The ideal real estate contract benefits both parties and allows everyone to walk away happy. However, there are many reasons why a real estate deal may fall apart. If you are buying or selling a home or property in the near future, you will want to familiarize yourself with real estate contingencies to prepare for a smooth transaction.
A contingency is a clause that is included in a purchase offer that places conditions on the transaction. If the conditions are not met in time, the deal may be invalidated. Contingencies are common in the real estate industry and can be beneficial to both parties, if used correctly. However, they can also be abused and cause adverse results for the transaction, so it is best to understand how contingencies work to ensure they are used for you (not against you) in your next real estate deal.
Smart buyers are hesitant to enter into such a large transaction without an “in case of emergency” option, but contingencies are still sometimes viewed negatively by real estate agents, as they can terminate the entire transaction. However, they are actually an essential component of a real estate transaction, put in place to help both sides work towards a successful and ethical deal. Contingencies are negotiable, so neither party is forced to sign anything they are not comfortable with, and the details of a transaction can be refined to compensate for a contingency.
There are several types of contingencies that may be used in the real estate industry, but there are 4 types most commonly seen in a standard transaction:
A buyer who is not comfortable purchasing a home without an independent appraiser’s inspection can exercise their right to an appraisal contingency. This helps the buyer feel confident about their transaction and provides reassurance to any involved lenders if they feel a buyer may be at risk of overpaying for a property, or that the asset (property) is not sufficient collateral for the loan.
If an appraisal indicates the home’s value is below the asking price, a lender may not provide all the necessary funding, and the buyer may hold the right to terminate the transaction if they do not want to produce the rest of the money or negotiate a reduced price with the seller. It’s important to remember that a contingency does not automatically terminate a transaction, but it does provide an escape option for both parties if they fail to complete the contingencies.
A buyer may be denied funding for a number of reasons, and a mortgage or loan contingency takes into account the need for adequate funding when purchasing a home. This contingency allows the buyer to safely back out of the transaction without being held legally responsible if they are denied a loan. This contingency type usually requires a long contingency period. It mostly benefits the buyer, protecting from a situation of “the eyes being bigger than the pocketbook”. The bank loan process, in most instances, takes close to or beyond thirty (30) days. A strong buyer will be more appealing to sellers by obtaining a pre-approval letter from their lender before shopping for their property and showing that the loan contingency will not be an obstacle.
Crafty buyers may use this contingency to get out of a deal by merely claiming they could not get funding. A sneaky buyer might place rate caps and loan terms into the loan contingency for further protection. This safeguards the buyer if they are only able to get a loan on unfavorable terms (high interest rate, points, down payment, etc.), allowing them to back out of the deal by stating their loan terms did not meet the terms of the contingency.
A home inspection contingency hinges on an inspection by a third party for defects within the structure, foundation, systems, land, or function of the home. This differs from the appraisal contingency in that no valuation tools are used during this inspection. If any previously unreported defects are found in the home within the contingency period, the buyer may legally exit the transaction.
This contingency may be used to the benefit of the buyer. In some instances a desperate buyer will over-bid for the property in order to get into a Purchase and Sale Agreement (PSA). If and when defects or items of correction are noted in the inspection, the buyer can then use the costs of repair and replacement as a further negotiation tool to reduce the sale price and/or get credits in escrow.
Sellers are not obligated to accept any demand for a credit or to make any repairs. However, some sellers are anxious to consummate the transaction and make certain concessions. This is an area for further bargaining between both the seller and buyer.
If a buyer is selling their current residence in order to purchase a new home, they may protect themselves by utilizing a home sale contingency, wherein the sale of their home is added as a condition required to complete the transaction. If their home does not sell, the buyer can back out of the transaction without legal ramifications. If the contingency is not met within the contingency period, the seller is free to move to the next offer.
While many people cannot afford multiple mortgages, this tool is used for protection to the buyer. However, these days there are many buyers who may not need to sell their current property or have worked out other arrangements. As such, a buyer who demands a home sale contingency may not even be considered by a seller because of the many unknowns around when the buyer’s other home may sell and/or fall out of escrow. Savvy sellers will not permit a home sale contingency or will put severe restrictions on one.
Contingency periods can not go on indefinitely, but they are negotiable, so the duration can vary. In California, if a party does not clearly state a contingency period’s duration, the default time frame is short, sometimes as few as five (5) days. Once the seller accepts the buyer’s offer, the contingency period for any proposed contingencies begins. In light of the strict time deadlines, the buyer must act quickly. It is suggested that home inspections (of as many disciplines as possible) be lined up and conducted immediately. If there is no loan pre-approval, it is important to immediately secure the assistance of a mortgage broker or other lender.
A contingency can be completed by satisfying the condition (e.g. inspection) or at the conclusion of the contingency period, assuming there is no dispute. In the state of California, a contingency removal form must be submitted by the buyer in order to officially complete the contingency. If the buyer does not submit the removal form, the seller has the right to submit a notice to perform, giving the buyer notice to complete the contingencies or officially terminate the contract. If the buyer does not proclaim their intent to terminate, the seller may then terminate the transaction. The buyer may also choose to remove their requested contingencies and move forward with the transaction.
A terminated transaction is never the goal of a contingency, and is not the outcome either party seeks when entering into a real estate contract. In most situations, contingencies are put in place to ensure both sides are benefiting from the transaction. Agreed upon contingency periods should not cause a long transaction delay. Clear communication from the real estate agents is necessary throughout the contingency period to keep tension low and ensure all parties remain happy.
Litigation often results from the failure to meet a contingency or the stale performance of an agreed contingency. It is therefore very important to comply with each contingency period or obtain a written extension. If the seller causes a delay in the performance of the work necessary to evaluate the contingency, seller and the agent may be placed on notice of such interference and the buyer may demand an extension.
In the event that a contingency is waived, missed, or ignored, and no more contingencies exist, the buyer is often obligated to consummate the transaction, or else there is a forfeiture of the earnest money deposit (usually 10% of the purchase price). If this is not paid, the seller will issue a Notice to Perform (NTP), permitting the buyer a few days to fully perform. If there is no performance, litigation often results. In California, typically, California Association of Realtors (C.A.R.) forms are used. These typically contain mandatory mediation and arbitration provisions and permit the successful party to recover their attorney’s fees and costs. As such, any breach must be taken quite seriously.
A real estate attorney is the best way to secure your Investment and property ownership. Having an experienced real estate lawyer by your side, especially one who also has an expertise in business law, provides you with the strength and security you need. Whether you are an investor, developer, contractor, homeowner, or property owner, it is pivotal that you have counsel to help you navigate the surprises that are often hidden in contracts, filings, property transfer, and titles of a new property. Contact us at Steinberg Law to help you close on your next opportunity.