon.
An alternative to requiring removal in writing is allowing contingencies to removed passively. Passive removal simply means that contingencies do not have to be removed in writing. Passive removal happens when the date agreed upon passes without the buyer exercising the option to cancel the purchase. Not every real estate agent understands passive removal. Additionally, some brokers will not allow their agents to accept passive release clauses. However, in hot seller markets, we will sometimes negotiate for passive removal.
Motivating buyers for speedy contingency removal
With high demand properties or sellers’ markets, sellers can charge per Diem fees if buyers close escrow late. For instance, we sometimes add the following clauses to our contracts. “Buyer will pay $125 per day should buyer not close escrow on time agreed. Seller agrees to pay buyer $125 per day for each day buyer closes prior to the time agreed.”.
This is very common when buying bank owned properties. Banks will charge buyers a couple of hundred dollars a day, for every day the buyer closes late. These fees are not exorbitant, but can be very motivating to buyers to make sure their transaction moves quickly. While I don’t typically add a per Diem to contingency releases, I will often add this to the close of escrow date.
Alternatives to contingent offers
Contingent offers make up the majority of purchase offers for homes. However, there’s a small portion of offers that have little to no contingencies. These typically come from cash buyers. Cash buyers are not dependent on bank loans and can buy homes in need of repair. Cash buyers can get a bad reputation from those who only offer low ball prices. However, every Realtor® I’ve ever met has at least one cash buyer in their contact list. When these agents have a home that needs need to be sold as is, they’ll call their local investor buyer. If you’re looking to sell your home quickly and with the least amount of contingencies, a cash buyer may be an option.
Contingent offers make up over 80% of the typical real estate transactions. Knowing what contingencies you are willing to agree to is part of the give and take during negotiation. Remember, you don’t have to accept every contract condition blindly. You can also counter any offer and negotiate alternatives, and shorten time periods. And you can insist that buyer’s home must already be in escrow if a selling their home is a contingency. Be specific about timelines and use per Diems as incentives.
Just be flexible, try to understand the other party’s needs and try to find a common ground.